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Hedging Many participants in the commodity futures market ar e hedgers.

They use the futures market to reduce a particular risk that they face. This ri sk might relate to the price of wheat or oil or any other commodity that the person deals in. The classic hedging example is that of wheat farmer who wants to hedge the risk of flu ctuations in the price of wheat around the time that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking into a predetermined price. Hedging does not necessarily improve the financial outcome; What it does however is, that it makes the outcome more certain. Hedgers could be government institutions, priv ate corporations like financial institutions, trading companies and even othe r participants in the value chain, for instance farmers, extractors, millers, processors etc., who are influenced by the commodity prices. 7.1.1 Basic Principles of Hedging When an individual or a company decides to use the futures markets to hedge a risk, the objective is to take a position that neutralizes the risk as much as possible. Take the case of accompany that knows that it will gain Rs.1,00,000 for each 1 rupee incr ease in the price of commodity over the next three months and will lo se Rs.1,00,000 for each 1 rupee decrease in the price of a commodity over the sam e period. To hedge, the company should take a short futures position that is designed to offset this risk. The futures position should lead to a loss of Rs.1,00,000 for each 1 rupee increase in the price of the commodity over the next three months and a gain of Rs.1,00,000 for each 1 rupee decrease in the price during this period. If the price of the commodity goes down, the gain on the futures position offsets the loss on the commodity . If the price of the commodity goes up, the loss on the futures position is offset by the gain on the commodity

There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. This is called short hedge. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. We will study these two hedges in detail

S h o rt He d ge A short hedge is a hedge that requires a short position in f utures contracts. As we said, a short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. F or example, a short hedge could be used by cotton farmer who expects the cotton crop to be ready for sale in the next two months. A short hedge can also be used when the asset is not owned at the moment but is likely to be owned in the future. For example, an exporte r who knows that he or she will receive a dollar payment three months later. He makes a gain if the dollar increases in value relative to the rupee and makes a loss if the dollar decrease s in value relative to the rupee. A short futures position will give him the hedge he desires. Let us look at a more detailed example to illustrate a short hedge. We assume that today is the15th of January and that a refined soy oil producer has just negotiated a contract to sell10,000 Kgs of soy oil. It has been agreed that the price that will apply in the contract is the market price on the 15th April. The oil produ cer is therefore in a position where he will gainRs.10000 for each 1 rupee increase in the price of oil over the next th ree months and loseRs.10000 for each one rupee decrease in the price of oil during this period. Suppose the spo t price for

soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.465 per 10 Kgs. The producer can hedge his exposure by selling 10,000 Kgs worth of April futures contracts (1 unit). If the oil producers c loses his position on April 15, the effect of the strategy would be to lock in a price close t o Rs.465 per 10 Kgs.

L o n g He d ge Hedges that involve taking a long position in a futures con tract are known as long hedges. Along hedge is appropriate when a company knows it will have to pur chase a certain asset in the future and wants to lock in a price now. Suppose that it is now January 15. A firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract. The spot price of silver isRs.26800 per kg and the April silver futures price is Rs. 27300 per kg. Table 7.2 gives the contract specification for silver. A unit of trading is 30 kgs. The fabricator can hedge his position by taking a long position in ten units of futures on the NC DEX. If the fabricator closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs. 27300 per kg. Figure 7.2 gives the payoff for the buyer of a long hedge. Let us look at how this works. On April 15, the spot price can either be above Rs. 27300 or below Rs. 27300 per kg

Advantages of Hedging Besides the basic advantage of risk man agement, hedging also has other advantages: 1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait until his cattle are ready to market before he can sell them. The futures market permits him to sell fut ures contracts to establish the approximate sale price at any time between the time he buys his calves for feeding and the time the fed cattle are ready to market, some four to six months later. He can take advantage of good prices even thou gh the cattle are not ready for market. 2. Hedging protects inventory values. For example, a merchandiser with a la ge, unsold inventory can sell futures contracts th at will protect the value of the inventory, even if the price of the commodity drops. 3. Hedging permits forward pricing of products. For example, a jewellery ma nufacturer can determine the cost for gold, silver or platinum by buying a futures contract, translate that to a price for the finished p roducts, and make forward sales to stores at firm prices. Having made the forward sales, the manufacturer can use his capital to acquire only as much gold, silver, or platinum as may be needed to make the products that will fill its orders. 7.1.6 Limitation of Hedging: Basis Risk In the examples we used above, the hedges consider ed were perfect. The hedger was able to identify the precise date in the future when an ass et would be bought or sold. The hedger was then able to use the futures contract to remove almost all the risk arisin g out of price of the asset on that date. In reality, hedgi ng is not quite this simple and straightforward. Hedging can only minimize the risk but cann ot fully eliminate it. The loss made during selling of an asset may not always be equal to the profits made by taking a

short futures position. This is because the value of the asset sold in the spot market and the value of the asset underlying the future contract may not be the same. This is called the basis risk. In our examples, the hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use the perfect futures contract to remove almost all the risk arising out of price of the asset on that date. In reality, this may not always be possible for various reasons. 1. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. For example, in India we have a large number of varieties of cotton being cultivated. It is impractical for an Exchange to have futures contracts with all these varieties of cotton as an underlying. The NCDEX has futures contracts on me dium staple cotton. If a hedger has an underlying asset that is exactly the same as the one that underlies the futures contract, he would get a better hedge. But in many cases, farmers producing small staple cotton could use the futures contract on medium staple cotton for hedging. While this would still provid e the farmer with a hedge, since the price of the farmers cotton and the price of the cotton underlying the futures contract would be related. However, the hedge would not be perfect. 2. The hedger may be uncertain as to the exact date when the asset will be bought orsold. Often the hedge may require the futures contract to be closed out well before its expiration date. This could result in an imperfect hedge . 3. The expiration date of the hedge may be later than the delivery date of the futures contract. When this happens, the hedger would be required to close out the futures contracts entered into and take the same position in futures contracts with a later delivery date. This i s called a rollover. Hedges can be rolled forward many times. However, multiple rol lovers could lead to short-term cash flow problems