Hedging with futures
Hedging may be defined as the transferring of risk from the hedger, who has a portfolio or who is awaiting a certain sum of cash, to some other party in the market, usually another hedger or speculator. The hedger is concerned with price movements that may influence her existing portfolio, or a planned or anticipated portfolio.
The opportunities for hedging are many, and many a book has been written on hedging strategies. As this is an introductory text, this section deals with hedging basics and jargon and provides a few hedging examples.
Hedging basics and jargon
The jargon for hedging operations is interesting. For example, the investment community uses the terms micro hedging and macro hedging. Micro hedging is where each item in a balance sheet (liabilities and/or assets) is valued separately and an autonomous hedge set up for each item. Macro hedging is where the aggregate asset and/or liability portfolios are considered, and the overall risk is hedged in one operation. Examples are interest rate gap management (a banking problem) and changing asset allocation (an institutional problem).
A hedger may have a certain hedging horizon, i.e. a certain date on which the hedge will end (for example, a maize farmer who wishes to hedge from the planting stage to the harvest stage), or have no horizon at all (for example, a maize dealer who holds a permanent portfolio of maize and supplies feedlots and millers as they demand the product).
A hedge may be a long hedge or a short hedge, and they may be anticipatory hedges or cash hedges. A hedge may also be a direct hedge or a cross hedge. For example, a manufacturer of bread requires wheat on a regular basis. If the manufacturer requires additional wheat in two months' time and is concerned that the price will rise over this period, it is able to put in place a long anticipatory hedge by buying an appropriate number of wheat contracts now that mature in two months' time (if it is happy with the two-month futures price). This action fixes the delivery price in two months' time.
A short hedge is where the hedger sells a futures contract. For example, a gold producer is concerned that the gold price will fall sharply over the next three months when it will have 5 000 ounces to market, which will adversely affect profitability. Assuming that the producer is pleased with the three-month delivery futures price, it will sell an appropriate number of gold contracts (assuming no physical delivery) and thereby fix its price of delivery. If the spot price in three months time is lower than the futures price it will sell the 5 000 ounces at the spot price; but it will profit on the futures contracts to the extent of the difference between the spot price and the futures price. Thus, the producer's delivery price will be the futures price.
Generally, it is difficult to exactly match the cash market position with the futures hedge position undertaken, in terms of:
• Time horizon.
• Amount of the asset / commodity.
• Characteristics of the goods (e.g. maize or wheat grade).
In these cases the hedger will attempt to match as closely as possible the characteristics of the cash market asset with the futures position; the hedge will be a cross hedge.
Hedgers wish to establish a hedge ratio (HR). This ratio establishes the number of futures contracts to buy / sell for a given position in the cash market. The hedge ratio is given by:
HR = - (futures position / cash market position).
The hedger will undertake HR units of the futures to establish the futures market hedge. For example, if HR = -1, the hedger will have a matched long cash position and a short futures position.
A few examples of hedging follow.37