How to use commodity futures to hedge

Futures are a popular asset class used to hedge risks. Strictly speaking, investment risk can never be completely eliminated, but its impact can be mitigated or passed on. Hedging through future agreements between the two parties can be traced back to the 1800s. The Chicago Board of Trade standardized futures contracts in 1865, allowing farmers and dealers to trade grain and other soft commodities on future trading dates throughout the year.

Key points

  • Hedging is a way of reducing risk exposure by establishing offset positions in closely related products or securities.
  • In the commodity world, both consumers and producers of commodities can use futures contracts for hedging.
  • Futures hedging effectively locks in the price of today’s commodities, even if it will actually be bought and sold in physical form in the future.

Hedged goods

Let’s take a look at some basic examples of the futures market, as well as the prospects for returns and risks.

For simplicity, we assume that a unit of commodity can be a bushel of corn, a liter of orange juice, or a ton of sugar. Let us look at a farmer who expects to sell a unit of soybeans in 6 months. Assume that the current soybean spot price is $10 per unit. After considering planting costs and expected profits, he hopes that once his crops are ready, the minimum selling price will be $10.10 per unit. The farmer is worried that oversupply or other uncontrollable factors may cause future prices to fall, thus causing him to suffer losses.

The following are the parameters:

  • Farmers expect price protection (minimum $10.10).
  • Need to provide protection within a specified time period (six months).
  • The quantity is fixed: the farmer knows that he will produce a unit of soybeans within a specified period of time.
  • His goal is to hedge (eliminate risk/loss), not speculate.

The futures contract, according to its specifications, meets the above parameters:

  • They can be bought and sold today to fix future prices.
  • They are valid for the specified time period and then expire.
  • The number of futures contracts is fixed.
  • They provide hedging.

Assume that the six-month expiry one unit soybean futures contract is sold today at a price of 10.10 US dollars. The farmer can sell this futures contract (short sale) to obtain the required protection (lock in the selling price).

How this works: Producer hedging

If the price of soybeans soars to US$13 in six months, farmers will lose US$2.90 on the futures contract (selling price-buying price = 10.10-13.00 US dollars). He will be able to sell his actual crop products at a market price of $13, which will result in a net sales price of $13-$2.90 = $10.10.

If the soybean price stays at US$10, farmers will benefit from the futures contract (US$10.10-US$10 = US$0.10).He will sell his soybeans for $10, and the net selling price is $10 + $0.10 = $10.10

If the price drops to 7.50 US dollars, farmers will benefit from the futures contract (10.10 US dollars-7.50 US dollars = 2.60 US dollars). He will sell his crops for US$7.50, making his net sale price of US$10.10 (US$7.50 + US$2.60).

In all three cases, the farmer can protect the sales price he wants by using futures contracts. Actual crop products are sold at available market prices, but futures contracts eliminate price fluctuations.

Hedging is not without costs and risks. Suppose that in the first case above, the price reaches $13, but the farmer does not hold a futures contract. He could have benefited by selling it at a higher price of $13. He lost an additional $2.90 due to the futures position. On the other hand, in the third case, his situation may be worse, when he was sold for $7.50. If there are no futures, he will suffer a loss. But in all cases, he was able to achieve the expected hedging.

How it works: consumer hedging

Now suppose that a soybean oil manufacturer needs one unit of soybeans in six months. He is worried that soybean prices may soar in the near future. He can buy (go long) the same soybean futures contract and lock the buying price at the level he wants about $10, such as $10.10.

If the price of soybeans soars to US$13, futures buyers will make a profit of US$2.90 on the futures contract (selling price-buying price = US$13-US$10.10). He will buy the required soybeans at a market price of $13, which will result in a net purchase price of-$13 + $2.90 =-$10.10 (negative represents a net outflow of purchases).

If the price of soybeans remains at 10 USD, the buyer will lose money on the futures contract (10 USD-10.10 USD =-0.10 USD). He will buy the soybeans he needs for $10, changing his net purchase price to -$10-$0.10 = -$10.10

If the price drops to 7.50 USD, the buyer will lose money on the futures contract (7.50 USD-10.10 USD =-2.60 USD). He will buy the required soybeans at a market price of $7.50, making his net purchase price -$7.50-$2.60 = -$10.10.

In all three cases, the soybean oil manufacturer was able to obtain the buying price he wanted by using the futures contract. In fact, actual crop products are purchased at available market prices. Futures contracts reduce price fluctuations.

risk

Use the same futures contract with the same price, quantity and duration to meet the hedging requirements of soybean growers (producers) and soybean oil producers (consumers). Both can ensure the price they need to buy or sell goods in the future. The risk has not been transferred anywhere, but has been alleviated-one person loses a higher profit potential at the expense of another person.

The two parties can mutually agree on this set of defined parameters, which leads to a contract to be fulfilled in the future (constitutes a forward contract). Futures exchanges match buyers or sellers to realize price discovery and contract standardization, while eliminating the counterparty default risk, which is particularly prominent in mutual forward contracts.

The challenge of hedging

Although hedging is encouraged, it does bring a unique set of challenges and considerations. Some of the most common include the following:

  • Margin funds need to be deposited, which may not be easy to obtain. If the prices in the futures market are not good for you, even if you own physical commodities, you may need to call for margin.
  • There may be a daily market value requirement.
  • In some cases, the use of futures will take away higher profit potential (as described above). For large organizations, especially those with multiple owners or those listed on the stock exchange, this may lead to different views. For example, due to the increase in sugar prices in the last quarter, sugar company shareholders may expect higher profits, but may be disappointed when the published quarterly results show that profits are ineffective due to hedging positions.
  • Contract size and specifications may not always fully meet the required hedging range. For example, an Arabica coffee “C” futures contract covers 37,500 pounds of coffee, which may be too large or disproportionate to meet producer/consumer hedging requirements. In this case, small mini contracts (if any) may be explored.
  • Standard available futures contracts may not always match physical commodity specifications, which may lead to differences in hedging. A farmer who grows different varieties of coffee may not be able to find a futures contract covering its quality, which forces him to accept only available Robusta or Arabica coffee contracts. At maturity, his actual sales price may be different from the hedging from the Robusta or Arabica contract.
  • If the futures market is inefficient and poorly regulated, speculators can dominate and greatly affect futures prices, resulting in price differences between entry and exit (expiry), thereby canceling hedging.

Bottom line

With the opening of new asset classes through local, national and international exchanges, it is now possible to hedge everything. Commodity options are an alternative to futures that can be used for hedging. Care should be taken when evaluating hedged securities to ensure that they meet your needs. Remember, hedgers should not be tempted by speculative gains. When hedging, careful consideration and focus can achieve the desired effect.

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