Hedging

Mar 18, 2016   //   by Profitly   //   Profitly  //  Comments Off on Hedging

The recent volatility in the oil market have prompted many investors and traders to talk about a term called “hedging.” What exactly do they mean by that and who uses hedging? We found an exceptional article in the Financial Times that will explain just that:

How companies manage risks from market swings

The plunge in oil prices has strained the balance sheets of drillers and reduced costs for airlines. One way that companies manage the risks from commodities market swings is through hedging.

So what is hedging exactly?

No silly gardening jokes please. Hedging involves locking in a price to buy or sell a commodity in the future. It is a form of insurance against adverse moves in markets notorious for them. Hedging is also employed in currencies, interest rates and stock indices, but it originated in grain markets.

Who hedges commodities?

Businesses that are exposed to commodity price swings find hedging useful. A farmer worried that corn prices will fall after harvest might lock in a sale price during spring planting. Mexico annually hedges the value of its crude oil exports, paying banks a premium to ensure predictable revenue for its federal budget. Hedging “gives greater freedom for business action”, wrote Holbrook Working, a leading 20th-century economist of commodities markets.

OK, how do companies hedge?

Traditionally with derivatives such as futures and options. Futures contracts have two sides: a “long,” or buyer, and a “short,” or seller. An airline concerned about a future rise in the price of jet fuel might buy oil futures and take a long position. If crude jumps from $60 to $70 a barrel, the corresponding increase in the value of the airline’s futures position will help offset the higher price it will pay fuel suppliers. Conversely, an international oil producer worried that crude will fall from $60 a barrel to $50 might sell, or go short, in oil futures, locking in the sale price at $60.

Who takes the other side of the trade?

Futures markets are anonymous, so anybody from the oil producer to a hedge fund or bank could be the counterparty to the airline’s trade. Despite the name, hedge funds are classic speculators, or traders seeking to make money on price moves rather than insure against them. Commercial companies can also sometimes take speculative positions, meaning data (such as the US Commodity Futures Trading Commission’s “Commitments of Traders” reports) categorising trader positions as commercial or noncommercial should be viewed with care.

Can hedging have an impact on markets?

Big volumes from the execution of a hedging programme can move the price of futures markets and influence the value of options.

Hedges already in place can affect how companies respond to price signals. For example, US oil prices have declined more than 50 per cent since last June.

According to Barclays, US producers have hedged 22 per cent of their 2015 oil output. These hedges help soften the blow from oil’s fall and delay the imperative to cut production. The US government forecasts onshore production will keeping rising until May 2015 despite low prices — a phenomenon partly explained by hedging.

Hmm, if hedges are so handy, why doesn’t every company hedge?

To find this out, read the rest of the article on the Financial Times’ website by clicking here.