The concept of hedging in commodities markets is the same as in the financial markets and that is to mitigate the exposure to price movements due to the commodities positions. The most common instruments that are used for hedging purposes are futures contracts as they are highly liquid instruments. Futures contracts are the most popular instruments because their prices are highly transparent and the risk of counterparty default is borne by the exchange where such products normally trade. They are only exposed to movements in market prices or market risk and are highly standardized in nature compared to their OTC counterparts.
In situations where there are no futures on the commodities traded on the market hedging is carried out using futures on related commodities.
Types of Hedges
- A short hedge happens when a company holds a long position in a commodity i.e. it owns the commodity and has to sell futures contracts in order to hedge its long position.
- A long hedge happens a company takes a long position in a futures contract in order to hedge a short position in commodity (risk due to upward movements in prices).
- A cross hedge happens when there is risk due to market factors that need to be mitigated but there are no futures on the underlying commodities that are available for trading in the market.
Hedging Methods Specific to Commodities
A strip hedge happens when futures contracts over many maturities ranges are purchased to hedge the underlying cash positions. In other words strips of futures contracts are used. This normally happens when there is high liquidity for futures contracts over longer time horizons. There is no basis risk due to the strip hedge as the basis becomes locked and changes cannot affect the risk.
Stack ad Roll Hedge
This type of hedging involves purchasing futures contracts for a nearby delivery date and on that date rolling the position forward by purchasing a fewer number of contracts. This process then continues for futures delivery dates until each position maturity exposure is hedged. It normally happens when there is no adequate liquidity for the long term futures contract traded in the market. The following are the risks involved in stack hedging.
- Basis risk is locked only for the initial contracts and the future basis exposure is locked.
- Liquidity is higher as instruments with short maturity are being used.
- There are high transaction costs due to this type of hedging due to more contracts being required.
- The possibility of conflicting with position limits is high due to the high hedging volumes.
- If the market is in backwardation the stack strategy creates positive cashflows at roll-over dates. A short stack position generates negative cashflows under these conditions.
The following points are also to be noted
- Accounting regulations impact the profits and losses that are generated from the hedging methods and hence need to be taken into consideration.
- Margin calls on the futures can trigger panic in the market.
- If there are long maturity hedges then it is important to tail the futures position.