The Purpose and Need for Commodity Hedging
There is a lag time of a meaningful duration between the time that production begins on something and when the goods are ultimately sold in the marketplace. This is the case with both users of commodities and producers.
If there was no wait between the time that your company paid for something and when it got paid for selling it, then there would be no need for the futures market for commodities, as there would be no risk involved as far as costs and revenues go.
A farmer, for instance, has certain costs involved in growing their crops, and benefit from knowing what price they will get for these crops when they are ultimately sold in order to manage their farms.
This is not so much a matter of their not wanting to take a chance on things, and all business involves certain risks, but when you can reduce these risks this always becomes worth considering.
Those who will be looking to buy the farmer’s crops, a company that makes food, also want to reduce the risk of their having to pay too much for certain crops down the road, as with this benefit, they can conduct their business with more certainty.
So the two parties, the farmer and the food producer, may enter into a contract for the farmer to deliver the food company a certain amount of a crop at a certain time in the future for a certain price.
During this time, if the price goes down, the farmer will get the higher price that was agreed on in the contract, and for this, the farmer foregoes the benefit to him or her if the price rises over this period.
The food company knows it will pay a certain price then, protecting them against the price rising, and they give up the benefit of the price going down if that happens.
Both the farmer and the food company have business obligations that they need to continue to meet, and therefore, when the farmer starts laying out money to grow this year’s crop, or the food company makes investments in its production line, or enters into future sales agreements at a given price, the futures contracts they enter into lets them ensure that their cash flow will be managed with more certainty in the future, and that their businesses aren’t harmed by fluctuations over this period.
If prices end up moving against them during this time, futures contracts also allow them to prepare, as this gives them both a lead time on making the necessary adjustments to keep their businesses running.
So given that these contracts provide protection against certain risks, this is why primary futures contracts for commodities is driven by the desire and the need to hedge, as opposed to speculation, which is concerned primarily with making a profit on the contracts themselves.
Hedging is Driven By The Principal of Diminishing Marginal Utility
All forms of financial risk management, including hedging with futures contracts, is a form of insurance, which is based upon the principal that it costs more to lose than it benefits you to gain.
This is called the principal of diminishing marginal utility, which tells us that the first dollar will be the most valuable one, with each succeeding dollar being worth a little less. This makes a certain degree of risk aversion make sense, independent of one’s risk appetite, and the amount of risk aversion that is rational in a given situation will depend on the degree of risk present in addition to whatever other factors will be relevant.
If a person for instance has saved a certain amount for retirement, and was given the option to double that amount on a flip of a coin or lose it all, it would not be rational to take this bet, because being broke at retirement is quite a bit worse than having twice as much is better.
One could live more comfortably in retirement with double their savings, but the discomfort of losing it all would be significantly greater than the extra comfort gained.
This principle applies to businesses as well, and in the case of businesses looking to lock in prices in the future, this could mean anything from missed opportunities to expand the way they want up to defaulting on loans due to losses that may occur.
Futures contracts for commodities are essentially a zero sum proposition, and given that the costs of entering into these contracts are negligible, this becomes sort of like not partaking in our coin flip, where heads you make more money and tails you lose money.
Without engaging in futures contracts, if the price moves your way with a commodity over time, you win, and if it moves against you, you lose, and both parties who may potentially enter a futures contract are subject to this bet, if they don’t engage in the contact. So, doing so does allow them to protect themselves against losses due to diminishing marginal utility by agreeing not to take this risk.
Other Forms of Hedging with Futures
The same principles that apply to commodities hedging also apply to foreign exchange risk. If you are producing goods that are to be sold in a different currency than yours, or for any reason you prefer that you lock in a certain exchange rate in the future, you may want to enter into a forex futures contract.
Forex futures contracts are very popular, and comprise 3 of the top 10 most active futures. It’s not hard to imagine why, given how much foreign trade there is. The forex market is the largest in the world, and there’s not just a need to trade currency on the spot market, there’s also quite a bit of demand to trade it in the future at a known exchange rate.
This protects both buyers and sellers from currency risk, at least during the period of the contract, and like with commodity futures, gives them some insight into the future and lead time to prepare for upcoming significant fluctuations in exchange rates.
Interest rate hedging also comprises a big part of the futures market, where people look to lock in treasury notes, treasury bonds, and other debt instruments at a future point in time. These are used for a number of things, to hedge interest rate risk primarily, although they are also traded by bond speculators due to the ease of which to enter the market with bond futures as opposed to buying them from a dealer.
If someone feels that the market may take a turn for the worse for instance, they may purchase a bond futures contract, and if the market pullback does come to pass, they can purchase the bonds they would want at a known price.
Using bonds or other debt instruments this way would consist of a hedge, where if the price of the futures contract goes down, they may lose a certain amount, but if things do go sour, their losses in their other investments, which they are hedging with these trades, will be buffered.
People even use stock futures to hedge in some circumstances, even though stock futures are generally traded for the purpose of speculating on the price of a basket of stocks, most notably those in the S&P 500.
S&P futures are now the most heavily traded futures contract in the world, and in spite of the fact that people can readily buy the cash version of this index, many do choose to trade the futures version of it.
Knowing that you can buy this index in the future at a certain price can have its benefits for sure, and if you own stocks but are concerned about their losing value, but still want to keep your positions, selling a futures contract can hedge your potential losses without having to reduce your stock holdings.
Futures contracts based upon the weather is at least to some degree a duplication, when it comes to the risk involved in the weather affecting commodities, as you could just buy or sell a futures contract for the commodity itself.
However, commodity users aren’t the only thing affected by the weather, and for those who are concerned about the weather affecting their business, they can now enter into futures contracts based upon this.
Since the weather isn’t anything tangible, this sort of futures contract is based upon pure betting, but these are bets that do have willing participants, and all financial markets are basically just bets anyway.
While many weather futures are contracts between parties, over the counter, weather futures are now available on the CME, standardized contracts which are traded on the exchange.
While much of futures trading involves parties looking to profit from price changes with the underlying assets of futures contracts, hedging strategies to use these contracts to reduce one’s risks still plays a fundamental role in these markets.