Hedging

Hedging may be defined as the reduction or controlling of risk in a particular investment.

Hedging may be done by assuming a particular position in the market for futures. A futures market is the direct opposite of a physical market. The basic premise of hedging is to reduce as well as limit the amount of risk an investment might be exposed to as a result of changes in prices.

Basis:

In case of commodity transactions the spot price and futures prices are different. The futures prices are basically cost adjusted spot prices and include a number of factors that may be enumerated as below:

• Freight
• Quality
• Handling
• Storage

The price difference between the spot prices and futures prices is known as basis. The risk that results from the basis is known as basis risk. The basis is changing on a regular basis. The situation whereby the basis reduces is known as narrowing of the basis. In cases when the difference of the futures prices and the spot prices increases the situation is termed as the widening of the basis.

The narrowing of basis is beneficial to the short hedger and widening of the basis is good for the long hedger. This is applicable in a market where the futures prices are higher than the spot prices. This situation is known as contango. In case there is a backwardation, whereby the futures prices are lower than the spot prices the narrowing is beneficial for the long hedger and widening is beneficial for the short hedger.

Steps of Hedging

There are two basic steps of hedging. First, a profit or a loss in a cash position, occurring due to alterations in the level of prices, is countered by alterations in the worth of a particular futures position. In case of losses a profit in the futures position is employed to counter the losses suffered as a result of lowering of prices.

Process of Hedging

In case of hedging the hedger attempts to fix the price at a particular level. The main aim behind this step is to make sure that there is a surety of the revenue of sale or cost of production.

Transactions in Futures Markets

In the futures markets a significant number of speculators participate in the proceedings. They assume positions on the basis of movements of prices. They also place bets upon the possible movements of prices. There are some arbitrageurs who participate in the futures markets to make profits in case the prices become inefficient. The arbitrageurs, however, try to make sure that the spot prices and futures prices stay correlated.

Selling Hedge or Short Hedge

The process of selling hedge is also known as short hedge. The term implies the selling of a futures contract for purposes of hedging. Short hedge is a pretty useful process. Its main uses may be enumerated as below

• Covering the prices of manufactured products.
• Covering the prices of production estimates of manufactured products.
• Protection of inventory that has not been covered by forward sales.

Short hedgers are processors and merchants who have acquired inventories of a particular commodity in the spot markets. They also sell the same amount of inventory or a bit lesser in the futures markets. In these circumstances the hedgers are referred to as short in the futures markets transactions and long in the spot markets transactions.