Introduction
Commodity markets are primarily composed of speculators and hedgers. It is easy to understand the role of speculators; they take risks in the markets to make money. Hedgers, on the other hand, are here for a completely opposite reason: to reduce the risk of losing money.
Key Takeaways
Individuals and companies use hedging to limit the risk of losing money in the commodity market. Selling a futures contract provides protection if prices fall, but you may miss out on higher prices if they rise more than expected. After fuel prices surged in 2008, airlines began using hedging to protect themselves from rising jet fuel prices. Hedgers must pay a margin, but margin levels are usually much lower for hedgers than for speculators.
Example of Soybeans
A farmer is an example of a hedger. Farmers grow crops – like soybeans in this example – and bear the risk of falling soybean prices by the time of harvest. Farmers can hedge against this risk by selling futures contracts for soybeans, which can lock in the price for their crops early in the growing season.
A futures contract for soybeans on the CME Group’s Chicago Board of Trade consists of 5,000 bushels of soybeans. If the farmer expects to produce 500,000 bushels of soybeans, they would sell 100 futures contracts for soybeans.
Let’s assume that the current price of soybeans is $13 per bushel. If the farmer knows they can make a profit at $10, it might be wise to secure the $13 price by selling futures contracts. This way, the farmer can avoid the risk of the soybean price dropping below $10 when they are ready to sell.
There is always the possibility that the price of soybeans could rise significantly by harvest time. The price of soybeans could rise to $16 per bushel, and the farmer would miss out on that higher price if they sold futures contracts at $13 per bushel.
Not Hedging
Most airlines are now eager to use hedging to protect themselves against rising jet fuel prices. However, in 2008, major airlines incurred substantial losses – some even filed for bankruptcy protection – after fuel prices skyrocketed.
Sometimes farmers do not hedge until the last moment. Grain prices often rise in June and July due to weather threats. During this time, some farmers watch prices increase and become greedy. They wait too long before locking in high prices before they drop. In fact, these hedgers turn into speculators.
Original Purpose of Exchanges
Futures exchanges were originally created to allow producers and buyers to hedge against their long or short cash positions in commodities. Although traders and other speculators represent the bulk of trading volume on futures exchanges, hedgers are the true reason for their existence.
Although futures exchanges require hedgers to pay margin – upfront money to cover potential losses – just as they do with speculators, margin levels are often much lower for hedgers. This is because futures exchanges view hedgers as less risky since they have a cash position in a commodity that offsets their position in futures contracts. Hedgers still need to apply for these special margin rates through the exchange and receive approval after meeting certain criteria.
Source: https://www.thebalancemoney.com/hedging-in-commodities-809379
Leave a Reply