What the term hedging refers to in the financial industry is it offsets financial risk. So what needs to be realized are the circumstances to hedge. The Futures Market as we know it today, was originally developed as an exchange to hedge product.
The purpose of the Futures Market which was originally established in Chicago in the early 1800’s, was designed to insulate and protect the farmers during that time, from the risk of adverse price swings in their crops, enabling them to price protect their commodity from loss.
The first commodity products were as a result agricultural based, such as corn, wheat, sugar, soybeans, and then eventually other derivatives were included, such as Interest Rates, Stock Indices, Precious Metals, Currency, Steel, Oil and Gas, etc.
The real intent of the Futures exchange was created as a method to hedge, and not for profit speculation as it is today, but the speculator plays a beneficial role as they increase trading volume and volatility in the markets, which would otherwise be stagnant.
Why Hedge
Someone who hedges has an actual product to buy or sell, be it orange juice or lumber. What they’ll do is establish an off-setting position in the commodity exchange, which establishes a firm guaranteed price for their product.
Someone who buys a hedge is “Taking Delivery” or going “Long” in traders jargon. Someone who’s selling a hedge is “Making Delivery” or going “Short.” These positions known as “Contracts,” are strictly enforced by the exchange and legally binding.
Examples Of Hedging
Hedging is the mitigation of risk by buying or selling exchange traded derivatives.
Example 1: A mutual fund manager has a portfolio that’s valued at $10 million, and it closely resembles the movements of the S&P 500 Index.
The Portfolio Manager predicts that the economy is about to worsen resulting in deteriorating corporate returns, which will be reflected in the quarterly corporate earnings report that’s due in the next few weeks.
Until he finds out which companies in the report will have poor earnings, his biggest concern are the results from a short-term market correction. So since he doesn’t have the privilege of foresight, he’s not sure of the magnitude that the earnings figures will produce.
He thinks of his options, the biggest risk is he does nothing. If the market happens to fall as expected, he’ll risk giving up all recent gains. If he happens to short his portfolio too early, he can risk being wrong and then miss out on a potential rally.
So he realizes that a hedge is the best option, this to mitigate his short term risk. What he decides to do is place an order to short (sell) the equivalent of $10 million of the S&P 500 Index.
So if the market falls as expected, he’ll off-set any losses in his portfolio with the gains that he realizes from the S&P 500 Index hedge. If the earnings report happens to be better than expected, and his portfolio continues to go upwards, he’ll then increase the portfolios profit.
Soon after the report, he can close the hedge by buying back the equivalent number of contracts. So regardless of how the market reacts, he was protected during the period of uncertain short term volatility, thus posing no risk on the portfolio.
Example 2: A US electronics company has recently won a contract to deliver $5 million in electronic components to a retailer located in Europe. These components are to be built in 5 months, for delivery on site in 2 months after that.
The manufacturer realizes that they’re exposed to two separate risks.
• The current increasing price and volatile nature of copper in the next 5 months could potentially result in a loss of profit.
• The fluctuating price in the US dollar and Euro could easily compound those losses.The company can’t absorb any losses because of the highly competitive market and low margins. Any significant loss from this contract could result in potential plant closure.
AdSo the company decides to place two hedges, both set to expire in 7 months, the date of delivery.
The first hedge is to go long (buy) $5 million of copper contracts which locks in today’s current price against any further price increases. They’ve now eliminated the potential price increase of copper.
The second hedge is to sell (short) the equivalent Euro Currency vs the US Dollar, this because the company is accepting Euros as payment. A rising US dollar and a weakening Euro would be detrimental, as it would erode profits further.
The end result of the hedging eliminates all risk while posing no surprises to the manufacturing firm, in either the potential fluctuating copper or currency prices.
What results is a risk free transaction along with full transparency. In 7 months, the order is completed and the customer accepts delivery, The company then notifies their commodities broker to close out the hedge positions by selling the copper, and then buying back the Euro/USD currency contacts.
Example 3: A farmer decides to hedge his crop of corn, this because of the constant fluctuation of its supply and demand, which will often experience price swings going in either direction.
So regardless of the current price of corn and the forecasted price at harvest, the farmer goes ahead and plants his corn despite the forecasts, so he’s committed himself to growing the corn for the season.
If the actual price of the corn rises significantly between planting and harvest, the farmer will then stand to make additional profits, but if the price happens to drop at harvesting time, his losses could be devastating.
So if the farmer at planting time shorts (sells) the same number of corn futures contracts which is equivalent to his expected crop size at harvest, what he’s doing is locking in the price of corn at the time of planting.
The contract agreement is to deliver a certain number of corn bushels to a specified place on a certain date sometime in the future, this for a certain fixed price.
What the farmer did was he hedged his exposure to the fluctuating corn prices, so as a result, he doesn’t care if the price of corn goes up or down, this because he’s guaranteed that price by the corn contracts.
There’s no longer the worry he could be wiped out by lower corn prices at harvest, while also giving him the opportunity of making additional profits from a higher corn price at harvest.
However, the hedge introduces a risk to the farmer. Since he has committed to sell a certain amount of expected crop, if he happens to have a bad year which results in lower than expected yields, and he’s not able to meet the quantity that he committed to, he’ll then need to purchase replacement crop at a worse price, this to equal his futures contract.
Hedging Is Price Protection
Hedging is a strategy that involves the reduction of the risk of price fluctuations, serving as a form of insurance. Hedging is used by anyone who’s uncertain of the future price of a commodity, usually a short term fluctuation.
Hedging offsets or reduces the risk of a potential price movement of an asset, security, or a position that’s currently held.
The Speculators Hedging Of Commodities
Market speculators on the other hand view hedging slightly differently because they’re not protecting an actual asset, but rather they’re protecting a market position.
The typical speculative hedge will use options which are related to the underlying contracts that’s being traded. The end game however is the same where the positions are protected.