The Hindu Business Line : When the hedge offers protection

In June, `A', a seller in the physical market, strikes a contract with `B', a buyer, for supply of 100 tonnes of groundnut in October at Rs 20,000 a tonne, which includes his profit of Rs 500 a tonne.

The groundnut crop is in the making during June-September, and would arrive in the market from early October on. The crop size will depend on various factors including weather conditions, acreage and so on. So, prices may either rise or fall, hurting one of the parties.

`A' is keen to hedge his price risk and lock in his profit margin. To do that, he goes to a commodity futures exchange where groundnut futures contracts are traded.

`A' has sold in the physical market for a forward month (October); therefore, he puts through an opposite transaction in the futures, that is, he buys a futures (October) contract.

Let us assume that in June the October futures contract is trading at Rs 20,000 a tonne. The difference between the June spot and the October futures prices should generally represent the `cost of carry', although other factors, including seasonal, may come into play.

Let us further assume that by end-September a below-normal monsoon reduced groundnut production marginally. The spot price early October rises to, say, Rs 21,000 a tonne. Now, `A' has sold at Rs 20,000 a tonne but the market rate is Rs 21,000 at the time of delivery in October.

`A' will have to buy physical goods (100 tonnes of groundnut) at the market price of Rs 21,000 a tonne and deliver to buyer B. `A' would lose at the rate of Rs 1,000 a tonne (purchase price Rs 21,000 minus the sale price Rs 20,000).

However, he has also purchased October futures contract, as said earlier, in order to hedge his price risk and lock in profit.

When the futures contract matures, there will be a convergence of spot and futures price. By early October, reflecting tightness in new crop supplies due to lower production, October futures prices would also have risen and be equal to the spot price, that is, Rs 21,000 a tonne.

So, what does `A' do? He will sell at Rs 21,000 the October futures contract he purchased in June and make a profit of Rs 1,000 a tonne.

Therefore, his loss in the physical market is offset by his profit in the futures market. `A' has thus hedged his price risk and protected his profit.

`B', the buyer, too will hedge. Because `B' has bought physical goods in June for taking delivery in October, he will put through an opposite transaction in the futures by being a seller of October futures.

This is a simple example of how futures trading can help hedgers minimise price risk and protect the profit margin. It is a useful tool for producers, industrial consumers and traders and provides a safety net to market participants. The futures market captures in a rational manner the overall mood of the market participants. Over the years, various trading strategies have evolved.

Direct and Indirect Hedging

Two types of hedging are possible. Direct hedging is one where the commodity to be hedged is listed and traded on the futures exchange, and the party seeking to hedge has direct exposure to the commodity.

A wheat flour miller or edible oil refiner or cotton textile mill will go to the exchange (to buy or sell futures contracts) where these commodities are traded.

Indirect hedging is also possible. Assume an edible oil refiner wants to hedge his price risk relating to refined groundnut oil or groundnut extraction, but the commodity is not listed/traded on any exchange (for whatever reason).

The refiner can take a position in groundnut (the raw material) and indirectly hedge his risk in derivative products of groundnut such as oil and meal.

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.

More Stories on : Commodities | Investments | Young Investor

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page