Offsetting hedge

The workbook splits hedging into two basic strategies. The difference between them is timing.

An offsetting hedge comes after the event. A hedge can be undertaken to offset price risk that has arisen over a physical market activity that has already been undertaken.

Something has happened. You have bought the stock, taken the order, or harvested the crop. The exposure is on your books now, and the hedge is a response to it.

The other strategy runs the other way. There a hedge serves to lock in an attractive price level for a transaction not yet done — fixing a sales price above known costs for a seller, or fixing a purchase price at a lower level for a buyer.

So one hedge answers a risk you already have. The other creates certainty about a risk you are about to take on.

Both are hedges, and mechanically both work the same way. You take a position in the derivatives market opposite to your position in the physical market.

The two basic strategies, as the workbook lists them.

1. Hedges can be undertaken to offset price risk that has arisen over a physical market activity that has already been undertaken. This is known as an offsetting hedge.
2. Hedges can serve to lock in an attractive price level from a transaction, by fixing the sales price at a level above the known costs in the case of a seller, or fixing a purchase price at a lower level in the case of a buyer. The workbook's examples for this second one: a processor locks the raw material purchase price for stocks to be used in his manufacturing process for the next 3 to 6 months; and during the sowing season, farmers lock in the selling price of the upcoming harvesting season, even though the produce will be harvested and delivered a few months later.

The common mechanics. Hedging means taking a position in the derivatives market opposite to a position in the physical market, with the objective of reducing or limiting the risks associated with price changes. It works because spot and futures prices tend to move in tandem — close enough, even if not identical — so losses in one market are offset by gains in the other.

The two-step process, and where an offsetting hedge usually finishes. If the hedger plans to buy in the spot market at a future date, he buys futures now and then takes delivery against the futures position at expiry, or squares off if he manages to buy in the spot market in the interim. If he plans to sell in future, he squares off the futures position when he sells, or delivers the commodity against his sell position at expiry, or exits the futures immediately if he sells in the spot market in the interim.

How much to offset. Not necessarily all of it. The hedge ratio indicates the number of lots the hedger must buy or sell to cover his exposure, and equals 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 worked case gives correlation 0.93, spot standard deviation 3.56, futures standard deviation 3.63 and therefore a ratio of 0.912 — so a 50 MT exposure with a 5 MT lot is hedged with 9 contracts, not 10.

What it does not do. The workbook's own limitations list: price risk cannot be fully eliminated; basis risk remains; transaction costs are incurred; and margin must be maintained, creating cash flow pressures. It adds a warning about picking and choosing which exposures to offset — selective hedging, with the choice to hedge or not to hedge, is as good as speculating on the commodity, so a business focused on its core competency hedges its incidental risks at all times instead.

Harihar Oil Mills buys 50 MT of castor seed in the spot market on 5 June at Rs 6,000 per quintal:

500 quintals x Rs 6,000 = Rs 30,00,000

The purchase has already happened. The exposure is on the books, and any hedge against it now is an offsetting hedge, not a lock-in.

Castor seed trades in a lot of 5 MT, so 50 MT is 10 lots. Applying the workbook's hedge ratio of 0.912, Harihar sells 9 lots — 45 MT, or 450 quintals — of castor seed futures at Rs 6,100 per quintal, deliberately leaving 5 MT unhedged.

By 20 July castor seed spot has fallen to Rs 5,700 and futures to Rs 5,780.

So Rs 1,50,000 of exposure came down to Rs 6,000. What is left is the residual from hedging 9 lots instead of 10, together with the basis move — castor seed spot fell Rs 300 while futures fell Rs 320, so the basis moved too.

A full 10-lot hedge would have returned (6,100 - 5,780) x 500 = Rs 1,60,000, a net gain of Rs 10,000. On this particular path the 0.912 ratio cost Rs 16,000 against a full hedge. That is not a mistake in the ratio: the hedge ratio minimises the variance of the combined position over many paths, not the loss on one of them.

Contrast the other strategy. Had Harihar on 5 June not yet bought the seed, but known it would need 50 MT in July, it would have bought futures to fix the purchase price. That is the lock-in strategy, and a long hedge rather than a short one — same mill, same tonnage, opposite trade, purely because of when the physical activity happens.

Chapter 5 (Uses of Commodity Derivatives), section 5.1 on hedging, where the two basic hedging strategies are listed and this one is named. Section 5.2 works both hedges through, and section 5.2.1 supplies the hedge ratio.

Expect the definition as a fill-in: a hedge undertaken to offset price risk that has arisen over a physical market activity already undertaken is known as an ____ hedge — offsetting. The paired question asks about the other strategy, locking in an attractive price level, whose worked illustrations are the processor's 3 to 6 month raw material lock and the farmer's sowing-season lock of the coming harvest's selling price.

• Offsetting comes after the exposure; locking in comes before it. That is the whole distinction, and both are hedges.
• The mechanics are identical. Both strategies take an opposite position in the derivatives market; only the sequence differs.
• The only figure in the section belongs to the other strategy — the processor locking raw material prices for the next 3 to 6 months. The offsetting-hedge sentence itself carries no number.
• An offsetting hedge need not be one-for-one. The workbook's hedge ratio of 0.912 leaves part of the exposure open on purpose.
• It does not remove risk. Price risk cannot be fully eliminated, basis risk remains, transaction costs are incurred and margin must be maintained.
• Choosing which exposures to offset is selective hedging, which the workbook says is as good as speculation — and it says an entrepreneur focused on his core competency avoids it.
• Delivery is not the only exit. The second step of a hedge can be giving or taking delivery at expiry, or squaring off the futures once the physical leg is done in the interim.