What Is a Buying Hedge?

A buying hedge is a transaction a company engaged in manufacturing or production will undertake to hedge against possible increases in the price of the actual materials underlying a futures contract. This strategy is also known by many names including a long hedge, input hedge, purchaser's hedge, and purchasing hedge.

The managers of a manufacturing company may use a buying hedge to lock in the price of a commodity or asset they know they will need for future production. The buying hedge allows the managers to protect the company against the price volatility that could occur in the underlying asset from the time they initiate the buying hedge to the time they actually need the commodity for production. A buying hedge is part of a risk management strategy that helps companies manage fluctuations in the price of production inputs.

Key Takeaways

  • A buying hedge is a transaction that helps protect an investor or company against possible price increases in the commodities or assets underlying a futures contract.
  • Manufacturers use buying hedges to lock in the price of a commodity they will need at a later date for production.
  • Buying hedges are part of an overall strategy that assists companies in managing the costs of their production inputs.
  • Investors will use a futures contract as a buying hedge that allows them to buy a certain amount of a commodity at a fixed price in the future.

Understanding Buying Hedges

A buying hedge could take the form of a manufacturer purchasing a futures contract to protect against increasing prices of the underlying asset or commodity. A futures contract is a legal agreement to purchase or sell an asset or commodity at a specific price at a predetermined future date.

The purpose of a hedge is to protect; thus, a hedge position is undertaken to reduce risk. In some cases, the one placing the hedge owns the commodity or asset, while other times the hedger does not. The hedger makes a purchase or sale of the futures contract to substitute for an eventual cash transaction. Investors may also use a buying hedge if they predict having a future need for a commodity, or if they plan on entering the market for a particular commodity at some point in the future.

Benefits of a Buying Hedge

Many companies will use a buying hedge strategy to reduce the uncertainty associated with future prices for a commodity they need for production. The business will attempt to lock in the price of a commodity such as wheat, hogs, or oil.

Investors might use a buying hedge if they expect to buy a certain amount of the commodity in the future, but are worried about price fluctuations. They will buy a futures contract to be able to buy the commodity at a fixed price later. If the spot price of the underlying asset moves in a direction more beneficial for the holder, they can sell the futures contract and buy the asset at the spot price.

A buying hedge may also be used to hedge against a short position that has already been taken by the investor. The objective is to offset the investor’s loss in the cash market with a profit in the futures market. The risk of using the buying hedge strategy is that if the price of the commodity drops, the investor may have been better off without buying the hedge.

Buying hedges are speculative trades and carry the risk of being on the wrong side of the market, in which case the investor could lose some or all of their investment.

Example of a Buying Hedge

Suppose a large flour miller just signed a contract with a bakery that produces a variety of packaged breads, cakes, and pastries. The contract calls for the flour miller to provide the bakery with an ongoing supply of flour to be delivered on a predetermined schedule throughout the year.

The production managers for the miller calculate their breakeven cost for flour production and find they must purchase wheat at $6.50 a bushel to break even. In order to fulfill the bakery's orders for flour and make a profit, the miller must pay less than $6.50 per bushel. Currently, it's March and the price of wheat is $6.00 per bushel, which means the miller will make a profit.

However, the miller anticipates a spike in the price of wheat due to a prediction of hot, dry weather over the summer, leading to a decrease in wheat production. To initiate a buying hedge against this possible price increase, the miller purchases long positions in September wheat futures and can lock in a price of $6.15 per bushel. Should the price of wheat skyrocket as anticipated in September, the miller will be able to offset this by gains made in the buying hedge.