|
In the broad sense, hedging is the transfer of price risk from one party to another. More specifically, hedging can proceed in two ways:
Sell or short hedge - An entity (producer, or someone with an inventory) who has or will have a commodity for sale in the future transfers the risk of price change by selling short that commodity now in the futures market. “Selling short” is the present sale of a futures contract with the promise to deliver the commodity or repurchase the contract at a future date. If a contract is sold (short) for $70, the seller will profit if prices decline before he is obligated to deliver the underlying commodity or repurchase the contract. If the price drops from $70 to $50 and the seller opts to repurchase the contract at $50, he keeps $20 as profit.
When a hedger “sells short,” he has two positions: a long cash position (the physical commodity he is holding) and a futures position (short). Because cash and futures prices tend to move in parallel, if prices decline, the value of his cash position declines, but the value of the short futures position increases. You may think of the short hedge as a “substitute sale.” in the futures market, although the final price received depends on any change in the price difference between the two positions during the term of the hedge (basis). Basis is the difference between cash and futures price (Cash - Futures = Basis). Thus, a hedge position in futures may not give full protection against an adverse price movement because of changes in the basis.
Buy or long hedge - An entity (a merchandiser, processor, or user) who will need to purchase a commodity for use or sale at some date in the future can transfer the risk of price change by purchasing futures contracts.“ Buying long” is the purchase of a commodity futures contract with the promise to take delivery of the commodity or resell the contract at a future date. Some people refer to a long hedge as a “substitute purchase.” However, ownership of a futures contract does not transfer title to the underlining commodity. Title transfer happens once a given commodity has been delivered and payment received.
If a futures contract is bought for $70, the buyer will profit if prices rise before he is obligated to take delivery of the underlining commodity or resell the contract. If the price rises from $70 to $90 and the buyer opts to resell the contract at $90, he will have a $20 profit. When a hedger “buys long,” he has two positions: a short cash position (his requirement for the physical commodity) and a futures position (long). If prices rise, he suffers a “loss” in his cash position because cash and futures prices tend to move in tandem. The cash commodity purchase will cost him more, but he will gain on the futures position, which will reduce his net cost (or vice versa). The long hedger may be said to have fixed the cost of the commodity he will be purchasing when he goes “long” in futures, although the final purchase price depends on any change in the price difference between cash and futures during the term of the hedge (basis).
By hedging, producers and users (commercials) can set the prices they will receive or pay within a determinable range. This “price insurance’ aspect of hedging also produces a much smoother cash flow.
This is all made possible by the speculator, who assumes the risk of price change when he takes the futures position opposite the hedger, A speculator doesn’t have a cash position - he usually intends to resell or repurchase the futures contract. He will realize a profit if prices rise (long position) or decline (short position); he will suffer a loss if prices decline (long position) or rise (short position).
The risk of loss from price change is “transferred” because the sale of futures contract to a speculator (speculator establishes a long futures position) enables losses in the short hedger’s cash position to be offset by gains from his short futures position. A long hedger transfers his price risk when the speculator sells futures contracts (establisher a short futures position) and the hedger buys futures contracts. Any loss in the hedger’s cash position can be offset by gains from his long futures position. The remaining risk; i.e., that the cash and futures prices will not move by the same amount, is minimal and is attributed to the change in basis. The hedger reduces his price risk and assumes basis risk. Because basis is less volatile than prices, the hedger effectively reduces his overall price risk.
|
