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Hedging is a futures transaction that acts as a substitute for a later cash transaction. It is roughly equal and opposite to the position the hedger has in the cash market. Let us take the example of Company A, which produces sugar and Company B, a consumer of sugar. Company A plans to sell 50,000 quintals of sugar in December 2005. It expects futures prices to be lower and feels that Rs. 1,850 per quintal will be a good price to get in December. This will cover the cost of production and give a reasonable margin.
The Strategy
So, Company A decides to lock in 50,000 quintals at a price of Rs. 1,850
on the futures market for December contract.
Scenario I
The predictions of Company A has come true. Spot prices for December 1
is Rs. 1840 per quintal.
| Spot | Futures | ||
| Price | Rs. 1,840 | Locked in at Rs. 1,850 for 50,000 qtls. Current price @ Rs. 1,840 | |
| Sales | Sells all of 50,000
qtls. in the spot @ Rs. 1,840 |
Squares off 50,000
qtls. @ Rs. 1,840 |
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| Result | Loss of Rs. 10 against budget | Gain of
Rs. 10 per quintal from spot against the budget. Bought @ Rs. 1,840 and sold @ Rs. 1,850 for 50,000 quintals |
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| Net |
No profit or No loss on the budgeted price of Rs. 1,850 | ||
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Net result is that Company A has got an average price of Rs. 1,850. Example on hedging with Futures by a sugar consumer. |
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The Strategy
The Company B buys 50,000 quintals of sugar for December contract at Rs.
1,850 since it expects the prices to go up in future.
Scenario I
The predictions of Company B has come true. Spot prices for December 1
is Rs. 1,870 per quintal.
| Purchase | Buys all of 50,000
qtls. in the spot @ Rs. 1,870 |
Squares off 50,000 qtls. @ Rs. 1,870 | |
| Results | Loss of Rs. 20 as against the budget | Gain of Rs. 20. Budget @ Rs. 1,850 and sold @ Rs. 1,870 | |
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Scenario II
The predictions of Company B has gone wrong. Spot
prices for December 1 is Rs. 1,830
per quintal
| Spot | Futures | |||
| Price | Rs. 1,830 | Locked in at Rs. 1,850
for 50,000 qtls. |
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| Purchase | Buys all of 50,000 qtls. in the spot @ Rs. 1,870 | Squares off 50,000 qtls. @ Rs. 1,870 | ||
| Results | Gain of Rs. 20 against budget | Gain of Rs. 20. Budget @ Rs. 1,850 and sold @ Rs. 1,870 | ||
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Net result is that Company B has got an average price of Rs. 1,850. The budgeted price of Rs. 1,850 per quintal for 50,000 quintals is assured irrespective of the price fluctuation both in case of producer and consumer. |
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What makes hedging work?
Spot and Futures price for the same commodity tend to go up and down together.
Losses in one side are cancelled out by gains on the other.