Hedging in commodities markets – By Prof. Simply Simple

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Presentation transcript:

Hedging in commodities markets – By Prof. Simply Simple Commodity hedging means reducing or controlling risk arising out of fluctuation in raw-material prices Commodity hedging is done by taking a position in the futures market that is opposite to the position in physical market Any manufacturer (buyer) or seller facing the risk of volatile commodity prices can do commodity hedging after compliance with regulatory requirements.

Basically… 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 futures position For instance, a wheat farmer can sell wheat futures at current prices 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 the futures position Thus, the farmer meets his objective of ensuring certainty in his revenue

Example… Suppose, it is July and a farmer expects an unfavorable drop in the selling price of corn He expects this drop around the time his anticipated production of 15000 baskets of corn are ready for sale in September The current price as of July is $4.50 per basket To hedge his risk of getting a low price for corn, he sells three 5000 basket futures contracts on October corn for more than the current price...say at $5 per basket When September arrives, prices have actually fallen down to $3.90 a basket

continued… So, he is now going to receive a much lower price on his corn To offset this potential loss, he buys corn futures, for $4.60 per basket If you remember, he had sold corn futures at the price of $5 and he is buying it back at the lower price of $4.60. This is because, price of corn futures has also now come down with the fall in price of corn So, in futures markets, he has earned a profit of $0.40 due to the difference in his selling and buying prices ($5 sale price - $ 4.60 buying price = $0.40 gain)

continued… Though, he is forced to sell the corn at the reduced price of $3.90 per basket, his effective selling price works out $4.30 per basket ($3.90 + $0.40 profit from futures) So, his effective sales revenue comes to $64500 ($4.30 X 15000 baskets) He would have lost $6000, if he had not hedged i.e. profit from futures ($0.40 X 15000 = $6000) So, between his cash and futures positions, he has effectively reduced his losses from the price decline

Hope you have now understood the concept of commodity hedging. In case of any query please email to hmasurkar@tataamc.com