The principles of hedging

Created on Saturday, 23 March 2013 16:29

Last Updated on Saturday, 23 March 2013 16:29

The principles of hedging

The LME offers those at all stages of the metals supply chain the opportunity to hedge their price risk and gain protection from adverse price movements.

Hedging is the process of offsetting the risk of price movements in the physical market by locking in a price for the same commodity in the futures market.

There are two main motivations for a company to hedge:

• To lock in a future price which is attractive, relative to an organisation’s costs
• To secure a price fixed against an external contract

When hedging, an organisation starts with price risk exposure from its physical operations, and will buy or sell a futures contract to offset that price exposure in the futures market. An organisation can decide on the amount of risk it is prepared to accept. It may wish to eliminate price risk entirely.

Speculation

Hedging is the opposite of speculation as its primary purpose is to offset risk. Speculators, however, come to the futures market with no initial risk. They assume risk by taking on futures positions, which in turn provides market liquidity. Hedgers reduce or eliminate the chance of future losses or profits, while speculators risk losses in order to make profits.

Hedging programme

To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the LME Official Settlement Price in order to achieve the most effective hedge and to meet the international accounting standards. 

The programme can be as simple or as complex as a company wants to make it, but it will depend on that company’s appetite for risk, internal practices, pricing policies and hedging motives. Not only must a hedging programme be well devised, but it must also be managed according to the changing circumstances of a company’s physical operations.