Hedging means mitigation of risk/minimizing risk arising out
of volatile, unexpected, uncertain and adverse price movements in the future of
the underlying commodity due to various factors affecting prices. A Hedger of
the commodity is the person or company which is typically involved in a
business related to a particular commodity. They are usually a
producer/seller/stockist of a commodity or a buyer of the commodity in the
future. Hedging typically involves taking an equal and opposite offsetting
position on the futures markets as compared to the position held in the spot
In either case, the hedger is exposed to price risk example,
a farmer who grows maize for a living, let us assume, currently the prices of
maize are Rs. 2000 a quintal (100Kgs), if the prices of Maize fall in the
future by the time his sowing is over, the farmer stands a chance to loose the
value of his produce in the future as typically in the harvest/arrival season
the supply would increase and the prices would drop. In order to minimize the
risk, the user of the commodity in this case farmer, should hedge his
production of maize under the futures derivatives markets.
The strategy to be used by a producer/seller or stockiest of
the commodities is the sell an equivalent quantity of the commodity in the
Futures contract on the commodity exchanges by paying up an initial upfront
margins. In the case mentioned above let us assume the farmer estimates a total
production of 10,000 Kg (10 Metric tone) and the lot size on futures contract is
1 Metric Tonne. The farmer would know that harvesting the same would take about
3 months post which he would have to sell in the physical markets. Since he is
committed to sell the produce in future he should lock in the price by selling
10 Lots (10 Metric Tonne) on the Futures market and lock in the sale price of
his produce. On the completion of 3 months the farmer would face 2 scenarios:
Scenario 1: if the prices drop, seller can either give delivery on the
exchange platform there by receiving the proceeds of the prices earlier locked.
He may also square up the futures positions, book the profits and sell the
produce in the spot markets at the lowered prevailing prices since the prices
would have fallen, being the arrival season.
Scenario 2: prices have actually risen than the prices earlier hedged
(demand is higher than the increased supply). Seller can sell at the prevailing
higher prices in the physical markets than earlier anticipated and square up
his positions simultaneously & book the losses on futures market.
The above is a simple illustration of how a
producer/seller/stockiest of a commodity could hedge his futures sales and the
opposite strategy is applicable for the person who has to buy the commodity in
the future. He has to buy the futures contract of the commodity he is planning
to buy in the future and lock in the prices on the exchange and protect himself
against unexpected price rise in the future.
Hedging on the derivatives markets is to be done purely to
minimize the risk of the future unexpected volatile price movements and hence
there will either be a gain/loss on the futures markets and a simultaneous
loss/gain in the spot market, thereby minimizing risk arising out of volatility
in commodity prices and protecting the value of the inventory/business margins
of the hedger.