This document discusses hedging strategies used by participants in commodity markets to reduce price risk. It describes how hedgers use derivatives contracts like futures to lock in prices for transactions that will occur in the future. There are two main types of hedges - short hedges where the hedger sells an asset, used by producers worried about falling prices, and long hedges where the hedger buys an asset, used by buyers concerned about rising prices. The optimal hedge ratio, which minimizes risk, depends on the correlation between the underlying asset price and futures price as well as their standard deviations. An example calculates the optimal number of cotton futures contracts a company should purchase to hedge its need to buy 11,
2. • Hedgers participate in derivatives market to
lock in the prices at which they will be
transacting in future.
• They try to avoid price risk by entering in
future contract.
• Example. A wheat farmer
Hedge
3. • Hedgers can be govt. institutions,
private institutions like financial
institutIons, trading companies.
• They can also be participants like
farmers, millers, extractors, processors
who are influenced by commodity
prices.
Who are Hedgers
4. • Hedger normally takes an opposite position in
the derivatives market to what he has in the
underlying market.
• Investor will always try to neutralize the risk.
Principles of Hedging
5. • Short hedge:-
short future position
sell an asset
• Long hedge:-
long future position
buy an asset
TYPES OF HEDGES
6. Short Hedge
• Short hedge is strategy used by
producer/seller to reduce the risk of price
movement of any commodity.
• Short hedge occurs when hedger already
owns the asset, or is likely to own the
asset and expect to sell it at some time in
future.
• Short hedge takes place when producer
fears that price of commodity will go down.
7. Example
• Suppose it is April 1 and a refined soy oil producer
expects to produce soy oil in June. He has just
negotiated contract to sell 10,000 kg of soy oil in June 1
market price.
• On April 1, the cash price for soy oil is Rs 450 per 10 kg.
• June NCDEX soy oil futures price is Rs 465 per 10 kg.
• The farmer is worried that cash price of soy oil(in June)
may decline significantly.
• The farmer may hedge against the declining price risk by
short hedging.
• To fully cover expected cash position, he needs to short
10 NCDEX soy oil futures (because the size of NCDEX
soy oil futures is 1000 kg.)
9. Long Hedge
•Hedges that involve taking long position in
future contract are known as long hedge.
•It is appropriate when a one know it has to
purchase certain asset in future and fear in
rise in prise.
10. Long Hedge Cont…..
• Purpose oh hedging is not to make profit ,
but to lock on price to be paid in the future
upfront.
• Hedger with long position usually avoid
any possibility of having to take delivery
by closing out their position before
delivery period.
11. Long Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future purchase of an
asset by entering into a long futures
contract
• Cost of Asset=S2 –(F2 – F1) = F1 + Basis
13. Hedge Ratio
• Hedge ratio is the ratio of the size of position taken in
the futures contracts to the size of the exposure in the
underlying asset.
• A ratio comparing the value of a position protected
via a hedge with the size of the entire position itself.
• Say you are holding $10,000 in foreign equity, which
exposes you to currency risk. If you hedge $5,000
worth of the equity with a currency position, your
hedge ratio is 0.5 (50 / 100). This means that 50% of
your equity position is sheltered from exchange rate
risk.
14. Optimal Hedge Ratio
• The hedge ratio is important for investors in futures
contracts, as it will help to identify and minimize
basis risk.
• This one that minimizes the variance of the hedger's
position.
• For example, if the hedgers exposure in the
underlying was to the extent of 11 bales of cotton, the
futures contracts entered into were exactly for this
amount of cotton. We were assuming here that the
optimal hedge ratio is one.
15. Mathematical Formula
• h = ρ σS / σF
where:
• σS: Standard deviation of ∆S
• σF : Standard deviation of ∆F
• ρ : Coefficient of correlation between .S and .F
• h: Hedge ratio
• ∆S: Change in spot price, S, during a period of time
equal to the life of the hedge
• ∆F: Change in futures price, F, during a period of
time equal to the life of the hedge
16. Example
Let us consider an example. A company knows that it will
require 11,000 bales of cotton in three months. Suppose
the standard deviation of the change in the price per
quintal of cotton over a three-month period is
calculated as 0.032. The company chooses to hedge by
buying futures contracts on cotton. The standard
deviation of the change in the cotton futures price over
a three-month period is 0.040 and the coefficient of
correlation between the change in price of cotton and
the change in the cotton futures price is 0.8. The unit of
trading and the delivery unit for cotton on the NCDEX
is 55 bales. What is the optimal hedge ratio? How many
cotton futures contracts should it buy?
17. Cont..
• If the hedge ratio were one, that is if the cotton spot and
futures were perfectly correlated, as shown in Equation 2,
the hedger would have to buy 200 units (one unit of
trading = 55 bales of cotton) to obtain a hedge for the
11,000 bales of cotton it requires in three months.
Number of contracts =11, 000/55 1
N p=1 = 200 2
• However, in this case as shown in Equation 4, the hedge
ratio works out to be 0.64. The company will hence require
to take a long position in 128 units of cotton futures to get
an effective hedge (Equation 6).
Optimal hedge ratio = 0.8 x 0.032/0.040 3
• h = 0.64 4
• Number of contracts = 0.64 x 11,000/55 5
• N p=0.8 = 128 6
