Lead Hedging Basics
Commodity Hedging |
Updated on: 1st October 2021
For the uninitiated, when you agree to buy or sell a commodity and the prices are not fixed, you take a so-called ‘price risk’. Say, in June, a battery manufacturer agreed to buy one tonne of refined lead from a lead smelter for August delivery at August price. Since he doesn’t know the price after three months, he is taking a price risk (also a currency risk if he is importing it and paying a different currency). Simply, as the transaction is not at a fixed price, both the smelter and battery manufacturer may be exposed to a change in price between the date of agreeing on the transaction and its future delivery date. Here hedging comes into the picture – Hedging is a technique to ensure your position in the market is not affected by any adverse movements. We mainly hedge using a futures or options contract.
Hedging using Futures:
Sticking to the above scenario, the battery manufacturer is scared that prices might go up in the future. He wants to lock in the spot price that is $2138.50. He could enter into (buy) a ‘3-month futures contract’. This essentially means that he has to buy Leads from the seller after 3 months at the futures price. As shown in the chart below, 3 months’ futures are trading at $2138.50.
To offset this price risk exposure, in June the battery manufacturer buys one lot of LME Lead August futures at $2138.50.
After 3 months:
Let’s assume that the lead market price has increased after 3 months and the battery manufacturer buys the physical lead at the end of August at $2170.
Cash outflow: $2170 (P/L: Loss of $(2138.5-2170) = $31.5)
To close the hedge position, the battery manufacturer sells one lot of LME Lead. (Since futures and spot prices move together, we will assume that August Futures is trading at $2175).
Cash Inflow: $(2170-2138.5) = $31.5 (This is also the P/L of Futures transaction)
Hence the profit from the futures transaction would offset the loss of physical P/L.
- The main distinction between a Forward and a Futures contract is: Futures is a standardized contract (both in terms of lot size and date of settlement), it is exchange-traded, unlike a Forwards contract which is not standardized. In futures (unlike forwards), one has to pay a margin upfront to enter into the contract- P&L is realized daily (daily cash flow) unlike forwards markets where P&L is realized only at maturity.
- Initial margin costs and trading fees have been excluded in this example.