Part Two: A User’s Perspective
The goal of hedging is to transfer price risk from one party to another. You may remember this from the initial article I wrote on hedging. This article will focus on how users of a product can roughly lock in a price to transfer risk to another party. If you would like to learn more about how a producer can roughly lock in a price, read my previous article here: Hedging with Commodity Futures: It’s All About Managing Price Risk!
Why should I hedge?
This is the question you will have to ask yourself when trying to figure out the benefits of hedging. As a user, would you like to be able to roughly determine the price you will have to pay for a commodity in the future? The futures markets can help you do this.
Cash – Futures = Basis!
This is a very important formula to remember. Basis is the difference between the cash price and the futures price of a commodity. Basis consists of carrying charges and costs of transportation for the commodity to an exchange approved delivery point. For example, if the cash corn market is at $6.93 and the futures price is $7.00, the basis would be -.07 (6.93-7.00). As the delivery month draws near and the prices converge, basis approaches zero.
There are two types of hedges, long hedges and short hedges. This article focuses on long hedges. Someone who is buying the commodity later in the cash market is a long hedger. A long hedger is someone who wants to protect themselves from price increases (user). A long hedge is also known as being “Short the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative. In the corn example above, if it was a long hedger, he would want the basis to get more negative.
To sum it up, a long hedger wants to protect against increasing prices and benefits when basis weakens.
A feed company will need to buy 25,000 bushels of corn on December 1st. Due to rising per capita incomes around the world, the feed company believes that increased demand for feed grain and food could result in an increase in corn prices. The company decides to place a long hedge on March 23rd to protect themselves from rising prices. December corn futures are currently trading at $6.15/bu and the December cash market is currently at $5.83/bu. Each corn futures contract contains 5,000 bushels. The feed company buys five corn futures contracts at $6.15/bu. The feed company’s goal is to lock in a price of roughly $5.83/bu for corn.
It is now November 30th and the feed company’s concern that corn prices would rise held true. Corn futures are currently at $7.58/bu and December cash corn is at $7.46/bu. The company exits its futures positions and buys the cash grain. See the table below for the sum of the transactions.
Change in Basis
|= -1.63||= + 1.43||= -.20|
The feed company lost $1.63 on the cash side and gained $1.43 on the futures side. The net result of the hedge is a loss of 20 cents per bushel.
X 5000 bu/contract
X 5 contracts
$-5000 loss in dollars
The net price paid for the corn is calculated by subtracting the change in futures to the cash price at which the grain was sold.
|Cash Price Received:||$7.46/bu|
|Gain on Futures:||-1.43 (reduces cost)|
|Adjusted by net result:||+0.20|
Basis strengthened during the hedge, causing the feed company to pay more than they had hoped. Remember that the goal of hedging is to transfer price risk and set the price you would like to pay in a roughly determinable range. Had the feed company not hedged, they would have been stuck paying $7.46/bu of corn! This is quite a large difference from the $6.03 they actually paid.
Add Hedging To Your Plan
Hedging is a great risk management tool. Yes, the corn prices in the example could have decreased and the feed company would have lost money in futures, but they would have paid less for the cash grain. If that was the case, a producer could have benefitted by placing a short hedge! Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range. Reducing exposure to market surprises allows users and producers to plan their operations more confidently.