Hedging 201

In the last article on hedging, we discussed how to hedge against price increases. However, hedging the downside affords a hedger a way to transfer risk if prices fall.  Let’s say an exporter buys and sells commodities but is concerned about an economic slowdown affecting sales. The exporter is concerned that his mounting inventory is going to be worth less and less if prices continue to decline.  The exporter decides to insure part of his inventory. The company has all types of insurance but the company does not have any insurance on its inventory so the exporter decides to insure part of his company’s inventory.  The hedger decides that initially hedging half of his inventory is a good starting point. If prices decline, he benefits from the protection on the hedged portion of his inventory but is only subject to price risk on half of his inventory. If prices rise, the hedger will concede price appreciation on the half of the inventory that is hedged but will still be able to sell the other half that is not hedged at higher prices. This is a win-win situation for the hedger.

If prices increased rather than declined over the life of the hedge, the hedger would have conceded that he would have lost on the futures but would have the benefit of still being able to sell half of his inventory at higher prices.

On February 1st, the hedger decided to “short” the market at $40. Shorting the market is a term used to describe protecting against the downside. Whether it is a commodity or a stock, “shorting” a market is a way to sell something in advance but you must buy it back at a future date. The sale and subsequent buy offset just the same way buying it first and then selling would.   So in the above example, the hedger sold the market at $40 per unit and then bought in back on May 1st   for $20 to yield a gain of $20 per unit. This $20 gain offsets the $20 loss on inventory in his physical market.

Since hedging is about transferring risk, it is conservative. Lending institutions like to see companies protecting against extreme swings in their balance sheet. A stable company is a creditworthy company. Implementing a hedge program would make the balance sheet of a company more attractive to a lending institution.

Steve Murphy
Murphy Futures