Hedging is a way to transfer risk. A hedge is established in one market to offset price risk in another. The concept of hedging applies to a whole range of commodities and financial instruments such as interest rate and currency risk.
If the cost for an item to be hedged is currently $20 but a marketer will not have to purchase it for use or resale until 3 months from now, and if prices go up to $40, the marketer will have to spend double the money for the item. This could severely impact the bottom line because it may not be possible to pass on all of the costs and still remain competitive. What can be done to avoid such a dilemma?
A marketer can transfer such price risk by purchasing a futures contract or using another financial instrument. For example:
With prices at $20, he can enter into an agreement to buy hypothetically 100 units of a commodity at $20 per unit. He does not necessarily have to take delivery of the commodity. He can simply sell out of the contract to offset his position and thereby relieve himself of the obligation to take delivery. The hedger is just using the futures market to act as a substitute transaction for his local market.
In the above scenario, nothing would change for his physical transactions. The hedger would pay $40 for the physical commodity on May 1. The extra expense would cause him to spend another $2000 from the price in February. However, the $20 gain from buying futures at $22 on February 1 and selling them out at $42 on May 1 would cause his futures account to have an extra $2000 in it. In essence, the hedger transferred price risk. It should also be noted that futures and local physical prices need not be the same exact price level. The prices for the 2 markets simply need correlate in order to use the futures to hedge a local market.
The above example is a “long hedge” or a “substitute purchase”. (The same concepts apply in reverse to hedge against declining prices.) Had prices declined, the hedger would have lost money on the futures but would have the opportunity to buy his local physical market cheaper. A long hedge is considered a cash flow hedge for accounting purposes. Hedging is not about making money but it is about transferring price risk and is therefore conservative. A hedger has to concede that they will make money on one side of the hedge and lose on the other.
Since hedging is conservative, it is appealing to lending institutions to know that their customers can determine what cash flows may be. Otherwise, if a company does not hedge, it is subject to market fluctuations and is gambling or taking on unforeseen risk. Hedging takes the guesswork out of pricing.
Steve Murphy
Murphy Futures
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