Hedging

Many market participants use futures contracts to hedge risks. In regard to futures, a hedge is a futures position approximately equal and opposite to the hedger's position in the underlying asset. The risk is hedged because the price of the futures position moves opposite to that of the underlying asset. So if a wheat farmer sells short a wheat contract, then the price of the wheat contract will vary inversely with the spot price of wheat, especially as the delivery date approaches. So if on the delivery date, the price of wheat is high, then the farmer will profit on the sale of his wheat but lose on the futures contract. If the price of wheat is low, then the farmer loses on the sale of his wheat but gains on the futures contract.

A perfect hedge eliminates all risk. However, perfect hedges are rare. A futures contract for the underlying asset may not be available or the delivery date may not be optimal. A more perfect hedge can be achieved with a forward contract since all the terms of the contract are negotiable. However, forward contracts have their own problems, including the need to find a counterparty willing to accept the terms of the contract. Moreover, there could be substantial credit risk because a counterparty may be unable or unwilling to fulfill the contract. Futures contracts solve these problems by standardizing the terms of the contract and by having the exchange of the futures contract serve as a counterparty to both the long and the short position. But for many in the market, futures will not serve as a perfect hedge — hence, various strategies must be considered to achieve the best hedge possible.

To simplify the discussion of hedging strategies, the rest of this article will assume that the hedge is entered into and not adjusted until the delivery date, and that futures accounts are not marked to market, since the time value of money complicates the analysis.

Short Hedges

A hedger will go short when he owns or produces the underlying asset and expects to sell it at a later time. A short hedge helps to protect against a decline in the spot price of the underlying asset. For instance, a farmer is growing 5,000 bushels of corn for delivery in September. In June, he takes a short position in a corn futures contract for 5,000 bushels at the price of $5.20 a bushel. Consider several possibilities:

If the price of corn drops to $4.20 a bushel, then the farmer will receive $5,000 less without the futures contract. With the futures contract, a loss on the corn is compensated by the increase in the value of the futures contract. If the price of corn increases to $6.20 a bushel, then the farmer receives $5000 more for his corn but loses the same amount on the futures contract, so the net value remains $26,000.

Long Hedges

A hedger will go long if she will need the particular asset or will receive it at some future time. A long hedge helps to protect against increases in the spot price of the underlying asset. For instance, suppose a business in the United States signs a contract with a business in Europe in which the American business will receive €1,250,000 in December, which at the current exchange rate of $1.30 for each euro, is $1,625,000, which covers the cost of production and includes a small profit. Futures can protect this business's profit when the exchange rate changes, as it always does:

If the business entered a futures contract for the foreign exchange rate of $1.30 per euro, then it can be guaranteed that it will receive $1,625,000 in December regardless of the exchange rate. If the exchange rate drops to $1.15 per euro, then the business will receive $187,500 less, but it will profit from its futures contracts with a gain of $187,500, yielding a total net value of $1,625,000; a similar analysis applies if EUR/USD rises.

Economics of Hedging

Hedging makes sense for a business that incurs costs for producing its product if the hedged asset constitutes a large portion of the final product and if the business cannot adjust the price of its product to compensate for changes in the cost of the asset. For instance, it makes little sense for oil producers to hedge the price of oil, since any change in its price will be reflected in the price of the final product. Likewise, jewelry makers do not have to worry about the cost of gold or silver, since they can easily adjust their prices to reflect any changes.

Hence, hedging makes sense for those businesses producing a product or providing a service that must be sold at market prices, but requires a minimum to cover their costs. Thus, a farmer should hedge its produce to ensure receiving enough money to cover his costs, because, as a seller in a perfectly competitive market, the farmer is a price taker who will be unable to sell at any price other than the market price. Likewise, if a business enters into an agreement with a foreign company to either sell its product or buy the product from the other company at some later time, then it should hedge against foreign exchange risk, so that the company can know what it will cost or what it will receive when the transaction is completed, since the price is set by contract and the business cannot control the exchange rate.

Risks of Hedging

Although a perfect hedge eliminates risk in a theoretical world, hedging in the real world has risks. Two of the most important of these risks are liquidity and basis risks.

Because futures contracts are marked to market daily, there may be a liquidity risk even for a perfect hedge, since margin must be posted to cover the futures position, although the margin requirement is lower for hedgers than it is for speculators. So if the value of the futures contract declines substantially during its term, the hedger may be subject to margin calls. Even though the hedger will recoup any losses on its futures contracts by having an opposite position in the underlying commodity, the clearinghouse for the exchange where the futures are traded does not hold the underlying commodity, so it cannot be used to satisfy margin requirements.

Basis risk arises because a futures contract does not perfectly mirror the price of the underlying commodity.

Basis = Spot Price − Futures Price

The spot price of the underlying is determined by supply and demand for the commodity, whereas the futures price is determined by traders' expectations as to what the commodity price will be on the delivery date. Increases in basis increases gains for the short position and losses for the long position; decreases in basis have the opposite effect. The longer the term of the futures contract, the greater the basis and the greater the risk. As the delivery date approaches, the futures price and the price of the underlying asset converge, as they must, reducing the basis to near zero. However, closing a hedge position during the delivery month has 2 major risks:

1. the price of the futures can be erratic during the delivery month, and
2. the long position risks having to take delivery of the underlying, which is costly and inconvenient.

For these reasons, hedgers usually select the nearest delivery month that occurs after the hedge is no longer needed. The other advantage of selecting near delivery months is their greater liquidity — more contracts are traded as the delivery time approaches.

Imperfect Hedges and Cross-Hedges

Hedges may not be perfect because:

1. The quantity to be hedged may differ from the quantity that can be covered by a futures contract.
2. Futures contracts for a particular commodity or for a particular quality of the commodity may not exist.

Futures contracts, being standardized contracts, cover a specific quantity of the underlying commodity, so if a hedger has a different quantity, then she will either have to under-hedge or over-hedge her position. For instance, a futures contract for live cattle covers 40,000 pounds, so if a farmer has 60,000 pounds, then any hedge would have to be unbalanced. Whether the farmer decides to under-or over-hedge depends on expected prices. If prices are expected to fall, then it benefits the farmer to over-hedge, since she will receive a guaranteed price for the entire herd. On the other hand, if prices are expected to rise, then it makes sense to under-hedge, since, then, the 20,000 pounds not covered by a futures contract can be sold for the higher market price. A long position would adopt the exact opposite strategy.

Another drawback of standardization of contracts covering commodities is that the quality and kind of the commodity must be specified, so that commodities not covered by any futures contract cannot be hedged directly by using futures. However, these commodities can be covered by non-regular hedges, such as cross-hedges and ratio hedges.

Cross-hedging hedges a commodity with a futures contract for a closely related commodity not covered by a futures contract, but which has a positive price correlation. For instance, there are no futures for palm oil, but there is for soybean oil. Both oils are used extensively in food processing, so they are closely correlated in price. Another common type of cross-hedge is the hedging of interest rates on different financial instruments. For instance, commercial paper and CDs can be hedged with futures of short-term Treasuries, while investment-grade corporate bonds can be hedged with Treasury bond futures.

Ratio hedges are used when the volatility of the underlying assets in a cross-hedge differ significantly. Instead of having a one-to-one relationship, the less volatile asset is hedged with a lesser quantity of the more volatile asset. So if the volatility of commercial paper is 1.1 times the volatility of two-year T-note futures, then a hedger can cover $900,000 worth of commercial paper with $1 million of T-note futures.