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CHAPTER 1
The Markets
Welcome to the virtual market, where you can trade all sorts of commodities without any of them changing hands!
Before we dive right into hedging, let me introduce you to a new marketplace. You'll learn much about it in the pages ahead, but it is important to establish up front that hedging will require you to think about more than just the traditional marketplace you've been accustomed to for years.
We'll call the traditional market the physical market. It's where tangible goods move about ... in exchange for cash, of course. It's how most people think about business transactions. You want something I sell? Give me some money and I will give it to you. That's the traditional market at its core.
The new marketplace is a bit different. It anticipates prices in the future and it operates with its own set of rules. Yet it is connected to the traditional market, in that it trades the same commodities. We'll refer to this market as the futures market.
"Commodities?" you ask. Yes, you know them: corn, soybeans, wheat, cattle, electricity, natural gas, crude oil, gasoline, milk, sugar, coffee, gold, silver, copper, and platinum, among others ... the basic building blocks of an economy. Even debt, currency, and weather act as commodities in some businesses. Many companies use commodities, and their prices tend to oscillate based on the laws of supply and demand. Supply and demand are tied to any number of unpredictable factors, either real or anticipated, that can tip the balance. When this happens, price, the great equalizer, moves to reestablish equilibrium.
You will encounter discussions in this book about both the physical market and the futures market for the same commodity. Each market has its own set of prices and its own pool of buyers and sellers. Yet, when these two markets come together, they give birth to hedging. The effective hedger establishes positions of opposing risk in each market. When combined, the risks associated with the positions in the two markets essentially cancel each other out.
A physical market is a collection of buyers and sellers who transact with the express purpose of exchanging a commodity. In a futures market, by contrast, the exchange of a commodity can be a rare occasion. We'll define a futures market as an aggregation of traders who are willing to commit to delivering, or taking delivery of, a specific commodity at some point in the future for a certain price. The futures market will allow them to back away from those delivery commitments before they arrive. Most traders need this flexibility or they won't participate.
The purpose of the futures market is more about establishing future prices than it is about arranging future deliveries. Establishing future prices helps businesses plan, manage risk, and actually transact orders before delivering the products they sell. When a business strategically unites the physical and futures markets as choreographed dance partners, risk has been escorted to the door and invited to spoil someone else's party, if not their bottom line.
Some buyers and sellers of a commodity will participate in both the physical market and the futures market. The futures market, however, will have a much larger pool of buyers and sellers than the physical market, some of whom are not really in a business related to the commodity they are trading. They are trading futures because they think they can make money, whether or not they have an offsetting risk in their portfolio. Yet it matters not. They help others in that market who have a direct business interest in the commodity at hand by providing additional trading partners for them. When there are more traders in a given market, pricing is typically more transparent and more equitable because bidding is more active and more competitive.
The commodity itself may be the only connection between the physical and futures markets that trade it. Yet, sometimes, those markets are tied together in business deals. For example, you may contract with a vendor to purchase a commodity based upon its futures price. When you transact that purchase, you are still trading in the physical market even though your price is predicated on other people's trades in the futures market.
These two markets can also be linked together when a futures contract expires. In order to honor the commitment to deliver under the futures contract, an exchange of the commodity for cash will occur. But, again, this transaction occurs in the physical market, with the futures market merely determining the commodity price.
Although the term "futures market" implies singularity, in reality the market is complex and fragmented. For our purposes, we might rather think of the futures market as a collection of alternatives for trading commodities for future delivery. You'll discover a variety of these hedging tools as you dig deeper into this book.
Now that you've been introduced to the futures market, I'd like you to consider some of the reasons for hedging, and what hedging really is. Then we'll delve into how the futures market works to establish an effective hedge on commodity price risk.
CHAPTER 2
Why Hedge?
Doing nothing is a decision ... sometimes a regrettable one.
What is the purpose of hedging? Why trade in the commodity futures market? Doesn't this activity come with its own set of risks?
The benefit of trading in this market, for those who understand it and use it wisely, is that trading can reduce the overall risk of doing nothing. Effective hedging ultimately protects a business's asset value and net worth. It stabilizes the earnings stream, bringing predictability out of the unpredictable. It can help you stay in business for the long term.
Price Risk Scenarios
Consider the following:
1. A wholesaler purchases a large quantity of gasoline at a fixed price. The market price could decline before he liquidates his inventory. What can he do to protect the value of his inventory, and therefore the value of his business?
2. A heating oil distributor contracts with his customers in June for delivery of heating oil the following winter at either a fixed price or a price not to exceed a certain level. The price of oil may go up, but the distributor's selling price for these gallons cannot, since he has already committed to a fixed price or a capped price with his customers. How does the distributor protect his profit margin on the sales of these fixed-price and capped-price gallons?
3. It is early in the growing season. A wheat farmer who has planted fifty thousand acres is concerned that there may be a glut of wheat on the market at harvest. She sees that she can lock in a fair price now, four months before harvest. This will at least help her cover some of her costs and ensure she can pay the mortgage. If she waits, maybe she'll get a better price, especially if the United States brokers that deal they've been working on with Russia. However, if that falls through, surely the price will decline. How does the farmer secure the profit margin on some of her wheat in order to pay the bills?
4. A real estate investor purchased a large office building six months ago. He financed the purchase at a variable interest rate. Most of the building is now leased over a reasonably long term. If interest rates go up substantially, the rent will not cover the increased debt payments. He'd like to convert the financing to a fixed rate, even though he'll pay a higher rate, because the rent is sufficient to cover the payments at the higher fixed interest rate. He can then be assured of a steadier stream of cash with a higher likelihood of meeting his financial obligations. How does the investor fix his interest rate?
5. A manufacturer uses large amounts of copper in its process. The business has just secured a large contract for one of its premier products. If copper prices increase beyond a certain threshold, the business will lose money on this contract. How does the manufacturer prevent a loss of money on this contract due to potential increases in the price of copper?
6. A US farming operation has just signed a contract to sell some of next summer's harvest in Europe. It will collect its sales proceeds in Euros, and its contract has fixed the price. If the value of the Euro weakens against the US dollar, the farming operation will receive less compensation when it converts the sales proceeds into its own currency. How can the operation protect itself from losing money due to a weakening Euro?
7. A regional airline has just instituted a price change to cover recent increases in jet fuel costs. It doesn't want to increase rates again in the near term, yet management is concerned about the possibility of additional price spikes for jet fuel in the coming months. What steps can the airline take to ensure that a further rise in the cost of fuel doesn't necessitate another fare hike?
8. A Midwestern farmer has a pending deal to acquire more acreage and growing capacity from an estate. He would like to commit this acreage to corn next year, and the futures prices suggest more than a handsome return on this investment, thanks to a deal the US government has just negotiated with China. However, what if another development between now and then causes the price of corn to decline? How can he lock in that price today before committing time and money to expanding his corn crop?
9. It's summer, and there's a glut of heating oil on the market. Meanwhile, long-term weather forecasts are suggesting a very cold winter, causing prices for wintertime heating oil to trade nearly 30 cents per gallon higher than the current market price. An oil supplier has substantial unused storage capacity, and he can borrow money now at very low cost. If he could lock in the high selling price for delivery sometime next winter, he'd be willing to buy some oil now because he knows he can make a lot of money on the deal. In fact, he is estimating a 35 percent annualized return on the capital he would invest. He knows he can sell the product to some distributors at favorable prices when cold weather arrives. How can he confidently proceed with the purchase now while capitalizing on the high selling price for winter oil?
In each of the above cases, the businessperson is concerned about an adverse change in the price of acommodity that will cause him or her to lose money. Each has a commodity price risk. A business has a commodity price risk if either an increase or a decrease in the price of a commodity will reduce the business's overall value. When a material risk exists, other financial obligations will often demand that a business find an effective risk management solution. The futures market, or some other hedging mechanism, can help contain the risk.
Grappling with Risk
Have you ever heard the old axiom "you don't get something for nothing?" Well, it's true — never more so than with managing commodity price risk. There's a cost to hedging that risk, including the cost of managing and executing an effective program. Hedging cost also includes a forgone benefit (i.e., anopportunity cost), which is usually more material than the costs of administering the hedge.
The opportunity cost presents an interesting dilemma. With changing commodity prices, if you don't get a bad result, you're usually left with a pleasant surprise. And the stakes can be very high. If you don't mind risk and you don't mind jeopardizing the value of your business, then you might rather save the opportunity cost and go it alone ... and stop reading any further about this hedging nonsense.
However, if you're like most businesspeople, you'll want to make sure you live to fight another day. You've made a long-term investment in your business, and you anticipate the payday down the road when you exit the business — or pass it on to your heirs. You may conclude, as most do, that the opportunity cost is an investment in your long-term livelihood.
Risk and reward are indeed lifelong partners. You can't have one without the other. When you ask one of them to leave you alone, its companion waltzes right out the door with it. Yet that's okay, because you're in business for the long haul. When you hedge your commodity price risk, you still bear enough business risk to earn a handsome reward, but you eliminate the nasty commodity price risk you could do without.
Sometimes, risk may be right under your nose without you knowing it. It may sneak in undetected until telltale signs surface. It may expose itself unashamedly, stealing away a large percentage of annual earnings that you just can't miss. Or, it may hibernate. You may discover it when something good happens. The change in the price of a commodity may actually increase your business's value. Take note, however: behind unexpected gains, an unmanaged price risk may be lurking. What may benefit your business today could come back to bite it in the future. Good news sometimes portends catastrophe.
One way or the other, risk must be unmasked. If you don't know and understand your price risks, you'll never be able to hedge them. This is the single most important rule of hedging: know your risk!
Once you understand your risks and resolve to manage them, your hedging costs will invariably be less than the cost of doing nothing when the price of a commodity tied to your business changes in a dramatic and adverse way. Although the cost of eliminating all risk is to exit the business and forgo its financial rewards, most prudent businesspeople will make a reasonable assessment of risk and then decide how to best mitigate that risk.
What's your business risk? Do price swings in certain commodities threaten your bottom line? If you take steps now to assess your risks, you'll be in a better position to manage them. Don't wait until it's too late! Your payday may never come if you don't manage risk well.
CHAPTER 3
What Is Hedging?
Hedging is simple. Its details, however, will confound you.
Hedging has been around for many years. I know that because my mother supported traders of Aroostook County potatoes in the 1960s from a potato house in Houlton, Maine. You may have heard the term tossed about in the business news, perhaps tied to the word "fund" and to a scandal, with a visual of a white-collar criminal escorted from a courtroom in handcuffs, headed to a more modest dwelling than the one he was accustomed to. Hedging can mean different things to different people. Many skeptics may equate it with gambling or greed. Yet, for those with otherwise unmanageable risk, it's the white knight who saves the damsel in distress.
In the context of commodity price risk, we'll define hedging as any technique used to transfer or mitigate the risk through a specific course of action. Usually, a business does this by entering into a transaction that offsets the risk associated with another transaction.
Consider the following. If a company purchases oil at a fixed price without any firm sales commitments, and the market price of oil falls before it can liquidate the inventory, it will lose money. As the price of oil drops, so too will the value of the business's inventory. Commodity price risk is looming.
The business can hedge this risk by finding another party who will agree to fix a selling price for the oil. By its very nature, the futures market offers willing and ready buyers to would-be hedgers. "Selling" the oil on the futures market will establish that fixed selling price. It will create a position in the futures, or "paper," market that opposes the business's position in the physical market. I will explain this in more detail later in this chapter.
Often, hedging involves giving up an opportunity — as well as its associated risk. If the company in the prior example chose not to sell futures contracts in the futures market, it could make a lot of money, were the price of oil to go up. The value of its inventory would then increase. This forgone benefit is the opportunity cost.
Nevertheless, when a company chooses to hedge a commodity price risk, a third party steps in to absorb the risk. Whatever the third party's circumstances may be (and these circumstances are irrelevant to the hedger), the third party judges itself to be in a position to take on the associated risk, or to offset it with an opposing risk it may already own.
When a business enters into a hedging transaction, it is trying to secure a profit or to limit a loss. It is attempting to reduce uncertainty in its financial performance. Stakeholders, such as bankers and investors, want predictable earnings. Hedging may entail forgoing additional gains in order to secure a lesser benefit. Regardless, it is ultimately designed to reduce risk. Because of the perception of forgone profits, hedging may come with some internal angst. And since greed often wages war against the need to hedge, a disciplined approach becomes the hallmark of an effective program.
Another way to describe hedging is to consider what it is not. Hedging is not speculation. Speculation is trading in the markets without having a risk to offset. You may have industry knowledge that leads to insights and hunches about price direction, but unless you have a risk to transfer, any trading on that knowledge is mere speculation that the price will move in your favor. This type of trading is more akin to "playing the markets." Although a lot of money can be made, much can be lost as well. Hedging and speculation are sisters with opposite personalities.
(Continues…)
Excerpted from "Hedging Demystified"
by .
Copyright © 2014 Timothy G. Bishop.
Excerpted by permission of Open Road Press.
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