What is Hedging ? Trading in futures contracts consists of two kinds: one is hedging and the other is purely speculative. Hedging is a device usually adopted by dealers, millers and other processors of some staple agricultural products to cover their losses due to changes in the prices of the products they deal in. The prices of the agricultural commodities do not generally remain stable throughout the year. Thus the persons dealing in these products are exposed to the risk of price fluctuations. Hedging protects them from such risks. The dictionary meaning of hedging is “to protect oneself from loss on, by compensatory transactions.”
In marketing, hedging may be defined as a device which consists of the simultaneous purchase and sale of equal amounts of a commodity, with the expectation that the loss on one set of transactions will be offset by a gain on the other when the hedge is closed. It is a means of getting some degree of protection against inevitable price changes.
Hedging has been defined by C.O. Hardy and L.S. Lyon as follows: The essence of a hedging contract is a coincident purchase and sale in two markets which are expected to behave in such a way that any loss realized in one will be offset by an equivalent gain in the other. The commonest type of hedging transaction is the purchase and sale of the same amount of the same commodity in the spot and the future markets.
To hedge means to enter into a contract to purchase or sell a product in the futures market with the expectation that losses from changes in the price of goods now owned, or contracted for future purchase or sale, will be largely offset by equal changes in future prices.
This means that the risk of loss from such price changes is shifted to others and the hedger’s risk of loss is confined to any adverse changes in the relations between cash and future prices. We may cite an example of hedging. Suppose, a country elevator (a person who lifts up grain or any crop for the purpose of sale) who buys jute from farmers and expects to sell it at a profit. If the price falls while the elevator owns the jute, he loses.
To prevent such a loss, as soon as the jute is purchased, the elevator may sell on the Produce Exchange a future contract to deliver an equal quantity of jute. He is then protected from loss in case the price falls. That is, if he buys, say for example, 500 maunds of jute in the spot market and at the same time sells 500 maunds for future delivery, he has hedged his purchase and thereby reduced the risk of loss, should the price decline before he sells.
The trader, by hedging, merely attempts to neutralize the fluctuations of prices by executing offsetting contracts in the futures market. These futures contracts are available only for some agricultural staples and hedging neutralizes only part of the fluctuation in their prices, not all of it. Further more hedging is not much direct use to the farmers who produce the staples ; it is useful chiefly to the dealers, millers and other processors of these products.
Mechanism or Procedure of Hedging
The procedure of hedging consists of buying a specific quantity of a commodity and simultaneously selling the same quantity of the same commodity for future delivery. In other words, hedging involves the purchase of a certain quantity in one type of contract—cash or future—and the sale of a similar quantity in the opposite type. When the hedge is closed, a similar, though opposite, type of transaction is necessary. We may illustrate the procedure of hedging in the following way. Whenever an elevator buys 1000 maunds of corn @ Tk. 90 per maund he can immediately sell a 1000 maunds corn future. Then when he sells the corn a week or so later on the terminal market he can buy back his future. If the price of cash corn has fallen five takas, he loses five takas on his cash corn but the future in most cases will have fallen about five takas also, and he will gain on the future transaction as much as he lost on the cash. He will therefore break-even : the hedge will have protected him against loss.
The hedge will also have protected the elevator man against any gain. If the price of corn had risen five takas, he would have profited on his cash corn, but the future would have risen too and he would have lost an equal amount there. In other words, by hedging the elevator man avoids making any speculative losses or gains, and derives his entire income from his physical grain-handling operations.
Hedging in Wheat
(A) Opening the Hedge : Here we shall discuss the procedure of hedging by a flour miller. Suppose, a flour miller bought on the 1st July 5,000 bushels of wheat at Tk. 50 per bushel to grind into flour. He could secure protection against price fluctuations by a hedge in the futures market. Therefore, when he bought 5,000 bushels of wheat at Tk. 50, he sold a future contract calling for a delivery of 5,000 bushels of contract grade wheat in December of the same year at Tk. 53. We may summarize these transactions as follows:
(1) 1st July transactions: Bought 5,000 bushels cash wheat @ Tk. 50 bushel Sold 5,000 December wheat @ Tk. 53 with a Net gain of — Tk. 3 “
(B) Closing the Hedge on a Falling Market : Assume that on August 8 the price of spot wheat declined Tk. 3 a bushel and that this was accompanied by a proportionate fall in the price of flour. On August 8 the miller accepted an order for flour @ Tk. 47 per bushel. Tk. 50 was actually paid for cash wheat and the December futures suffered a decline having fallen from Tk. 53 as of 1st July to Tk. 50 as of August 8. In brief, the transactions on the 8th August were as follows:
(2) August 8 transactions Sold 5,000 bushels wheat ( as flour ) @ Tk. 47/bushels. Bought 5,000 bushels. December wheat @ Tk 50/ bushels with a Net loss of Tk. 3/ bushels.
(C) Closing the Hedge on a Rising Market : Now let us consider the case if the price of spot wheat had advanced by August 8 to Tk. 55 per bushel. Here note that if the miller had not hedged his July purchase, this advance of Tk. 5 per bushel would have resulted in his obtaining not only the milling profit but also an additional speculative gain. But the miller did not speculate rather he hedged the purchase. Since it is assumed in hedging that the future price changed in line with the cash price, the rise of Tk. 5 per bushel would have made no difference. The transactions would appear as fallows:
(3) August 8 transactions Sold 5000 bushels (as flour) @ Tk. 55 Bought 5,000 December wheat @ Tk. 58 with a Net loss Tk. 3.