Hedging Against Rising Tin Prices using Tin Futures

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Using Futures to Hedge Against Shifts in Commodity Prices

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Producers and consumers of commodities use futures markets to protect against adverse price moves that could result in large financial losses. A producer of a commodity is at risk of prices moving lower while a consumer of a commodity is at risk of prices moving higher.

Hedging is an important tool when it comes to running a business from either of those perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price. A hedge will guaranty a producer a known price for their commodity output.

Advantages of Futures

Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers alike a mechanism with which to hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that closely reflect their risks. Additionally, futures contracts are liquid instruments, meaning there’s a lot of trading activity in them and they’re generally easy to buy and sell.

Aside from producers and consumers, speculators, traders, investors, and other market participants utilize these markets. The exchange requires those who hold long and short positions to post margin, which is a performance bond to cover potential losses.

Producers and consumers often receive special treatment on commodity exchanges. As hedgers, their margin rates are often lower than other market participants, who are trying to make money on trading, not protect against losses.

Reducing Risks

To hedge, it is necessary to take a futures position of approximately the same size—but opposite in price direction—from one’s own position. Therefore, a producer who is naturally long a commodity hedges by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer, who is acting as a short hedger.

A consumer who is naturally short a commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer, who is acting as a long hedger.

While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk. Producers and consumers who use futures markets to hedge transfer their price risk.

If someone holds the physical commodity, they assume the price risk for it as well as the costs associated with holding that commodity, including insurance and storage costs. The price of a commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures is higher than nearby futures prices.

When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity, they exchange price risk for basis risk, which is the risk that the difference in the cash price of the commodity and the futures price will diverge against them.

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Futures exchanges have associations that act as clearing houses, which means they become the transaction partner of a trade. They match up buyer and seller, check their creditworthiness, and ensure each one is paid what they’re owed. Therefore the clearing houses help remove credit risk from the system.

A Drawback of Hedging With Futures

Hedging in the futures market isn’t perfect. For one thing, futures markets depend upon standardization. Commodity futures contracts require certain quantities to be delivered on set dates. For example, a futures contract for corn might entail a delivery of 5,000 bushels in December 2020. And sometimes quality—for example, the purity of precious metals—comes into play.

Hedgers sometimes produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures.

Alternatives to Futures Markets

Futures markets are not the only choice for hedgers. They can also use forwards and swaps to hedge. These markets entail principal-to-principal transactions—meaning no exchange is involved—with each party assuming the risks of the other. However, these tailor-made transactions may meet the specific needs of commodity consumers or producers better than standardized futures contracts can.

Hedging Strategies Using Futures – Basics of Hedging

Hedging Strategies Using futures

Financial Risk Manager (FRM®)

Part I of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.

Hedging Strategies Using Futures

Welcome to the 3rd session of Financial Markets and Products. In the earlier session, we have learned the basics of futures markets, including the settlement and delivery procedures. In this session, we will learn the basic concepts of hedging. The term hedging means protection from uncertainty. For example, a trader insuring his shipment is hedging himself against loss due to unforeseen events such as theft etc. We will learn how futures can be used to hedge a position and reduce risk. Let us begin our discussion.

The main agenda of our discussion will be learning the various concepts used in hedging with futures contracts. In this session, we will begin by learning the basic concepts and types of hedging. We will then introduce the concept of basis risk, which arises due to a mismatch between an underlying price and its futures contracts. We will learn how to quantify the number of contracts for an effective hedge. We will use this concept of hedging for adjusting the systematic risk of a portfolio. Finally, we will end the session by briefly discussing about rolling a hedge.

In financial markets, any trader can be in a long or a short position. In a long position, the trader has a requirement to sell any asset on the future date, while in a short position, the trader needs to purchase the asset on a future date. For example, a farmer who has yet to harvest his crops is in a long position, as he will need to sell the crops on a future date when the harvesting is complete. There is always uncertainty associated with future dates, and traders usually hedge their uncertain positions through purchasing or selling futures contracts. In a short position, traders enter into a long hedge by buying futures contracts. This is done to protect them against chances of rising prices. For example, an oil company buys crude oil futures to hedge against rising prices. In a long position, traders enter into a short hedge by shorting futures contracts. This is done to protect them against the chances of a decline in prices. For example, a farmer sells rice futures to hedge against declining prices. There are advantages of hedging, such as the reduction of risks due to uncertain price movements, as in the examples we just quoted. Another advantage is that it enables companies to accurately forecast earnings into the future, and thus enable them to maintain a more stable financial position. A major disadvantage with hedging is that the hedger forgoes the advantage due to favorable price movement. For example, a hedged farmer has no advantage if the prices increase in the future, as any advantage is offset due to the loss in the futures contracts.

Hedging against rising oil and gas prices for private households?

Inspired by this article Hedging Against Rising Heating Oil Prices using Heating Oil Futures, I wonder whether hedging against rising oil and gas prices makes sense for private households, too? If so, which financial instruments are particularly useful?

Many people claim that a big amount of their income goes to heating and electricity directly. Consequently, they are hit quite severe by a sudden increase in the prices of the underlying commodities.

Thus, even though they do not use a million barrels a month, it might still make sense, right?

In which case this thought is not entire without merit: Of course, the average person will be most likely less informed about all the available instruments. However, households could also team up in some kind of association, to follow just that common interest. Are you aware of any such institution?

2 Answers 2

My gas and electric bill average $600/mo or $7200/yr total.

While I believe there’s merit in the idea, it would need to be structured in a way that was easily transacted. For example, the oil company (I mean your deliver guy) would tell you the price today is, say $1/gallon, but in exchange for you paying a slight premium, maybe $1.05/gal, he will fix the price for a full year.

Given a total bill of the $5K range (mine is above average, I’m sure), even with swings of 20-25% over a season, it would still take some effort to create and sell what you seek, but to hedge a potential $1000-$1200 type of risk. How much would you be willing to pay to lock in a price for a year?

As I said, interesting idea, tough to execute.

Update – Just as an example, a 1 year option on USO (an Oil ETF) has a premium of 15%. The ETF trades at $36.20, but a Jan ’12 option at $36 costs $5.60. The cost to execute this is impractical for the intended goal.

Where r discount rate n number of periods discount

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