Introduction
Producers and consumers of commodities use futures markets to hedge against adverse price changes that can lead to significant financial losses. The commodity producer is exposed to the risk of falling prices while the commodity consumer is exposed to the risk of rising prices.
Advantages of Futures Contracts
Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers with a mechanism through which they can hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that accurately reflect their risks. Additionally, futures contracts are liquid instruments, meaning there is a lot of trading activity in them and they are generally easy to buy and sell.
Reducing Risks
To hedge, it is essential to take a position in futures contracts that is approximately equal in size – but opposite in price direction – to the current position. Thus, a producer holding a commodity hedges it by selling futures contracts. Selling futures contracts serves as an alternative to selling the physical product, with the producer acting as a short hedge.
Meanwhile, a consumer who needs a commodity hedges it by buying futures contracts. Buying futures contracts serves as an alternative to the consumer’s physical purchase, with the consumer acting as a long hedge.
When supply and demand for commodities fluctuate, prices also fluctuate. A producer or consumer who does not hedge is exposed to price risk. Producers and consumers who use futures markets to hedge transfer price risks.
If someone owns the physical commodity, they bear price risks in addition to the costs associated with holding that commodity, including insurance and storage costs. The price of the commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures contracts is higher than that of near-term futures contracts.
When a producer or consumer uses the futures exchange to hedge a future sale or purchase of a commodity, they exchange price risks for basis risks, which is the risk that the difference between the cash price of the commodity and the futures price will move against them.
Futures exchanges have clearinghouses that act as settlement centers, meaning they become the trading partner for the transaction. They match the buyer and seller, check their creditworthiness, and ensure each party receives what is due. Thus, clearinghouses help eliminate credit risk from the system.
Drawback of Hedging with Futures
Hedging in the futures market is not perfect. For example, futures markets depend on standardization. Futures contracts for commodities require specific amounts to be delivered on certain dates. For example, a corn futures contract might involve the physical delivery of 5,000 bushels in December 2021. Sometimes quality intervenes – for example, the purity of precious metals.
Occasionally, hedgers produce or consume goods that do not meet the specifications of futures contracts. In these cases, hedgers bear additional risks by using standardized futures contracts.
Alternatives to Futures Markets
Futures markets are not the only option for hedgers. They can also use forward contracts and swaps to hedge. These markets involve transactions between principal parties – meaning no exchange is involved – where each party assumes the risk of the other. However, these custom-designed transactions may better meet the needs of commodity consumers or producers than standardized futures contracts.
Note
The Commodity Futures Trading Commission (CFTC) offers a helpful glossary of terms and definitions related to commodity futures.
Source: https://www.thebalancemoney.com/hedging-controlling-price-risk-using-futures-markets-808965
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