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Hedging with commodity futures

Monday, June 19, 2017 | Category : Commodities | 1 Comments
Hedging with commodity futures
What is hedging?
Hedging is an investment undertaken to limit losses arising from future uncertainties of the underlying asset. Normally, a hedge consists of taking an offsetting position off the underlying commodity, on the futures/derivatives market.

To understand the concept and to be able to relate to simply, an individual takes up a life insurance policy to protect his family from future financial uncertainties that could arise from the individual’s death is also Hedging; keeping extra money in pocket is also hedging to protect your-self from unplanned expenses.
So we knowingly or unknowingly hedge ourselves from future uncertainties whether in small scale or large scale. Hedging has become most important aspect of our life. In the above examples we had talked about hedging personal lives. We all know how hedging can help us in our personal lives. In the personal lives uncertainties are rarely occur, but in the commercial environment, there are lot of uncertainties.
There are huge number of factors affecting demand and supply. Entrepreneurs are always striving for maintaining margins and improving or keeping the market share intact. Introduction of commodity futures market have given lot of entrepreneurs a sigh of relief. Entrepreneurs such as farmers, jewelers, metal traders, etc. can take advantage of protecting their business margins by locking in commodity prices on commodity exchanges such as MCX and NCDEX.

How commercial hedging takes place?
For eg.
Metal traders:
A Metal manufacturing company (XYZ) in the business of supplying refined copper Rods is required to supply Copper Rods to a construction company for their requirement of a project which is likely to begin 3 months from current date at a market price prevailing at that point in time. Let us assume, the current price of Copper is Rs. 350 per Kg in the SPOT Physical markets, however, he is exposed to the risk of losing the value on his goods over the 3 month period due to uncertain volatile factors which could lead to price fall or gain, however being in the business of supplying goods and making a simple profit margin he wants to protect the value of his inventory against unexpected price fall, as after 3 months he would have to deliver the goods to the construction company at the “then” prevailing market rates. XYZ as a strategy would go short on copper for the required quantity on the futures exchange and lock in the selling price. Upon nearing the expiry (simultaneous delivery period date of the goods to the construction company), XYZ would close out the position on the exchange and either book profits/loses on the futures exchange arising out of price fall/gain respectively which would be compensated or matched by the loss/gain in the physical market realized on delivering the goods at the “then” prevailing market price.

Farmers:
A Farmer holds an agricultural land which is suitable for sowing and harvesting a couple of crops such as Soya bean, Guar seed and Mustard seed however the costs involved sowing and harvesting for either of the crop are more or less similar, which the harvest season couple of months away, the farmer needs to decide on the crop to produce based on the future potential demand and which would yield him maximum returns on this crop produce. Which future price on an exchange is a reflection of the future potential demand/supply, so he checks the price in the exchange of the various crops which would fetch him a higher profit. He sees that Guar seed in the month of harvesting is trading at higher price when compared to Soya bean and Mustard seed, so the farmer decides to sow for Guar seed. As the sowing begins, he should also short (sell) a judgmental quantity of Guar seed of the closest to the harvesting month contract as just like him there would be several other farmers and in the harvesting (arrival) season the prices would tend to drop as the supply increases. By selling the Guar seed on the futures market well in advance he has locked in the selling price of his good and has secured his profit margins, which otherwise would have diminished as the arrival season would come closer, had he not, hedged on the exchange
 
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Ashish Shah | AVP - Commodities

He is a certified NSE (NCFM/NISM Certification) For: Derivatives Market, Capital Market, Currency Market & Commodities Market & he has also done MCCP (Mcx Certified Commodity Professional) & DICM – Diploma in Commodities Market (Wellingkar Institute, Mumbai). He is regularly featured on Chat Shows on moneycontrol.com, live interaction on CNBC TV18 & BTVi.

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