• Hedging - the advantages

    Hedging offers definite advantages to commodity producers and costs comparatively little. Hedging with futures allows a producer to lock in a price that reflects the producer's business goals (a profit). The producer should therefore determine the actual price available in the futures market that will support the cost of production plus a profit. If prices fall, the producer still achieves something near the originally intended pricing goals. If prices rise, the producer foregoes a larger profit margin.

    The loss of this potential (speculative) extra profit is balanced by the protection afforded against dramatic and damaging declines in the market. There are also other advantages in addition to this price-insurance aspect of hedging.

    First, hedging offers a flexible pricing mechanism. Anyone who feels they have made the wrong decision on the exchange can have an alternative order executed easily and immediately. Second, hedging operations involve only small initial outlays of money. If the price of futures goes up, the producer who has sold futures may be asked to pay additional margins; but the price of their physicals will also have risen. Third, because a futures contract provides considerable price protection, banks and other financial institutions are more likely to finance producers, exporters and traders who hedge their crops and positions than those who do not.

    Finally, commodity trade banks and risk solution providers put together different risk mitigation instruments that are tailored to a client's requirements. For example, a put option can be graduated to extend over the usual marketing season by spreading equal portions over two or three futures trading positions, at different strike prices if so wished. Each individual portion can then be exercised individually. Alternatively a solution provider may simply guarantee a minimum price. For payment of a premium, they undertake to make good any shortfall between the insured price (the minimum price the producer wishes to secure) and the price ruling for the stated futures trading positions (New York or London), either at a given date or based on the average price over a number of trading days. In doing this the producer buys a 'floor': a guaranteed price minus the cost of the premium.
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