Futures are a popular asset class used to hedge against risk. Strictly speaking, investment risk can never be completely eliminated, though its impact can be mitigated or passed on. Hedging through future agreements between two parties dates to the 1800s. The Chicago Board of Trade standardized futures contracts in 1865 to allow farmers and dealers to trade grain and other soft commodities at future transaction dates throughout the year.
- 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.
Let’s look at some basic examples of the futures market, as well as the return prospects and risks.
For simplicity's sake, we assume one unit of the commodity, which can be a bushel of corn, a liter of orange juice, or a ton of sugar. Let's look at a farmer who expects one unit of soybean to be ready for sale in six months’ time. Assume that the current spot price of soybeans is $10 per unit. After considering plantation costs and expected profits, he wants the minimum sale price to be $10.10 per unit, once his crop is ready. The farmer is concerned that oversupply or other uncontrollable factors might lead to price declines in the future, which would leave him with a loss.
Here are the parameters:
- Price protection is expected by the farmer (minimum $10.10).
- Protection is needed for a specified period of time (six months).
- Quantity is fixed: the farmer knows that he will produce one unit of soybean during the stated time period.
- His aim is to hedge (eliminate the risk/loss), not speculate.
Futures contracts, by their specifications, fit the above parameters:
- They can be bought or sold today for fixing a future price.
- They are for a specified period of time, after which they expire.
- The quantity of the futures contract is fixed.
- They offer hedging.
Assume a futures contract on one unit of soybean with six months to expiry is available today for $10.10. The farmer can sell this futures contract (short sell) to gain the required protection (locking in the sale price).
How This Works: Producer Hedge
If the price of soybeans shoots up to say $13 in six months, the farmer will incur a loss of $2.90 (sell price-buy price = $10.10-$13.00) on the futures contract. He will be able to sell his actual crop produce at the market rate of $13, which will lead to a net sale price of $13 - $2.90 = $10.10.
If the price of soybeans remains at $10, the farmer will benefit from the futures contract ($10.10 - $10 = $0.10). He will sell his soybeans at $10, leaving his net sale price at $10 + $0.10 = $10.10
If the price declines to $7.50, the farmer will benefit from the futures contract ($10.10 - $7.50 = $2.60). He will sell his crop produce at $7.50, making his net sale price $10.10 ($7.50 + $2.60).
In all three cases, the farmer is able to shield his desired sale price by using futures contracts. The actual crop produce is sold at available market rates, but the fluctuation in prices is eliminated by the futures contract.
Hedging is not without costs and risks. Assume that in the first above-mentioned case, the price reaches $13, but the farmer did not take a futures contract. He would have benefited by selling at a higher price of $13. Because of futures position, he lost an extra $2.90. On the other hand, the situation could have been worse for him the third case, when he was selling at $7.50. Without futures, he would have suffered a loss. But in all cases, he is able to achieve the desired hedge.
How This Works: Consumer Hedge
Now assume a soybean oil manufacturer who needs one unit of soybean in six months’ time. He is worried that soybean prices may shoot up in the near future. He can buy (go long) the same soybean future contract to lock the buy price at his desired level of around $10, say $10.10.
If the price of soybean shoots up to say $13, the futures buyer will profit by $2.90 (sell price-buy price = $13 - $10.10) on the futures contract. He will buy the required soybean at the market price of $13, which will lead to a net buy price of -$13 + $2.90 = -$10.10 (negative indicates net outflow for buying).
If the price of soybeans remains at $10, the buyer will lose on the futures contract ($10 - $10.10 = -$0.10). He will buy the required soybean at $10, taking his net buy price to -$10 - $0.10 = -$10.10
If the price declines to $7.50, the buyer will lose on the futures contract ($7.50 - $10.10 = -$2.60). He will buy required soybean at the market price of $7.50, taking his net buy price to -$7.50 - $2.60 = -$10.10.
In all three cases, the soybean oil manufacturer is able to get his desired buy price, by using a futures contract. Effectively, the actual crop produce is bought at available market rates. The fluctuation in prices is mitigated by the futures contract.
Using the same futures contract at the same price, quantity, and expiry, the hedging requirements for both the soybean farmer (producer) and the soybean oil manufacturer (consumer) are met. Both were able to secure their desired price to buy or sell the commodity in the future. The risk did not pass anywhere but was mitigated—one was losing on higher profit potential at the expense of the other.
Both parties can mutually agree with this set of defined parameters, leading to a contract to be honored in the future (constituting a forward contract). The futures exchange matches the buyer or seller, enabling price discovery and standardization of contracts while taking away counter-party default risk, which is prominent in mutual forward contracts.
Challenges to Hedging
While hedging is encouraged, it does come with its own set of unique challenges and considerations. Some of the most common include the following:
- Margin money is required to be deposited, which may not be readily available. Margin calls may also be required if the price in the futures market moves against you, even if you own the physical commodity.
- There may be daily mark-to-market requirements.
- Using futures takes away the higher profit potential in some cases (as cited above). It can lead to different perceptions in cases of large organizations, especially the ones having multiple owners or those listed on stock exchanges. For example, shareholders of a sugar company may be expecting higher profits due to an increase in sugar prices last quarter but may be disappointed when the announced quarterly results indicate that profits were nullified due to hedging positions.
- Contract size and specifications may not always perfectly fit the required hedging coverage. For example, one contract of Arabica coffee "C" futures covers 37,500 pounds of coffee and may be too large or disproportionate to fit the hedging requirements of a producer/consumer. Small-sized mini-contracts, if available, might be explored in this case.
- Standard available futures contracts might not always match the physical commodity specifications, which could lead to hedging discrepancies. A farmer growing a different variant of coffee may not find a futures contract covering his quality, forcing him to take only available robusta or arabica contracts. At the time of expiry, his actual sale price may be different than the hedge available from the robusta or arabica contracts.
- If the futures market is not efficient and not well regulated, speculators can dominate and impact the futures prices drastically, leading to price discrepancies at entry and exit (expiration), which undo the hedge.
The Bottom Line
With new asset classes opening up through local, national, and international exchanges, hedging is now possible for anything and everything. Commodity options are an alternative to futures that can be used for hedging. Care should be taken when assessing hedging securities to ensure they meet your needs. Bear in mind that hedgers should not get enticed by speculative gains. When hedging, careful consideration and focus can achieve the desired results.