HOW TO HEDGE?

HOW TO HEDGE?

Hedger - Risk Management

  • Hedgers refer to individuals/companies who wish to protect themselves or “hedge” against adverse price movements by using futures.
  • Hedgers are able to hedge by buying and selling futures contracts to offset the risks of changing prices in the physical market.
  • Benefits of importers, exporters and physical dealers as hedgers are:

    • Hedging and forward price fixing
    • Scheduling of imports and exports
    • Hassle free price negotiation
    • Inventory management

Hedging

Hedging is to take a futures position that is equal and opposite to a position which they already held in the physical market in order to mitigate the risk of an adverse move in price of the underlying assets
  
Alternatively, they can lock in the price of the underlying assets that they intend to purchase or sell in the future by buying or selling the commodity futures contract.

In this way, they attempt to protect themselves against the risk of an unfavorable price change in the interim.

However, by doing so, they forego the potentials of making profit in the event the price of the underlying assets go favorable, in exchange for the elimination of the downside risk.


Practical Hedging Operation (Crude Palm Oil)

If Sales contract & Total cost is fixed as shown below, hedging in futures market is basically not necessary, since the profit of MYR20/MT is completely secured.

Diagram 1



Long Hedge

If the Total cost is NOT fixed as CPO is not procured while the sales contract is fixed, it is necessary to operate long hedge in futures market.

Long Hedge Diagram


Example of Long Hedge

The supplier has fixed the sales contract for 500MT of CPO @MYR2,550/MT(CIF).
If the total cost is MYR2,530/MT, the supplier makes a profit by MYR20/MT (MYR10,000/500MT) by sales. In contrast, if it is MYR2,570, the supplier makes a loss by MYR20/MT. The supplier decides to operate long hedge to avert the loss by an increment in the total cost.

Physical Trade
Fixed at MYR 2,550 / MT
Futures Trade
Buys (long)
20 lots @ MYR 2,530
Total
If price rises
(MYR 2,530 / MT → MYR 2,570 / MT)
MYR 1,275,000 (MYR 2,550 x 500MT) – MYR 1,285,000 (MYR 2,570 x 500MT) = MYR 10,000 (MYR 2,570 – 2,530) x 25MT x 20 lots = MYR 20,000 MYR 10,000 + MYR 20,000 = MYR 100,000
If price falls
(MYR 2,530 / MT → MYR 2,510 / MT)
MYR 1,275,000 (MYR 2,550 x 50MT) – MYR 1,255,000 (MYR 2,510 x 500MT) = MYR 20,000 (MYR 2,510 – 2,530) x 25MT x 20 lots = MYR 10,000 MYR 20,000 + MYR 10,000 = MYR 100,000
Note: 1 lot = 25MT, 20 lots = 500MT
Note: BMD Crude Palm Oil price is based on FOB


Short Hedge

If a Sales contract is NOT fixed while CPO is procured and the total cost is fixed, it is necessary to operate short hedge in futures market.

Long Hedge Diagram



Physical Trade
Fixed at MYR 2,530 / MT
Futures Trade
Sells (short)
20 lots @ MYR 2,550
Total
If price rises
(MYR 2,530 / MT → MYR 2,570 / MT)
MYR 1,285,000 (MYR 2,570 x 500MT) – MYR 1,265,000 (MYR 2,530 x 500MT) = MYR 20,000 (MYR 2,550 – 2,570) x 25MT x 20 lots = MYR 10,000 MYR 20,000 + MYR 10,000 = $ 100,000
If price falls
(MYR 2,530 / MT → MYR 2,510 / MT)
MYR 1,255,000 (MYR 2,510 x 500MT) – MYR 1,265,000 (MYR 2,530 x 500MT) = MYR 10,000 (MYR 2,530 – 2,510) x 25MT x 20 lots = MYR 20,000 MYR 10,000 + MYR 20,000 = $ 100,000
Note: 1 lot = 25MT, 20 lots = 500MT
Note: BMD Crude Palm Oil price is based on FOB

CONTACT US

Okachi (Malaysia) Sdn. Bhd.

Level 8, Pavilion KL,
168, Jalan Bukit Bintang,
55100 Kuala Lumpur.

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