The commodity markets are made up primarily of speculators and hedgers. While speculators are all about taking on risk in the markets to make money, the function of hedgers is to reduce their risk of losing money. Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security. In the world of commodities, both consumers and producers of them can use futures contracts to hedge.
- 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 buyer or seller facing the risk of volatile commodity prices can do commodity hedging after compliance with regulatory requirements.
Hedging is a two-step process.
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…
A farmer who has standing crop of basmati paddy would like to sell the crop in advance. Suppose in the month of August or September, the farmer sees the basmati paddy futures price for October contract and find the price favourable to sell. So, he sells the October futures basmati paddy contract through broker and delivers the material in the exchange designated warehouse before contract expiry, let’s say in September last week. The contract settles on 5th of October and he will get the payment by 7th of October. Delivery process and final settlement usually completed within 5 to 7 days. Similarly, a basmati exporter who requires paddy to make rice for export down the line in the month of October. He will buy basmati paddy futures contract at commodity exchange for October delivery by paying a small margin amount of only 5-10%. Upon contract settlement in the month of October he will make the payment to get the delivery.
Key Takeaways
- Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security.
- In the world of commodities, both consumers and producers of them can use futures contracts to hedge.
- Hedging with futures effectively locks in the price of a commodity today, even if it will actually be bought or sold in physical form in the future.
