Naturally short

A business that has to buy something later is already exposed to it, before it buys anything at all.

A jeweller who will need a kilogram of gold in August is hurt if gold gets dearer. He is better off if gold gets cheaper. That is the shape of a short position, and he never sold anything.

The workbook says it plainly. Any business or value chain participant is naturally short on raw materials and long on finished goods. They gain if raw material prices fall and lose when raw material prices rise.

So naturally short is the input side of every business.

The remedy is to go the other way. The hedger does not own the commodity but needs to acquire it in future, so he locks in the price he will pay by buying futures.

The workbook's own words for it: he is already naturally short on the underlying commodity because he must buy it in future, and he offsets this naturally short position by taking a long position in futures.

That is a long hedge.

The exposure. Commodity users use commodities as a raw material, and any business or value chain participant is naturally short on them: it gains if raw material prices fall and loses when they rise. The workbook groups such firms as commodity users — processors and consumers — as against commodity producers. Importers are given as a named case: importers need protection against price drops in the domestic market for goods they have pre-agreed to import, while exporters need protection against price increases on goods for which they hold export obligations at committed prices but have yet to procure domestically.

The hedge. In a long hedge the hedger does not own the underlying commodity but needs to acquire it in the future. He can lock in the price he will pay by buying, or going long in, futures contracts. In effect he is already naturally short, and he offsets that by taking a long futures position.

The two steps. If the hedger plans to buy a commodity in the spot market at a future date, he buys the futures contract now — step one — and then takes delivery against his futures position on the expiry date. Alternatively, if he manages to buy the commodity from the spot market in the interim, he may square off his futures contract.

With options instead. A naturally short buyer can also cap his purchase price with a call option, paying a premium instead of taking on a futures obligation. The workbook sets out the call option as a price-protection tool for hedgers against the possibility that market prices move against them.

One firm, both exposures. The naturally short input and the naturally long output sit on the same balance sheet. Hedgers generally hedge by buying raw materials in forwards or futures, selling finished goods in forwards or futures, or both.

Sizing the long. The number of lots comes from the hedge ratio — the correlation between spot and futures multiplied by the standard deviation of the change in spot price divided by the standard deviation of the change in futures price. The workbook's silver illustration gives spot standard deviation 1.17, futures standard deviation 0.62 and correlation 0.60, so a hedge ratio of 1.132258. On a 500 kilogram exposure that is an optimal hedge of 566.18 kilograms of futures and, at a silver lot of 30 kg, 19 lots rather than 17. The workbook adds a caution on that case: the 0.60 correlation is for explanation only, and in a liquid, transparent market the correlation, and therefore the hedge ratio, would generally be higher.

The naturally short sentence itself carries no figure; it is a statement of direction. The figures belong to the worked hedges beneath it.

The workbook's own long hedge, which is the naturally short case in full.

A jeweller needs to buy 1 kilogram of gold at the end of July at Rs 50,000 per 10 grams to make his desired profit, and has provided Rs 50.00 lakh for it. He is naturally short gold: he must buy it, and a rise hurts him.

The arithmetic on each leg, gold being quoted per 10 grams on a 1 kilogram lot of 100 quotation units:

Extra spot cost = (51,600 - 50,000) x 100 = Rs 1,60,000 Futures gain = (52,000 - 50,400) x 100 = Rs 1,60,000

Net effect nil. The jeweller's effective cost is back at his Rs 50.00 lakh plan, and his margin survives a Rs 1,600 per 10 gram move in gold.

Now the other path. Had gold fallen to Rs 48,500, he would have bought the kilogram for Rs 48.50 lakh — Rs 1.50 lakh cheaper — and given back roughly the same on the long futures. The hedge removes the rise and the fall.

And note the two possible endings the workbook allows. He squared off the futures because he bought the physical gold in the market. Had he not, he could instead have taken delivery against his long futures position on the expiry date and never gone to the spot market at all.

Chapter 5 (Uses of Commodity Derivatives), section 5.1 on hedging, where the naturally short and naturally long sentence appears, and section 5.2, which names the naturally short position explicitly while explaining the long hedge and works the gold example. Section 5.2.1 supplies the hedge ratio arithmetic, including the silver case.

Expect a direction question: a business is naturally ____ on its raw materials — short — and the paired remedy, that raw materials are hedged by buying futures, which is a long hedge. The workbook's own phrasing, that the hedger offsets his naturally short position by taking a long position in futures, is close to exam wording. A calculation question on the gold long hedge, ending at Rs 1,60,000 on both legs, is equally standard.

• Naturally short on raw materials, naturally long on finished goods. Two directions in one sentence, and reversing them inverts the hedge.
• The hedge for a natural short is a LONG hedge — buying futures. Selling futures doubles the exposure.
• You can be short without selling. The exposure arises from the obligation to buy later, not from any trade, which is why the workbook calls it natural.
• It depends on the firm, not the commodity. Gold makes a jeweller naturally short and a miner naturally long.
• Importers and exporters face it in opposite directions. Exporters with committed export prices and unprocured domestic goods need protection against a price rise; importers with pre-agreed import obligations need protection against a domestic price drop.
• The hedge kills the benefit of a fall too. The jeweller who locked Rs 50,400 pays that whether gold goes to Rs 51,600 or Rs 48,500.
• A hedge does not have to be one-for-one and can exceed 100%. The workbook's silver hedge ratio of 1.132258 turns a 500 kg exposure into 566.18 kg of futures, or 19 lots.
• Two exits exist, not one. Square off the futures once the physical purchase is made, or take delivery against the long futures position at expiry.