Commodity hedging! What you should know

What is Hedging?

Commodity hedging is when a company offsets risks arising out of fluctuations in raw-material prices.

How does it work?

For instance, if a manufacturer of copper wires expects the copper prices to rise in the next three months, he will buy a position in the futures market at current prices to offset the likely price increase. Similarly, if the prices are likely to fall, he will sell in the futures market at current prices against the physical goods he holds.

Who can hedge?

Any manufacturer that faces risks due to volatile commodity prices. Prior approval from the Reserve Bank of India is required. The products that are available for hedging are futures, options, and over the counter derivatives (where individual parties can strike a deal based on their requirements through a broker).

What are the costs involved?

In case of futures, the party hedging would have to pay a margin – a percentage cost of the contract value (usually between 5-8%). For options, they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due.

Is hedging risky?

Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings. For instance, if a copper manufacturer has a capacity of 200 tonne and decides to sell 300 tonne on the futures exchange the remaining 100 tonne is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 tonne he produces can be delivered on the exchange but he would have to incur losses on the additional 100 tonne.