basic principles of hedging

Basic Principles of Hedging,

NCDEX Institute of Commodity Markets and Research (NICR)

NCDEX Institute of Commodity Markets & Research2

Price Risk

To avoid this price risk manufacturers can buy and store the raw materials when prices are low. This would however: Block capital Increase storage costs

Alternative solutions: Pass on the price risk to the customers Enter into long term fixed price contracts with commodity suppliers Hedge in futures market

Increase in Price in the future

Reduction in Price in the future

Effect on Seller Profit Loss

Effect on Buyer Loss Profit


Basic principles of hedging

Hedgers are market participants who want to transfer risk

Hedgers could be producers or consumers

Producer hedgers want to transfer the risk arising from the possibility that prices could decline by the time their produce is ready for sale

Consumer-hedgers want to transfer the risk arising from the possibility that the prices will increase before purchases are made


Hedging strategies

There are two main types of hedges

Short hedge

Long hedge


Short hedge

An individual or a company wishing to sell an asset at a particular time in the future can hedge by taking a short futures position

When the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those initially sold

This is known as a ‘short’ or a ‘selling hedge’

A short hedge is appropriate when the hedger owns the commodity or is likely to own it and expects to sell it sometime in the future


Long hedge

An individual or a company wishing to buy an asset at a particular time in the future can hedge by taking a long futures position

When the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those purchased

This is known as a ‘long’ or a ‘purchasing hedge’


Advantages of hedging

Hedging stretches the marketing period The futures market allows a farmer to lock-in a price for his

produce even before it is ready for harvest

Hedging protects inventory values A merchandiser with a large, unsold inventory can sell futures

contracts that will protect the value of the inventory, even if the price of the commodity drops

Hedging permits forward pricing of products A manufacturer can determine the cost of raw materials by

buying a futures contract, translate that price to a price for the finished products, and make forward sales to stores at firm prices


Limitations of hedging

Hedging can only minimize the risk but cannot fully eliminate it.

The expiry date of the hedge may be later than the delivery date of the futures contract.

The hedger would then be required to close out the futures contract and take the same position in futures contract with a later delivery date. This is termed as a ‘rollover’ contract.

Multiple rollovers could lead to short-term cash flow problems

If prices behave contrary to expectations during the period margin calls will have to be paid, leading to short term cash outflows that maybe of high magnitude


Basis

Basis is the difference between the futures price (F) and the spot price (S). For commodities, it is given by

S – F

If the difference is a positive number, the basis is said to be ‘over’

If the difference is a negative number, the basis is said to be ‘under’

The ‘over-under’ terminology is used by the hedgers to describe the nature of trade


Basis …contd.

If the spot prices increases more than the futures price, the basis increases. This is called ‘strengthening of the basis’

If the futures price increases more than the spot price, the basis decreases. This is called ‘weakening of the basis’

When a hedger is in short futures, strengthening of the basis increases his gains

When a hedger is in long futures, weakening of the basis creates gains

If the asset to be hedged and the asset underlying the futures contract are the same at the time of expiration of the futures contract, convergence of futures and spot price will ensure that basis is zero


Basis risk

Basis risk is defined as the risk that a futures price will move differently from that of its underlying asset

The factors responsible for basis risk are; Supply and demand factors Transportation Storage availability Seasonality of harvest Potential demand and supply conditions


Cross hedging

We had assumed that the asset that gives rise to the hedger’s exposure is the same as the one underlying the futures contract for hedging

This may not be so if that asset is not traded on the futures exchanges

Thus the hedger has to hedge using an asset as identical to physical asset as possible

This further increases the basis risk

This kind of hedging is called cross/surrogate hedging


Reasons for cross-hedging

The reasons for cross-hedging are:

The hedging period may exceed the futures expiration period

Quantity to be hedged may not match the futures contract quantity

Differences in the physical characteristics of cash and futures contract commodities


Hedge ratio

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure

When the asset underlying the futures contract is the same asset whose exposure is being hedged, the hedge ratio will be 1

When the hedger has to resort to cross hedging, a hedge ratio of 1 may not be optimal

In that case the hedger must choose a ratio that minimizes the variance of the value of the hedged position, i.e. the deviation from the expected payoff should be minimized


Optimal hedge ratio

H = ρ (σS/σF)

where H = hedge ratio σS = standard deviation of changes in spot price

S for a period equal to the time of the hedge σF = standard deviation of changes in futures

price F for a period equal to the time of the hedge

ρ = correlation coefficient between changes in spot price and changes in futures

price for a period of time equal to the life of the hedge

If ρ = 1, σS = σF and H = 1, there is a perfect correlation between futures price and spot price


Optimal number of contracts

Let NA be the size of the position being hedged in units

QF be the size of one futures contract in units

N be the optimal number of contracts for hedging

The optimal number of contracts is then given by the formula

N = (H* NA ) QF


Optimal Number of Contracts

A company wants to buy 22,000 bales of cotton after 3 months

Suppose one futures contract is of 11 bales.

Standard deviation of the change in spot price of cotton over a period of three months is 0.030 and the standard deviation of the change in futures price is 0.040

Coefficient of correlation between change in spot price and futures price is 0.80


Solution

Optimal Hedge Ratioh* = 0.80 x (0.030/0.040) = 0.60

Thus optimal number of contracts = 0.60 x (22000/11) = 1200


Surrogate Hedging

If a commodity is not available/listed on the exchange then the trader can take a hedge position in a similar commodity which has a high price correlation with original commodity

When futures are not available for end products, surrogate hedging strategy can also be adopted using the futures of the primary raw material, provided there is a price correlation between the listed commodity (raw material) and the end product


Example

ABC Steels is a manufacturer of ingots. It has entered into a contract for importing iron scrap at Rs. 13500/MT. The material would reach India after one-month

The company wants to cover the potential downside risk in scrap during this one month and the consequent impact on price of ingots

However, futures contract in iron scrap is not available.

Thus, the company decides to hedge the price exposure through surrogate hedging with MS ingot futures.


Example

Spot Market Futures Market

Today Iron scrap imported at Rs. 13,500/MT Ingot price at Rs. 18,000/MT

Sell three-month MS Ingot futures contract at Rs. 19,000/MT

One month later when consignment arrives

Iron scrap price falls to Rs. 12,000/MT Ingot price falls to Rs. 17,000/MT

Buy back Ingot futures at Rs. 18,000/MT

Realization Sell Ingot in spot market at Rs. 17,000/MT Gain from Ingot futures is Rs. 1,000/MT Total realization is (17,000 + 1,000) = Rs. 18,000/MT


Thank You

basic principles of hedging

Documents