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Selective hedging

Hedging only some of a business's price exposure, based on a market view about which positions to cover — a choice that turns the hedged leg into its own form of speculation.

In plain language

Hedging is supposed to reduce risk. But a business does not have to hedge everything it is exposed to, and some businesses hedge only the exposures they feel less confident about, leaving the rest open because they have a view that prices will move in their favour.

This pick-and-choose approach is called selective hedging, and the workbook is blunt about what it really is: once you are choosing whether to hedge based on a market view, that choice is speculation, dressed up as risk management.

How it works

The workbook lists 5 limitations of hedging: price risk is never fully removed, basis risk continues, there is a transaction cost, margin must be maintained, and — fifth on the list — selective hedging. Selective hedging is not a benefit on this list; it is a limitation, because speculation and trading have payoffs on both sides, gains as well as losses, and selective hedging inherits that two-sided character. If a business hedges some positions and leaves others open based on its own view, the hedged leg itself can end up producing a loss, or a cumulative loss over time, precisely because the decision of what to hedge was itself a bet.

For this reason, the workbook's stated best practice for an entrepreneur who wants to stay focused on his core business is to avoid selective hedging entirely and instead hedge incidental price risks at all times, rather than picking and choosing based on a market view.

A worked example

A cotton ginning mill has two open exposures: 20 tonnes of raw cotton it must buy in three months at a budgeted Rs 1,60,000 per tonne, and finished yarn worth about the same it must sell in the same period.

The mill's owner is confident cotton prices will fall, so he hedges only the yarn sale (locking in his selling price) and leaves the cotton purchase unhedged, betting he can buy it cheaper later without a futures position.

Cotton instead rises to Rs 1,75,000 per tonne. On 20 tonnes, he now pays Rs 35,00,000 instead of the budgeted Rs 32,00,000 — Rs 3,00,000 more, with no offsetting futures gain, purely because he chose, selectively, not to hedge that leg. Had he hedged both legs as a policy rather than a view, the mill would have locked in its processing margin regardless of which way cotton moved.

Why NISM asks about it

Chapter 5 (Uses of Commodity Derivatives), in the "Limitations of hedging" list under section 5.2. Expect a question testing whether selective hedging is presented as a benefit or a limitation of hedging — it is a limitation — and why the workbook treats it as equivalent to speculation.

Common exam traps

  • Selective hedging is listed as a limitation of hedging, not an advantage. A question implying it improves outcomes is testing the reverse of what the workbook says.
  • The problem is not hedging less — it is hedging based on a view. A business that consistently hedges a fixed, smaller proportion of its exposure as policy is not doing the same thing as one that picks and chooses opportunistically.
  • Selective hedging can make the hedged leg itself lose money, which candidates sometimes assume is impossible for "a hedge."

Check yourself

  1. 1.Why does the workbook warn against selective hedging?

    1. a)Because SEBI prohibits partial hedging of commodity exposures
    2. b)Because choosing when to hedge and when not to is as good as speculation, with pay-offs on both sides
    3. c)Because partial hedges attract higher margins than full hedges
    4. d)Because basis risk only arises when a hedge is partial
    Show the answer

    Answer: (b) Because choosing when to hedge and when not to is as good as speculation, with pay-offs on both sides

    This is the most practically important sentence in the chapter. The moment a company decides when prices "look high", it has stopped hedging and started trading the commodity — with the operating business as collateral. The bet has simply moved from the price level to the timing of the decision.

    And it explains a pattern that puzzles many boards: a hedging desk showing cumulative losses over three years is not evidence that hedging fails. If the desk was hedging selectively, it was speculating, and speculation loses about as often as it wins. A systematic hedge is not expected to make money at all — its output is certainty, not profit.

    The other four limitations: price risk cannot be fully eliminated · basis risk continues to remain · transaction cost is to be incurred · margin is to be maintained, leading to cash flow pressures.

  2. 2.During sowing season, a farmer locks in the selling price for his crop that will be harvested and delivered a few months later. Which of the workbook's two basic hedging strategies is this?

    1. a)An offsetting hedge, because it offsets a physical activity already undertaken
    2. b)A selective hedge, because he chooses which crops to hedge
    3. c)A hedge to lock in an attractive price level for a future transaction — fixing the sale price above known costs
    4. d)A reverse cash and carry, because he sells before he holds the goods
    Show the answer

    Answer: (c) A hedge to lock in an attractive price level for a future transaction — fixing the sale price above known costs

    The two basic hedging strategies:

    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 '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 own examples of type 2: "processor locks the raw material purchase price for the stocks to be used in his manufacturing process for the next 3 to 6 months. Similarly, DURING SOWING SEASON, FARMERS LOCKS IN SELLING PRICE of upcoming harvesting season for their produce even though the produce will be harvested and delivered a few months later."

    Why the other options are wrong:

    • (a) The farmer has not yet done anything physical, because the crop is not harvested. An offsetting hedge covers an activity already undertaken.
    • (b) "Selective hedging" is the workbook's warning against hedging only some positions based on one's view. It is not one of the two strategies.
    • (d) Reverse cash and carry is an arbitrage by someone who already holds the asset.

  3. 3.Which of the following is NOT one of the limitations of hedging listed in the workbook?

    1. a)Price risk cannot be fully eliminated
    2. b)Basis risk continues to remain
    3. c)Hedging prevents advance production and business planning
    4. d)Margin must be maintained, leading to cash flow pressures
    Show the answer

    Answer: (c) Hedging prevents advance production and business planning

    Limitations of hedging:

    1. "Price risk cannot be fully eliminated."
    2. "Basis risk continues to remain."
    3. "Transaction cost is to be incurred."
    4. "Margin is to be maintained leading to cash flow pressures."
    5. Selective hedging "is as good as speculation or trading the commodity."

    Option (c) is the reverse of a stated BENEFIT. "Benefits of hedging: 1) Price risk is minimized; 2) PROVIDES FOR ADVANCE PRODUCTION/BUSINESS PLANNING AND CASH FLOW MANAGEMENT." Chapter 1 says the same: "Hedging can bring greater certainty over the planning cycle of the businesses."

    Note the tension in items (4) and benefit (2). Hedging helps cash flow management because costs become predictable. But daily margins can create cash flow pressure. Both appear in the workbook, and the exam can test either.

Where this is taught

Free preparation for NISM Series XVI

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