The most abused financial instrument called “Hedging” in Commodities
The commodity markets were intended to help agricultural producers manage risk and find buyers for their products. The stock and bond markets were intended to create an incentive for investors to finance companies. Speculation emerged in all of these markets almost immediately, but it was not their primary purpose.
Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has.
The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving. Speculators make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a commodity, is overpriced, he or she may short sell the respective commodity futures and wait for the price it to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.
Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of commodity futures.
In most cases, in the name of hedging, speculative bets are taken forgetting the underlying purpose for which the commodity derivatives markets were discovered. The abuse is very profound in agri commodities and to some extent in non-agri commodities as well. In agri-commodities, very few market participants use them as a “perfect hedge”. We have come across many instances where corporations instead of hedging their price risk, tend to increase the price risk further by taking additional speculative bets in futures mostly driven by greed. It does pay off some times, but most of the times leads to huge losses both in the underlying and the futures.
As examples of hedging, consider a food-processing company and the farmer who raises or grows the ingredients the company needs. The company may look to hedge against the risks of price increases of key ingredients — like grains, cooking oil, or soft commodities — by buying futures contracts on those ingredients.
That way, if prices do go up, the company’s profits on the contracts help fund the higher prices it has to pay to make its products. If the prices stay the same or go down, the company loses only the price of the contract, which may be a fair trade-off to the company.
The farmer/grower raising grains, soybeans, or pepper, cotton and coffee, on the other hand, benefits if prices go up and suffers if they go down. To protect against a price decline, the farmer would sell futures on those commodities. His futures position would make money if the price went down, offsetting the decline on his products. And if the prices went up, he’d lose money on the contracts, but that would be offset by his gain on his harvest.
For corporations desirous of offsetting their price risk in commodities, understanding their own organization’s risk appetite is the first and foremost step to arrive at a proper hedging solution and to put in a hedging policy in place. If the risk appetite is less (low risk) and the organization averse to risk, then almost eighty to ninety percent can be hedged leaving scope for just ten percent speculation. In cases where risk appetite is zero (no risk) and the organization just wants to lock the margins and happy as long as there is now downside risk, then a back to back hedge is recommended which is almost hundred percent. In the case of an organization which has some risk (medium risk) appetite at the same time if the underlying quantity has gone beyond the minimum capacity to hold, that much which is beyond the capacity to hold should be hedged. The three categories mentioned above, namely, low risk, no risk and medium risk qualify for the category “hedgers”. Someone with high risk appetite will come under the category called “Speculator” only.
CFTC, the regulator for commodities trading in the U.S, has clearly classified and urges the exchanges to do the necessary homework on what kind of trades take places in commodity futures and what nature they are( speculative or hedge). Such an exercise by the FMC (Forward Market Commission), the domestic regulator for commodities in India, will further strengthen the regulatory mechanism and avoid excessive speculative activity specially in agri commodities, which affect the common man’s interest. Once the FCRA bill is cleared by the Indian parliament, FMC could get more autonomy and resources to implement such globally time tested methods to avoid excessive speculation.
Markets have both hedgers and speculators in them. Knowing that different participants have different profit and loss expectations can help you navigate the turmoil of each day’s trading. And that’s important, because to make money in a zero-sum market, you only make money if someone else loses.