Hedging Strategies using Futures
Many participants in the futures markets are hedgers. Their main aim is to use the futures markets to reduce a particular risk that they might face. This risk might relate to the price of oil, a foreign currency, stock markets, wheat, pork bellies, orange juice, the weather, or some other commodity or variable. By definition a hedge is a trade that is designed to reduce risk. A futures contract is one that obligates the holder to buy or sell an asset at a predetermined delivery price during a specified time period.
A perfect hedge would be one that completely eliminates all risk - though these types of hedges are extremely hard to come by or their costs would be extremely high, negating any value. Therefore hedging strategies with futures usually turn out to be portfolios constructed in ways such that they perform the task as best as possible. When an individual or company chooses to use the futures markets to hedge a risk, the real objective is to take a position that neutralizes that risk as much as possible.
A short hedge involves a short position in the futures contracts. It is aplicable when the hedger already owns an asset and expects to sell it to someone in the future. So a farmer who owns cattle could use a short hedge to ensure that he/she receives a set price of their commodity sometime in the future. This type of hedging strategy would also work if say a company were going to be paid in Euros in two months and wanted to lock in a certain rate for when they received the payment and converted it to US dollars. This position would lead to a profit if the Euro increased in value compared to the US dollar and a loss if it decreased versus the dollar.
Hedges that require taking a long position in the futures market are known as long hedges. A long hedge might be appropriate when a certain asset or commodity would have to be purchased in the future and the company or individual wanted to lock in the price right now. Suppose a bread making company knew that it would have to buy a certain amount of wheat sometime in the near future. This company could take a long position on wheat futures contracts and lock in the future price of wheat. If the price of wheat increases, the bread company would gain as they have a locked in contract at a lower price and if the price decreases, the downside would be as much as the difference.
Hedging using futures contracts are sophisticated financial transactions. Therefore many companies who do not have the financial expertise or skills might avoid these instruments. In most cases, producing companies look at hedging when a commodity price is increasing - they usually want to lock in the price they are getting. This has been seen with gold miners and oil exploration companies. The downside of the hedges is that by selling into the future, they are in a sense creating a ceiling for the commodity price. On the way down, it is usually the users of commodities who are looking to lock in the lower prices but they are creating floors for the commodity price that is on its way down.
Therefore, hedging using futures contracts is a complicated process with possible consequences on the value of what is being hedged.
