What Is a Commercial Hedger?
A commercial hedger is an organization that uses derivatives such as futures contracts to lock in the price of specific commodities it uses in running its business. A commodity is a necessary good required for the production of a good or service.
Thus, a food manufacturer may practice commercial hedging if it purchases commodities such as sugar or wheat or which it needs to produce its products. Electrical component manufacturers may hedge copper which it uses in production.
- A commercial hedger utilizes the derivatives or securities markets in order to lock in prices for the goods that they produce or else consume in the production process.
- Commercial hedging allows firms to reduce their exposure to market risk, making them agnostic to whether the price of a commodity rises or falls once the hedge has been established.
- Airlines, for example, may purchase oil or gas futures in anticipation of future flights; or a breakfast cereal maker will purchase wheat or corn futures in light of future cereal demand.
- Oil refineries, on the other hand, may sell oil futures while wheat or corn farmers will sell agricultural futures ahead of their harvests.
Understanding Commercial Hedgers
An entity uses commercial hedging as a method of normalizing operating expenses as they attempt to control commodity price risk and more accurately predict its production costs. A hedge is like an insurance policy where an investment helps to reduce the risk of adverse price movements in an asset. Commercial hedgers deal in futures contracts to manage specific price risk.
In contrast, non-commercial traders are those investors who use the futures marketplace for commodity speculation. Speculation is the act of trading in an asset or conducting a financial transaction that has a significant risk of losing most or all of the initial outlay with the expectation of a substantial gain.
The Commodity Futures Trading Commission (CFTC), a U.S. government agency, sets parameters to classify traders to set limits on trading and position size which differ between commercial and noncommercial traders. In fact, the Commission’s weekly Commitments of Traders report lists the number of open futures contracts for both commercial and noncommercial traders.
A company may be considered a commercial hedger for one commodity, but not for others. A candy manufacturer classified as a commercial hedger for cocoa or sugar would not be classified for commercial hedging of aluminum, heating oil, or other commodities.
How Commercial Hedging Works
Futures contracts are used both for speculative trading and for hedging. The deals are traded on various exchanges and have a price basis for the delivery of a specific commodity amount at a pre-defined future date. These futures prices may vary from the current spot price of the commodity. The spot price is the current cost of the commodity in the open market.
For example, the spot price of copper may currently be $3.12 per pound. An electrical wiring company that uses copper in its production may set its prices based on that cost. However, the price may rise in the future. This rise in price forces the company to either make less profit or to raise their product's price. Conversely, a falling price may cause the company's product to be higher than competitors, costing them market share. To stabilize its price structure and lock in a price for copper it needs for future production the company could buy copper futures contracts.
Even though the spot price of copper may be $3.12 per pound, the price for future delivery is often higher to account for storage costs. For example, the price for delivery might be $3.15 per pound for delivery in three months, $3.18 delivery in six months, $3.25 in one year, and so on.
A commercial hedger may diversify their contracts across multiple months to assure a set price at specific future dates.
If the copper price falls below that of the futures contract, the business may sell its contract at a loss. Even taking a loss on the futures contract, the company was able to mitigate its risk against a rise in raw material costs. When the copper price rises, the electrical wiring company is not required to take physical delivery of the commodity but may sell the futures at a profit in the open marketplace. The company can buy or sell copper futures contracts on an ongoing basis as its needs change.