18.10 Participants in these markets
The commodities market will have three broad categories of market participants apart from brokers and the exchange administration - hedgers, speculators and arbitrageurs. Brokers will intermediate, facilitating hedgers and speculators. Now let us discuss in detail about Hedgers, Speculators and Arbitragers. The confluence of these participants ensures liquidity and efficient price discovery in the market. Commodity markets give opportunity for all three kinds of participants.
Hedging
Hedging means reducing or controlling risk. Many participants in the commodity futures market are hedgers. They use the futures market to reduce a particular risk they may be facing. The classic hedging example is that of wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a predetermined price.
Hedging does not necessarily improve the financial outcome; indeed, it could make the outcome worse. What it does however is, that it makes the outcome more certain.
Basic principles of hedging
When an individual or a company decides to use the futures markets to hedge a risk, the objective is to take a position that neutralises the risk as much as possible. There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position.
This is called a short hedge. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. Let us discuss these two hedges in detail.
Short hedge
A short hedge is a hedge that requires a short position in futures contracts. (A short hedge is also called selling hedge). A short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. For example, a short hedge could be used by a cotton farmer who expects the cotton crop to be ready for sale in the next two months.
Uses of selling hedge strategy.
- To cover the price of finished products.
- To protect inventory not covered by forward sales.
- To cover the prices of estimated production of finished products.
A short hedge can also be used when the asset is not owned at the moment but is likely to be owned in the future. For example, an exporter who knows that he or she will receive a dollar payment three months later, he makes a gain if the dollar increases in value relative to the rupee and makes a loss if the dollar decreases in value relative to the rupee. A short futures position will give him the hedge he desires.
Long hedge
Hedges that involve taking a long position in a futures contract are known as long hedges. (A long hedge is also called buying hedge). A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now.
Note that the purpose of hedging is not to make profits, but to lock on to a price to be paid in the future upfront.
Benefits of buying/long hedge strategy:
- To replace inventory at a lower prevailing cost.
- To protect uncovered forward sale of finished products.
The hedge has the same basic effect if delivery is allowed to happen. However, making or taking delivery can be a costly process. In most cases, delivery is not made even when the hedger keeps the futures contract until the de-livery month. Hedgers with long positions usually avoid any possibility of having to take delivery by closing out their positions before the delivery period.