A quick lesson to hedging for buyer
Price fluctuation may cost your organisation thousands, or even millions of dollars each year, especially when your organisation mostly buys from overseas or you often buy large bulk of commodities.
This is a risk that you cannot totally avoid but it can be managed with skills and knowledge. Futures, forward contracts and options are among the available tools to mitigate the risk of price fluctuation. In this post, we help you to define these tools and to see whether these tools appropriate to your situation.
Forwards, futures and options are methods of hedging. Simply put, hedging works like insurance, which means that it limits your loss when adverse event happens. For example, you buy a health insurance package, then when you get sick and hospitalised, most of your hospital fee will be paid by the insurer.
Similarly, you sign a fixed-price contract with your supplier on buying cocoa which will be harvested next year. Then in the harvesting season, some bad things (pestilence, flood, drought, crop failure,…) causes a cocoa shortage, the price increases tremendously. But your loss is minimised since you have the contract. The supplier is obliged to supply you the set quantity of cocoa at set price. If it is unable to do so, you may be entitled to terminate the contract and claim back your money. The contract in this scenario is called forward contract, a hedging tool.
So that’s enough for the introduction. Now we discover the 3 most common methods of hedging: forwards, futures and options.
We start with the most straightforward (and perhaps the most common) method of hedging: forward contract. Basically, it is just a one-off sale contract in which two parties agree on the specification of the commodity to be traded, delivery date in the future and delivery destination, price and other terms and conditions that contracting parties want. This type of contract is called over-the-counter (OTC). In many cases, the seller doesn’t have the commodity at hand (i.e. the farmers who did not harvest their crops) but it agrees to enter into a contractual relationship to mitigate the risk of price fluctuation.
You may be well acquainted with this type of hedging. To secure the supply source and proof against raising price in the future, you may sign a forward contract with your supplier. You may also go into a contract with your bank on buying foreign currency in the future with fixed exchange rate.
Similar to forward contracts, futures are the contracts in which both parties agree to buy and sell some particular assets (commodities, currency, stocks,…) at predetermined price at a specific time in the future. But there are some attributes that differentiate futures and forwards:
- While forward contracts are negotiated by two parties alone, futures are traded in a specialised exchange (such as forex exchange, commodity exchange, mercantile exchange). This exchange is operated by a state-owned or a private company who also provides other service such as brokerage, consultant, lending, etc.
- In forward contracts, the two parties may write down and agree on anything they want. On the other hand, futures contracts are largely standardised: the terms and conditions are known, the specification is fixed, the contract size is defined (i.e. in Chicago Board of Trade, each soybean futures contract represents 5,000 bushels of yellow soybeans), the delivery destination is predetermined. There are only two variables in futures: the expired date and the price. But in these two variables, the traders cannot decide everything. With expired date, traders are only entitled to select a few options depending on the underlying assets. With price, it can only fluctuate within the known limits and increase or decrease by the known increments.
- Futures contracts have higher level of liquidity in compare with forward contracts. With standardised nature, traders don’t need to care about the quality, they can easily trade the assets back and forth. Therefore, futures contracts are used for trade speculation.
Options is another type of hedging (and derivative). When you enter into an options contract, you are obliged to pay the premium, in exchange, you have the right (not obligation) to buy or sell an underlying asset at specific price in a specified period or specific point in time. If this definition confuses you, read the following example:
Imagine you have 1 metric ton of maize in your warehouse. Now you want to sell it at $1,500 in unknown date, but it must be sold before March 2021. You go to an exchange, buy an options to sell 1 ton of maize at $1,500 from December 2020 to March 2021. The options premium is $100. During the period (Dec ’20 to Mar ’21), maize’s spot price may fluctuate, but you can still sell your maize at $1,500 anytime within said period. You can also reserve the right to sell and keep the maize to feed your livestock.
Options contracts help you limit the risk of loss due to fluctuation to a known fixed price (the premium). In the above scenario, if you don’t buy the options and the maize price falls to $500, your loss will be $1,000. With options, you loss nothing except $100 premium.
Normally, there are two types of options: put options and call options. Put options is the options to sell, call options is the options to buy an asset.
What type of hedging should I select?
Hedging is a complicated topic in finance which cannot be explained in one or two blog posts. To select a right type of hedging, you should form a cross-organisational team with your finance colleagues and expert consultants. So in this section, I won’t give any advice but instead raise a few considerations.
While in more developed economies (such as the US, Japan, Singapore, EU and the UK), there are many derivative exchanges, developing countries don’t have such many options. There are many reasons for this. It may be due to speculation nature of derivatives such as futures and options so that the government doesn’t want to encourage its people to involve in such risky games. It may be due to lack of necessary regulations and managing expertise of government officials. Many countries solve this problem by allowing the domestic commodity exchanges to connect with international exchanges. However, this solution only opens a gate for speculators to trade derivatives, it does not expand the market for farmers, manufacturers and buying organisations.
Fixed and floated currency exchange
Hedging can be used to reduce the risk of currency fluctuation. But many developing countries deploy fixed currency exchange rate, which means every morning the central bank tells you how much local currency is needed to convert into 1 USD. In the countries, using options or futures to proof against exchange rate fluctuation is inappropriate. Of course, you can still go to a local bank and ask them to devise a currency forward contract.
Another obstacle for using forex options and futures is that the number of currency pairs is limited. The forex exchange only offers some currency pairs which mostly derive from major currencies (USD, EUR, GBP, AUD, JPY,…). Companies in Botswana, Nigeria or Vietnam do not easily trade their currency online and convert into major currencies.