Commodity Hedging – What Is It
Commodity hedging is when a company decides to offset or eliminate risks due to the fluctuations in the raw material prices. This is a risk management strategy to protect against price fluctuations and against losses and well as protecting profits.
How does it work?
To begin with, let’s explore some definitions. The cash or spot market is where you can actually buy or sell physical commodities. The futures market on the other hand involves the trade of contract, where it involves the physical delivery of the goods or commodities at the future date, where hedging can take place.
For example, if an aluminum producer expects the price of the raw material, aluminum to rise in the next two months, he will then enter into a long position of a futures contract to offset the increase of aluminum prices. Likewise, if he expects the price of aluminum to fall, he will enter into a short position in the futures market to sell in the futures market against the aluminum he holds.
Who will hedge?
Producers and manufacturers that are exposed to risks due to the volatility in commodity prices will see to hedge. In the case of Malaysia, it is a palm oil producing country, thus the majority commodity hedgers in Malaysia will be palm oil producers. They can enter the position in the futures market which is Bursa Malaysia Derivatives Exchange for Crude Palm Oil Futures (FCPO)
How to start hedging?
Hedging is the same as trading futures contract. One will need to enter into a position either long or short. The hedger will also have to pay a margin of the total contract value, which is usually 5-10% depending on the contract.
What about the risk?
As the producers are hedging against the physical goods, it is generally considered not risky if it is based on a short-term period. However, the hedger, if forecast the wrong price movement will lose out on potential savings.
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