Role of Hedging in risk management

Hedging plays an important role and as a protective device in risk management that has more or less the same effect as insurance but fundamentally differs in operation from the latter is hedging. Some products like wheat, oil seeds and textiles, which suffer a high degree of price. fluctuations, can be sold through forward contracts, which substantially eliminate the risk of these fluctuations.

Hedging refers to “the coincidence of purchase and sale in two different markets.” The prices in these two markets are expected to move in such a way that any loss suffered in one will be offset by an equivalent gain in the other. The most common instance of a hedging transaction is the purchase and sale of the same amount of the same commodity in the spot and future markets respectively. It is made in the future markets to counteract or neutralize speculative loss (and profit) on the trade contract.

Purpose of Hedging

Risks arising out of price changes in obedience to constant changes in supply and demand conditions affect those businessmen who own commodities in storage (while they are being processed), or when these commodities are in the form of inventories of finished goods until they are sold. Market price risk also affects those businessmen who expect to buy a given commodity at a later date in order to make delivery on a previous sale of such commodity. The market position of such businessmen is known as long in the previous case and short in the latter case. Whether the position is long or short in the market at any given time, all commodity handlers such as flour millers, food processors, distillers, food manufacturers, cotton merchants and many others are deeply concerned with the problem of price changes. Hedging is thus the device which protects dealers in spot and forward markets. The organized Commodity Exchange is the mechanism through which the device is made effective.

Hedging aims at:

  • Protecting purchases or inventories of a commodity not covered by actual sales of that commodity;
  • Protecting uncovered forward sales of a commodity;
  • Protecting or earning an expected carrying charge on the commodities that have been stored;
  • Protecting a given price for the prospective or estimated production of commodities.

Hedging is widely used for staple commodities. But it is impossible to make a close estimate of the actual number of hedging transactions. Outside the commodity markets, the most important application of the hedging principle is in connection with the risk of fluctuations in foreign exchange. When a merchant buys or sells goods for future payment in a foreign currency, he runs the risk that change in the foreign exchange rate before the settlement date may expose him to heavy losses. To avoid this risk, he may make use of the market in “forward” exchange.

Kinds of Hedging

Hedging may be for the purchase or for the sale of goods. Under hedging purchases, a merchant or wholesaler may go to the spot market and make purchases to resell goods at profit. He sells the same commodity in the cash market so that he may protect himself against any loss in price. So long as the spot and futures prices move in unison, the loss incurred by the merchant on the sales in the spot market is offset or counter-balanced by the profit on his dealings in the futures market.

In a hedge sale, a merchant sells the same commodity for cash, but he also sells it in the futures market so that he is protected against a fall in price. Any loss on a forward sale, consequent on a rise in the price of the actual commodity in the spot market, is offset by the gain on the hedge purchases in the futures market.

Limitation of Hedging

The protection furnished by hedging is never perfect. To eliminate completely the risk of price changes, it would be necessary that the relationship between the future price and the cash price at the time the hedging contract is closed should be definitely predictable on the basis of the relationship at the time when it begins. In fact, there is nearly always some fluctuations from month to month in the cash price and the various futures prices. For example, a temporary shortage caused by a delayed harvest, bad roads and transportation difficulties will cause the cash price and the futures to rise, and there is no way in which one can hedge against the decline in prices which will later wipe out these differentials.

A few important limitations of hedging are:

  1. Cash and future prices do not always move together, i.e., in the same direction. Hence hedging cannot prevent losses.
  2. Prices of contract or basic grade on a futures market and other grades in the cash market do not move together in the up or down direction. Hence, hedging may often fail.
  3. The unit of trade on the futures market is fixed, i.e., it is 100 tons, or 100 bales or 1,000 kgs. If a hedger’s needs fall short of the unit or its multiple, hedging is of limited use to offset losses against profits or vice versa as between the two markets.
  4. Hedging protects a manufacturer against a rise in the cost of production due to a rise in the price of raw materials. But if the rise in the cost of production is due to a rise in wages and other costs, hedging cannot provide protection.
  5. Hedging involves some expenditure-commission to brokers and the expenses involved in the time and effort required to study and analyze price changes in different markets.