Basic Principles of Hedging

Basic Principles of Hedging,
NCDEX Institute of Commodity Markets and Research (NICR)
Price Risk
Increase in Price in the future Effect on Seller Effect on Buyer Profit Loss Reduction in Price in the future Loss Profit
To avoid this price risk manufacturers can buy and store the raw materials when prices are low. This would however:
Block capital Increase storage costs
Alternative solutions:
Pass on the price risk to the customers Enter into long term fixed price contracts with commodity suppliers Hedge in futures market
NCDEX Institute of Commodity Markets & Research
Basic principles of hedging

Hedgers are market participants who want to transfer risk Hedgers could be producers or consumers Producer hedgers want to transfer the risk arising from the possibility that prices could decline by the time their produce is ready for sale Consumer-hedgers want to transfer the risk arising from the possibility that the prices will increase before purchases are made
Hedging strategies
There are two main types of hedges
Short hedge Long hedge
Short hedge
An individual or a company wishing to sell an asset at a particular time in the future can hedge by taking a short futures position When the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those initially sold This is known as a short or a selling hedge A short hedge is appropriate when the hedger owns the commodity or is likely to own it and expects to sell it sometime in the future
Long hedge
An individual or a company wishing to buy an asset at a particular time in the future can hedge by taking a long futures position When the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those purchased This is known as a long or a purchasing hedge
Advantages of hedging
Hedging stretches the marketing period
The futures market allows a farmer to lock-in a price for his
produce even before it is ready for harvest
Hedging protects inventory values

A merchandiser with a large, unsold inventory can sell futures
contracts that will protect the value of the inventory, even if the price of the commodity drops
Hedging permits forward pricing of products

A manufacturer can determine the cost of raw materials by
buying a futures contract, translate that price to a price for the finished products, and make forward sales to stores at firm prices
Limitations of hedging
Hedging can only minimize the risk but cannot fully eliminate it. The expiry date of the hedge may be later than the delivery date of the futures contract.
The hedger would then be required to close out the futures
contract and take the same position in futures contract with a later delivery date. This is termed as a rollover contract.
Multiple rollovers could lead to short-term cash flow problems If prices behave contrary to expectations during the period
margin calls will have to be paid, leading to short term cash outflows that maybe of high magnitude
Basis
Basis is the difference between the futures price (F) and the spot price (S). For commodities, it is given by SF If the difference is a positive number, the basis is said to be over If the difference is a negative number, the basis is said to be under The over-under terminology is used by the hedgers to describe the nature of trade
Basis contd.
If the spot prices increases more than the futures price, the basis increases. This is called strengthening of the basis If the futures price increases more than the spot price, the basis decreases. This is called weakening of the basis When a hedger is in short futures, strengthening of the basis increases his gains When a hedger is in long futures, weakening of the basis creates gains If the asset to be hedged and the asset underlying the futures contract are the same at the time of expiration of the futures contract, convergence of futures and spot price will ensure that basis is zero
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Basis risk
Basis risk is defined as the risk that a futures price will move differently from that of its underlying asset The factors responsible for basis risk are;
Supply and demand factors Transportation Storage availability Seasonality of harvest Potential demand and supply conditions
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Cross hedging
We had assumed that the asset that gives rise to the hedgers exposure is the same as the one underlying the futures contract for hedging This may not be so if that asset is not traded on the futures exchanges Thus the hedger has to hedge using an asset as identical to physical asset as possible This further increases the basis risk This kind of hedging is called cross/surrogate hedging
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Reasons for cross-hedging

The reasons for cross-hedging are:
The hedging period may exceed the futures expiration
period
Quantity to be hedged may not match the futures
contract quantity
Differences in the physical characteristics of cash and
futures contract commodities
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Hedge ratio
The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure When the asset underlying the futures contract is the same asset whose exposure is being hedged, the hedge ratio will be 1 When the hedger has to resort to cross hedging, a hedge ratio of 1 may not be optimal In that case the hedger must choose a ratio that minimizes the variance of the value of the hedged position, i.e. the deviation from the expected payoff should be minimized
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Optimal hedge ratio

H= where ( S/ F)
H = hedge ratio S = standard deviation of changes in spot price S for a period equal to the time of the hedge F = standard deviation of changes in futures price F for a period equal to the time of the hedge = correlation coefficient between changes in spot price and changes in futures price for a period of time equal to the life of the hedge If = 1, S = F and H = 1, there is a perfect correlation between futures price and spot price
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Optimal number of contracts

Let NA be the size of the position being hedged in units QF be the size of one futures contract in units N be the optimal number of contracts for hedging
The optimal number of contracts is then given by the formula N = (H* NA ) QF
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Optimal Number of Contracts

A company wants to buy 22,000 bales of cotton after 3 months Suppose one futures contract is of 11 bales. Standard deviation of the change in spot price of cotton over a period of three months is 0.030 and the standard deviation of the change in futures price is 0.040 Coefficient of correlation between change in spot price and futures price is 0.80
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Solution
Optimal Hedge Ratio h* = 0.80 x (0.030/0.040) = 0.60 Thus optimal number of contracts = 0.60 x (22000/11) = 1200
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Surrogate Hedging
If a commodity is not available/listed on the exchange then the trader can take a hedge position in a similar commodity which has a high price correlation with original commodity When futures are not available for end products, surrogate hedging strategy can also be adopted using the futures of the primary raw material, provided there is a price correlation between the listed commodity (raw material) and the end product
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Example
ABC Steels is a manufacturer of ingots. It has entered into a contract for importing iron scrap at Rs. 13500/MT. The material would reach India after one-month The company wants to cover the potential downside risk in scrap during this one month and the consequent impact on price of ingots However, futures contract in iron scrap is not available. Thus, the company decides to hedge the price exposure through surrogate hedging with MS ingot futures.
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Example
Spot Market Today Iron scrap imported at Rs. 13,500/MT Ingot price at Rs. 18,000/MT Iron scrap price falls to Rs. 12,000/MT Ingot price falls to Rs. 17,000/MT Futures Market Sell three-month MS Ingot futures contract at Rs. 19,000/MT Buy back Ingot futures at Rs. 18,000/MT
One month later when consignmen t arrives
Realization Sell Ingot in spot market at Rs. 17,000/MT Gain from Ingot futures is Rs. 1,000/MT Total realization is (17,000 + 1,000) = Rs. 18,000/MT
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Thank You
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Basic Principles of Hedging

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Basic Principles of Hedging,

NCDEX Institute of Commodity Markets and Research (NICR)

NCDEX Institute of Commodity Markets & Research