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At Sucden Financial, we are happy to help you design the hedging strategy that most suits your business or consult on use of exchange products.
What is Hedging?
• Hedging is a risk management strategy designed to reduce or offset price risks.
• Hedging involves the use of market instruments, the two most common of which are futures and options.
• In essence, when operating in futures markets hedging implies taking a position opposite to that in the physical market.
• Hedging is the opposite of speculation – hedgers are NOT trying to “win” and make money on the price movements. Locking a price today allows for better focus on planning and business development with
minimum exposure to an unwanted business risk.
• Hedging can vary in complexity from relatively simple “off-setting trades” through to complex derivative structures.
Why Hedge?
• For consistent and stable cash flows
• To determine a sale/purchase price of
a commodity/security
• To reduce your risk exposure
• To reduce transaction costs
• To manage stock levels by reducing
storage costs
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How does a Hedge work?
A producer takes opposite positions in two different markets that move together in order to mitigate loss in one, for a favourable movement in another.
Key Principles Behind Hedging
• An Open Hedge refers to the case when an investor opens the futures position opposite to physical market.
• A Closed Hedge refers to the case when an investor closes the futures position when the physical risk is no longer present.
• Producers are naturally LONG PHYSICAL commodity so to hedge they need to SELL FUTURES, protecting their profit margin against the price fall.
• Consumers are naturally SHORT PHYSICAL commodity so to hedge they need to BUY FUTURES, protecting against the rise in prices.
Hedging Strategies
• Arbitrage involves taking an advantage of discrepancy/differences on two different markets, for the same or similar products.
• Averaging is a strategy whereby, instead of hedging against a single price fixed on a single date, average transactions settle against average prices observed over a certain period of time.
• Offset is a simple offsetting of the physical market exposure.
• Price Fixing involves taking an advantage of the current favourable market levels for the future physical transactions.
Benefits versus Opportunity Costs
• Benefits: ability to manage the price risk to a necessary degree, better planning, business development and more flexibility with regards to pricing polices.
• Costs: foregoing any potential profits from market fluctuations, the temporary cash outlay and a broker’s fee. |
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