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Hedging 101    

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Every so often, I am reminded that the majority of business people are not very familiar with the concept of hedging and its arcane terminology.  This article is aimed at those looking to get a better handle on the basic concept of hedging and some of its applications to business.  I’m sure you have heard the phrase “to hedge one’s bet”.  An aspiring actor might say that their dream is to star on Broadway, but in order to “hedge their bet” they are taking classes toward a degree in business administration. 

Thus a hedge, in a general sense, is an act or means of preventing a complete loss of an action or bet with a partially counterbalancing or qualifying one.  Hedging in a business context is no different, as it is simply doing something to counterbalance a risk that exists due to the nature of your business. 

As an interesting side note, the original hedge funds operated in a fashion that did indeed hedge their bets to counterbalance the risk associated with their investment portfolios.  For example, one approach was to buy stocks they believed would go up, and balance this by shorting an equal dollar-value of stocks they believed would go down.  This approach offered some protection against a drop in the overall market, since they were short as many stocks as they were long in value terms.  However, many hedge funds these days are in fact the antithesis of hedging, taking huge, highly leveraged bets with their investors’ money.

So hedging is just doing something to reduce your risk.  Depending on the business you are in, you might have a multitude of risks relating to commodities, foreign exchange or interest rates.  In many cases, there are financial instruments available to allow you to counterbalance or “hedge” these risks – and not surprisingly these are called “hedging instruments”. 

Two important terms that you will often hear in the commodity world are “long” and “short”.  To be “long” a commodity simply means that you own it (either physically or through some financial arrangement) and thus are exposed to the risk of the price falling.  To be “short” a commodity simply means that you have made a commitment to sell it (either physically or through some financial arrangement) and thus are exposed to the risk of the price rising.  If you have made commitments to sell more of a commodity than you presently own, then you are “net short” the commodity.  If you have bought (or produced) more of a commodity than you have sales agreements for, then you are “net long”.  The term “natural long” refers to a company that produces a commodity, such as an energy producer that is perpetually long crude oil or natural gas.  The term “natural short” refers a company that consumes a commodity, such as a transportation company that is perpetually short gasoline or diesel fuel.

Armed with this basic understanding, let’s look at two examples.  The first example is a canola farmer – let’s call him Farmer Ron.  Since Farmer Ron owns canola and will be negatively impacted if canola prices fall, he could take a position in the canola futures market that will benefit him if canola prices fall (e.g., going “short” canola futures).  Conversely, if canola prices increase, he will be able to sell the canola he produced for a higher price, but will incur a loss on his position in the canola futures market.  Thus, the futures position “offsets” or “hedges” the price risk associated with the canola being produced on the farm. 

Bear in mind, that in most cases, Farmer Ron will never actually deliver his canola against his short futures contract.  Rather, he will reverse his short futures position by buying an equal quantity of canola futures (of the same delivery month) and then deliver his physical canola to the local elevator like always.  So the canola futures hedge in this example is related to the canola on his farm in a pricing sense, but is not related to the actual physical delivery of the canola.  Providing he reverses his short futures position at the same time that he establishes the price for his canola with the elevator company, the canola hedge will have served its purpose in counterbalancing his risk.  The same holds true for a lot of business hedging applications, where the hedge is placed in the financial markets, and while it has nothing to do with the delivery of the physical commodity, it serves the function of counterbalancing its price risk. 

Our second example is a manufacturer that uses a large amount of natural gas in its production process.  If the price of natural gas goes up, it cuts directly into their profit margin.  While they might have some ability to pass some of this on to their customers, this is highly uncertain and depends heavily on what their competitors do.  To counterbalance or “hedge” their risk associated with natural gas prices, they decide to buy natural gas futures.  Using our newly acquired terminology, they are short physical natural gas, but long natural gas futures as a hedge.  If natural gas prices rise, they will spend more money buying natural gas for their manufacturing plants, but they will make an offsetting gain on their long natural gas futures position.  Rather than taking delivery on their long natural gas futures position, they will just offset it in the market (by selling an equal quantity) about the same time as they lock in the price for the natural gas they are buying to supply their manufacturing plants. 

It should be noted that in some cases a company will also have the option of buying physical natural gas from their suppliers in the forward market.  We could call this a “physical hedge” as opposed to a “financial hedge”.  In the case of a physical hedge they will indeed take delivery of the commodity against their forward contract in most cases.

You have probably already twigged onto the idea that if these hedges are actually going to work, there had better be a very tight relationship between the price changes in the hedging instrument and the price changes in the underlying physical commodity – which are the physical canola and natural gas in our examples.  If the price of the canola at the elevator drops by $30 per tonne, but the futures price only drops by $20 per tonne, then the hedge didn’t fully protect Farmer Ron.  If the natural gas price paid by our manufacturing business went up by 50 cents per mmbtu, but the natural gas futures price went up by only 40 cents per mmbtu, then the hedge did not fully counterbalance the risk in the physical natural gas.  Thus we encounter the concept of “hedge effectiveness”.  If a hedge is to be effective in counterbalancing a risk, then there must be a tight relationship between the price of the underlying commodity and the hedging instrument.  We will provide some actual examples of the measures of hedge effectiveness in another article.  The lack of a perfect relationship between the underlying commodity and the hedging instrument is sometimes called “basis risk”.

One more term that you might hear is “cross hedging”.  This refers to using a hedging instrument from one commodity to hedge the risk of a different commodity, because of the alleged close relationship between the two commodities.  A common example is using corn futures to hedge feed barley.  Be careful with cross hedging and be sure to do a thorough job of examining the hedge effectiveness.

To sum up, hedging, in most business applications, is nothing more than doing something that counterbalances your commodity-related risk that arises due to the nature of your business.  You are essentially taking the opposite position in the financial markets to that which occurs in your underlying business. 

There are lots of variations on this theme relating to different types of hedging instruments, such as forwards, swaps and options, but that’s for another day.

Ron R. Gibson

 

Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca


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