Anticipatory Hedge

What Is an Anticipatory Hedge?

An anticipatory hedge is a futures position taken in advance of an upcoming buy or sell transaction. When the underlying product being bought or sold fluctuates in value, such as commodities, an anticipatory hedge may be used. Similarly, when a sale or cost is going to be realized in another currency at a future date, an anticipatory hedge may be used to control the risk related to exchange rate fluctuations.

Key Takeaways

  • An anticipatory hedge is used to lock in the rate of an upcoming cost or sale when the underlying product is subject to price change.
  • A long hedge is used to cover a cost, such as when an oil refiner knows it needs to buy oil each month. It can purchase oil futures in advance to lock in a price and the needed oil supply.
  • A short hedge is used to lock in a sale price, such as when a farmer wants to sell wheat. They sell futures contracts on the wheat so they know what price they will get come harvest.
  • Anticipatory hedges are also used to manage exchange rate risk.
  • Market regulators may sometimes impose position limits to restrict speculative hedging.

How an Anticipatory Hedge Works

Anticipatory hedges are used to hedge or manage business input costs, as well as exert some control over the sale price on products that are subject to constant price fluctuations, such as commodities.

Anticipatory hedges are a useful tool for businesses to lock in their costs or sales revenues. Businesses frequently run production and demand projections to estimate the materials they need to match their products to expected demand. Using these figures, a business can choose to hedge some or all of the expected need through anticipatory hedging.

Long Anticipatory Hedge

Some businesses enter into long anticipatory hedges into order to manage their cash flow. When they know they will have an upcoming cost next quarter, such as buying oil, they buy oil futures now so they know what their oil cost will be next quarter.

Locking in a rate today when the oil—or whatever input— is not needed till next quarter, means the company may sometimes end up paying more or less than they would have paid had they not hedged (not bought futures in advance). To many companies, this is inconsequential, since over time the ups and downs even out.

For other companies, they may attempt to hedge more or less depending on their outlook for costs. For example, if an oil refiner—that needs to buy oil to refine—is expecting the price of oil to rise over the next quarter, they may buy oil futures now when they are cheaper. If they believe oil is going to decline over the next quarter, they may not buy any futures now, or only a small amount, because they will simply buy their oil as needed in the spot market, at hopefully a cheaper price down the road.

Both approaches can result in the company making or losing out on money. Though, the company that always hedges, at least partially, will likely have a better idea of what their cash flow situation will be in the future.

Short Anticipatory Hedge

Sellers of commodities, products, or services can also use short anticipatory hedges to protect themselves from downside risks during the time between extracting, product or growing a commodity or service and actually selling it. 

A farmer may choose to sell futures contracts on their crop once the seeds are in the ground. They then know the price they will get for their crop. If the price of the commodity rises by harvest, the farmer missed out because they locked in at the lower rate. But at least they could budget for the amount of money they knew was coming in.

Another farmer may choose not to sell futures, and instead take the price available in the market come harvest time. Some years they may do better by doing this, while other years they would have been better off taking an anticipatory hedge. By taking no hedge, the farmer doesn't know the amount they will get for their crop until they sell it, which can make budgeting for expenditures more difficult.

More than 47,000 American farms use futures or options contracts to hedge against market risk, according to the U.S. Department of Agriculture.

Anticipatory Hedges for Currency Fluctuations

Anticipatory hedges are also used directly against currencies when sales are happening across borders.

For example, a car manufacturer exports cars from the United States to England and will be paid in British pounds once the goods reach the final destination.

Global logistics may require a shipping time of several weeks, so there is a real currency risk when the shipment is to be paid for on delivery, or net 30 days, for example. If the British pound falls by 5% during shipment, the US company will be receiving British pounds that are worth less than what they thought at the time of the sale.

If the car maker is worried that the pound will lose value over that time period when compared to the dollar, they could take a short position on the pound so that they can hedge the anticipated decline.

Not hedging means sometimes making more or less than if they had hedged. The argument is that over time these fluctuations even out. Not hedging means the incoming cash is unknown, which makes it harder for managing cash flow based on that unknown amount.

The CFTC limits hedging strategies in the forex market that rely on taking opposite positions in the same currency pair.

Anticipatory Hedges and Position Limits

Anticipatory hedges are often identified as the proper function of the futures market. Basically, the person or entity hedging needs protection for the cost or sale being hedged.

This is in contrast to speculative futures trading where an investor is taking up positions based on a market view of pricing changes without an actual stake in the end use of the commodity. A trader at home buying oil futures because they expect the oil price to rise has no interest in actually taking delivery, or delivering, actual oil. They only want to profit on price differences over time.

Because speculative hedging often exceeds anticipatory hedging by a wide margin, market regulators periodically impose position limits to keep the core function of the futures market based on real commodity markets. When these restrictions are being discussed, anticipatory hedging is often explicitly exempted from proposed position limits so that businesses can secure protection for some or all of their pricing exposure.

Example of an Anticipatory Hedge

A company in Canada sells approximately US$100,000 worth of products in the US each month. Because the Canadian and US dollars fluctuate (USDCAD), the Canadian company knows roughly how many US dollars (USD) they will be getting each month based on their historic sales, but they don't know much that US$100,000 will be in Canadian dollars (C$). Between 2007 and 2019, the USDCAD exchange rate has moved between 0.91 and 1.46.

When the USDCAD rate is high, say at 1.40, the Canadian company is taking in C$140,000 (US$100,000 x 1.4) per month. When the rate is low, say 0.95, the company is taking in C$95,000 per month (US$100,000 x 0.95).

That is a huge difference to a company. While their actual sales volume is steady from month-to-month, their Canadian dollar revenue can vary drastically.

When the rate is high, they could lock in favorable rates buying Canadian dollar futures out into the future. In effect, this means they are selling the USD, which they receive in cash each month, in the futures market. By locking in the price they can convert (sell) their US dollars, they can better anticipate their revue each month.

When the currency rate is unfavorable, they may hedge less into the future, or not at all, because they don't want to lock in unfavorable prices for an extended period of time. If the USD starts moving up again, a hedge means the company has kept themselves locked in at a worse rate for longer than necessary.

The company may also simple buy Canadian dollar contracts each month, regardless of the exchange rate, so they have a better idea of what their expected revenue is. This can help them budget for costs.

What Is Cross Hedging?

Cross hedging is the practice of managing risk by investing in two or more different assets that have a positive correlation with one another. This is typically done through derivatives, such as futures contracts. Cross hedging is less risky than holding just one of the assets, although the risk remains that the assets could move in opposite directions.

Is Hedging Illegal?

Hedging is generally legal in the U.S., provided it does not violate more specific laws on the trading of securities or commodities. For example, in the United States, forex traders cannot hedge their positions in a currency by taking an adverse position in the same currency pair.

What Is the Optimal Hedge Ratio?

The optimal hedge ratio for an asset is calculated by multiplying the correlation coefficient between its spot and futures price with the ratio of the standard deviations of those prices. This is used to determine how many futures contracts are needed to hedge a position in that asset.

What Is a Perfect Hedge?

A perfect hedge is a position that eliminates market risk from a portfolio by investing in an asset that has a negative correlation with the other investments in that portfolio. Because a perfect hedge requires a 100% inverse correlation with the original position, perfect hedges are rarely found in real market conditions.

Article Sources
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  2. Forex Bonuses. "Hedging and Forex Trading Explained."

  3. Yahoo Finance. "USD/CAD (CAD=X)."

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