Betting on futures to hedge future risk

Chiragra Chakrabarty

Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position. Basically, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.

Take chana, for example

Assume that a chana trader ‘A’ has on May 20, 2007 undertaken to supply 10 tonnes of chana to a vendor of sweets on August 20, 2007. He locks in the price of sale on May 20 at the spot price prevailing that day of, say, Rs 2,160 per quintal, which works out to Rs 2,16,000 for 10 mt. Since he plans to buy the chana for delivery to the vendor on August 20, he is exposed to the risk of rising prices of chana between now and August 20. To hedge against this risk ‘A’ buys on May 20 an August contract of 10 mt at Rs 2,186 per quintal from the exchange.

If his prediction is correct and chana spot price rises to Rs 2,507 per quintal, it would result in a concomitant rise in the futures price. Let’s assume the futures price on August 20 is Rs 2,650. Now, the trader has to buy chana from the spot market at a higher price of Rs 2,507 per quintal where he pays Rs 347 per quintal more or Rs 34,700 for 10 mt. However, since the futures price has risen by Rs 464 per quintal (Rs 46,400 per 10 mt), he makes a profit by squaring off his futures position, i.e., he sells one lot (10 mt). ‘A’ thus effectively offsets his loss in the spot market by making a gain in the futures market. His net purchase price works out to Rs 2,043, earning him a gain of Rs 117 per quintal.

The futures market has substantial participation by speculators who take positions based on the price movement and bet upon it. There are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

Or steel, for that matter

In another example, let us take an automobile manufacturer who purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the East European market. This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected.

Let us analyse the different scenarios:

• Increasing steel prices: If steel prices increase, this would result in an increase in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes a profit in the futures transaction. But, the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market. But, this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.
• Decreasing steel prices: If steel prices decrease, this would result in a decrease in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means, he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.

This results in a perfect hedge to lock in the profits and protect him from an increase or decrease in raw material prices. It also provides the added advantage of just-in-time inventory management for the automobile manufacturer.

The different ways you can do it

i) Buying/long hedge

A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge a cash position. Dealers, consumers and fabricators, etc, who have taken or intend to take an exposure in the physical market and want to lock in prices, use the buying hedge strategy.

The benefits of a buying hedge strategy are as follows:

• Replacing inventory at a lower prevailing cost
• Protecting uncovered forward sale of finished products

The purpose of entering into a buying hedge is to protect the buyer against price increase of a commodity in the spot market that has already been sold at a specific price but not purchased as yet. It is very common among exporters and importers to sell commodities at an agreed-upon price for forward delivery. If the commodity is not yet in possession, the forward delivery is considered uncovered.

Long hedgers are traders and processors who have made formal commitments to deliver a specified quantity of raw material or processed goods at a later date, at a price currently agreed upon and who do not have the stocks of the raw material necessary to fulfil their forward commitment.

ii) Selling/short hedge

A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to hedge.

Its benefits include:

• Covering the price of finished products
• Protecting inventory not covered by forward sales
• Covering the prices of estimated production of finished products

Short hedgers are merchants and processors who acquire inventories of the commodity in the spot market and who simultaneously sell an equivalent amount or less in the futures market. The hedgers in this case are said to be long in their spot transactions and short in the futures transactions.

Understand the basis

Usually, in the business of buying or selling a commodity, the spot price is different from the price quoted in the futures market. The futures price is the spot price adjusted for costs like freight, handling, storage and quality, along with the impact of supply and demand factors. The price difference between the spot and futures keeps on changing regularly. This price difference (spot-futures price) is known as the basis and the risk arising out of the difference is defined as basis risk. A situation in which the difference between spot and futures prices reduces (either negative or positive) is defined as narrowing of the basis. A narrowing of the basis benefits the short hedger and a widening of the basis benefits the long hedger in a market characterised by ‘contango’ - when futures price is higher than spot price. In a market characterised by ‘backwardation’ - when futures quote at a discount to spot price — a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger.

However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the case of narrowing.

The author is vice-president - training, consultancy & research initiatives at the Multi Commodity Exchange of India Ltd. The views expressed herein are his own.