How is Hedging Dependent on Basis


If you are a risk-averse investor, you want to find out wants to reduce risk. Hedging is one of the options you can use to do this.

A hedge is an investment that mitigates the risk of adverse price movements of an asset. The prices of commodities keep fluctuating. To hedge against such price risks, players buy or sell positions in the commodity futures markets. It is mainly the producers/sellers of commodities (e.g., farmers producing wheat) and the consumers/buyers of commodities (e.g., bread manufacturers who use wheat as raw material) who undertake commodity hedging.

Long Hedger

The long hedger is the consumer/buyer of the commodity. He wants to buy the commodity at a future date. But, he expects its price to rise in the future. So, he enters a futures contract to buy the commodity at the current lower price at a future date.

For example, suppose the price of wheat is Rs 30/kg. A bread manufacturer expects it to rise in the coming months. So, he enters into a contract in the futures market to buy wheat at the current price. Suppose the price rises to Rs 35/kg in a month. But, the bread manufacturer will still get it at Rs 30/kg from the seller at the end of the contract. This act of taking long positions in the futures market to avoid the risks associated with the rise in commodity prices is called taking a long hedge.

Short Hedger

The short hedger is the producer/seller of the commodity. He expects the price of the commodity to fall in the future. So, he wants to lock in the current price. He then enters into a futures contract to sell the commodity at the current higher price at a future date.

For example, suppose the price of wheat is Rs 30/kg. A wheat farmer expects the price to fall in the coming months. He will then enter into a contract in the futures market to sell wheat at the current price. Suppose the price indeed falls from Rs 30/kg to Rs 25/kg in a month. According to the contract, he will still get a price of Rs 30/kg for his crop. This act of taking short positions in the futures market to avoid the risk of a fall in commodity prices is called taking a short hedge.

Basis and Hedging

The ‘basis’ is the price difference between a commodity’s local cash price and the price of its futures contract.

Basis is an important factor on which hedging decisions are made. It helps both buyers and sellers to predict the final price for their product. Basis tends to be consistent despite price fluctuations. It can be accurately predicted using historical patterns. It also indicates when a buyer or seller should hedge against a risk.

A strengthening basis is beneficial to a seller or short hedger of a commodity. That is because the difference between the cash and the futures price becomes more positive. Thus, a seller will receive a higher cash price when he sells his product on the cash market.

A weakening basis is beneficial to a buyer or longer hedger of a commodity. That is because the difference between the cash and futures price becomes more negative. This enables the buyer to get the product at a lower price and thus, make more profit.

The matrix of sale and purchase for producers and consumers on basis is given below:

Long Hedge High Cash Price Low Cash Price
Strong Basis (Spot price > Futures price)
  • Delay cash purchase.
  • No hedge required.
  • Delay cash purchase.
  • Hedge Long Futures.
Weak Basis (Spot price < Futures price)
  • Purchase immediate requirements only.
  • Purchases as much as possible and store or hedge using Futures contracts.

 

Short Hedge High Cash Price Low Cash Price
Strong Basis (Spot price > Futures price)
  • Sell produce in cash
  • Sell produce
  • Re-own by going long on Futures
Weak Basis (Spot price < Futures price)
  • Delay cash sales/store produce
  • Hedge short Futures
  • Store for selling later

 

What next?

Now that you know how to hedge, let’s move on. In the next chapter, we will learn how to trade in the commodity market.

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