Risk Management in Commodities Trade

Risk Management through Commodity Hedging

for Commodity Traders, Processors and User Industries

By:

Vijay Sardana

http://www.arpl.in

All commodity companies are worried about global uncertainties and their impact on commodity prices. It is high time, when commodity players and processors adopt hedging to minimize their business risks.  

What is Hedging?

Commodity hedging is when a company offsets risks arising out of fluctuations in raw-material prices.

How does it Work?

For instance, if a manufacturer of agro products expects the prices to rise in the next three months, he will buy a position in the futures market at current prices to offset the likely price increase.

Similarly, if the prices are likely to fall, he will sell in the futures market at current prices against the physical goods he holds.

Who can Hedge?

Any manufacturer that faces risks due to volatile commodity prices can use the commodity derivatives to hedge the commodities.

The products that are available for hedging are futures, options, and over the counter derivatives (where individual parties can strike a deal based on their requirements through a broker). In India, only Futures are operational in commodity market exchanges.

What are the costs involved?

In case of futures, the party hedging would have to pay a margin – a percentage cost of the contract value (usually between 5-20%). For options, they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due. In India, options are not available on commodity exchanges.

Is Hedging Risky?

Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings.

For instance, if a manufacturer has a capacity of 200 MT and decides to sell 300 MT on the futures exchange the remaining 100 MT is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 MT he produces can be delivered on the exchange but he would have to incur losses on the additional 100 MT.

It’s a mechanism every market participant can benefit from.

Stakeholders along the value chain of physical commodities are exposed to price volatility. Be it an food product manufacturer who has delivery schedules to meet for an oil manufacturer, a oil miller purchasing seeds for making DOC & oil that is sold in the retail trade or an soya oil refinery that purchases crude soya oil for manufacture of different by-products or a farmer who needs to sell his produce during harvest season, the price risk is real for every participant in physical commodity markets.

How to Minimize Volatility by Hedging?

Short-hedging: Hedging is a good way of countering this risk. The process involves taking contrasting positions in two different markets. If a corporate entity is long in the physical commodity market (meaning, it has bought the physical commodity), it faces the risk of inventory devaluation resulting from a decrease in prices by the time the inventory is sold. In such circumstances, it is prudent to short (sell) futures contracts to offset the possibility of a decline in commodity prices. This method is usually referred to as the short-hedge.

Long-hedging: On the other hand, if the corporate entity is short (has sold) in the physical commodity market there is a risk of escalation of raw material prices by the time the manufacturer procures the commodity to manufacture the products. In order to beat the risk of prices increasing, one can take a long (buy) position in futures markets. This method is usually referred to as the long-hedge.

Say, a DOC manufacturer has to sell products consuming 2,000 MT of oilseeds to a company. If the delivery needs to be made after 4 months, he can take long (buy) position in futures market to hedge against the risk of increase in seed prices. Alternatively, if he has 100 MT of seeds in his inventory, there may be a threat of inventory devaluation due to decrease in DOC and oil prices. In this case, it would be prudent for him to short (sell) futures contract, to protect against any possible decline in prices.

Important: Hedging using commodity futures is based on the assumption that the futures contract prices and cash market prices move up or down in tandem to a large extent, with a fairly high degree of positive correlation. This is usually prevalent in a highly liquid and efficient commodity futures market, resulting in effective price discovery (fair value determination by market forces). Theoretically, if the futures price does not move in tandem with the cash market price for a particular commodity, it would give rise to arbitrage forces trying to establish equilibrium in the market. Ideally, the futures prices should converge with the cash market price on the expiry date.

Identify Hedging ratio: Hedging using futures contracts involves identification and quantification of the hedge ratio (the ratio of the number of futures contracts, each on one unit of the underlying asset to be hedged, as compared with one unit of the cash asset that needs to be hedged). The extent of volatility in futures contract prices as compared with the volatility in cash market prices needs to be ascertained along with the correlation between the cash price and futures price. The calculation of the hedge ratio is all the more important because of the threat of being under-hedged or over-hedged.

International practices for hedging against commodity price risk involve both static and dynamic hedging techniques.

Static Hedging: In a static hedge, the physical commodity price is locked in by hedging in futures market. This is irrespective of whether the commodity price increases or decreases, the underlying objective being protection against market risk.

Dynamic Hedging: In a dynamic hedge, judgmental positions are taken in futures markets, based on specific presumptions on possible price movements in the physical market. This may depend on fundamental factors of demand and supply that impact commodity prices. Dynamic hedge involves greater risk as compared with a static hedge.

Implementation of Hedging:

Hedging is usually implemented through ‘strip hedge’ or ‘stack-rolling hedge’ mechanisms.

Strip Hedging: In a strip hedge, the specific exposure in the physical commodity market across different months is hedged using futures or forward contracts that expire during that particular period.

Stack-rolling Hedging: On the other hand, a stack-rolling hedge involves hedging the physical exposure for the next few months with the near month futures contract. As the near month futures contract approaches expiry, the hedge position is “rolled over” into the next immediate month of expiry. Rolling over of positions involves squaring off (offsetting) of existing open positions in the near month futures contracts and taking fresh positions in the next immediate month’s futures contracts. The stack-rolling hedge is usually followed when the hedge horizon lies beyond the latest date of any futures contract that is being traded.

Corporate India is waking up to the need of hedging against volatility in commodity prices. This has become all the more important with the decreasing operating profit margins due to increase in prices of commodities in the last couple of years.

Important Things MUST know when you Start Hedging Operations

1.      Document your past mistakes with all facts and work out an action plan how to address the same situation now. Don’t try to memorize the facts because it is not available to others, when required. 

2.      Read the FMC/ Exchange guidelines and circulars available on the websites of the Exchanges

3.      Refer to Forward Contracts (Regulation) Act {FC(R)A}, 1952 before dealing in futures trading in commodities.

4.      Go through all rules, regulations, bye-laws and circulars issued by the Exchange available on the websites of the respective exchange.

5.      Read commodity contract specifications and the concerned circulars carefully including recent modifications, if any.

6.      Understand the commodity and price impacting parameters before participating in commodity futures.

7.      Study historical and seasonal price movement.

8.      Keep track of Government Policy announcements

9.      Be aware of the risks associated with your positions in the market and your ability to respond to margin calls on them as unfavorable price movement’s result into higher margin requirement.

10.   Collect/pay mark-to- market margins on your futures position on a daily basis from/to your Trading Member as per the Exchange rules and regulations

11.   Understand the Delivery and Settlement Procedure.

12.   Comply with taxation and other state regulatory issues relating to sale/ delivery and stamp duty.

13.   Apply your own prudent judgment while trading in a commodity.

14.   In case of any doubt/problem contact the Exchange help desk.

15.   Participate in the commodity derivatives markets after analyzing the facts and doing due diligence. Please reflect your own price views while participating in these markets and not of the others.

16.   In case of any dispute with a Member regarding the trades done on a Commodity Exchange, the client can contact the Exchange for suitable redressal as per the byelaws of the Exchange including use of arbitration mechanism of the Exchange.

17.   All rights are available to a client for all exchange-traded transactions for which the client must have a duly authorized contract note of the broker.

18.   Approach the Exchange Management or the FMC for redressal of the grievances.

19.   Any person who promises you high returns in a short span of time. No schemes for assured returns are allowed in commodity markets.

20.   Dabba’ (Bucket Shops). Dabba trading (trading outside the exchange platform) is illegal, punishable under law and highly risky.

21.   Advices through television or print media. They are not the opinion of the channel or publisher but of the individual speaker/writer.

22.   SMS’s / Emails / rumours and trading tips. Please do not be lured by such sources of information promising quick gains and unrealistic high returns.

23.   Advice available on Websites/Blogs/astrology predictions or /Newspaper. Use of such unconfirmed information exposes one to undue risk.

IMPORTANT CAUTIONS & WARNINGS:

In commodity markets, lot of money is involved; stakes are very high for many people. All sorts of unfair trade practices and wrong information can also influence the price movements.

The best way to take benefit of commodity exchanges in price discovery is to educate yourself. The more you will learn about your commodities and its behaviour, the better you can operate on commodity exchanges for hedging operations. While doing so, please take care of the following points.

1.    Do not fall prey to market rumors and tips.

2.    Do not act based on bull/bear run of market sentiment in the market.

3.    Do not trade based on long-term price prospects of the commodity without understanding your short-term risk bearing capacity.

4.    Do not let risks against your positions accumulate in the market beyond your capacity to bear them.

5.    Do not miss on keeping track of your financial and contractual obligations against your positions

6.    Do not go by any explicit/ implicit promise made by analysts/ advisors/ experts/ market intermediary until convinced.

7.    Do not go by the reports/ predictions made in various print and electronic media without verification.

8.    Do not trade in any commodity without knowing the risk and rewards associated with it.

9.    Do not deal with any intermediary not registered with the exchange on which you wish to trade.

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