Fundamentals of Hedging: What is it? Where should we start?
Learn the basic principles of hedging, and how to use it to protect yourself from risks in the commodity market.
If you’ve arrived at this article, you probably have some idea about what hedging is, or at least you’ve heard of it. But if you have no idea what it is, don’t worry: this post will address the key fundamentals, and clear up the doubts of those who have little or no knowledge of hedging.
hEDGEpoint is a global hedging company. Thus, we‘ve prepared this content for those of you who want to better understand how this specific practice works.
At the end of this text, you’ll walk away with basic knowledge of hedging, and how to use it to manage your business risks. Check it out.
What is hedging?
The English word “hedge” can be literally translated as “fence” or “limit.” That’s why we use the name for this trading model that guarantees protection against market fluctuations.
In practice, hedging is a mechanism that operates as a kind of insurance against market price variations. That is, it acts to reduce transaction risks. A strategy of this nature aims to offer more predictability to those who have exposure to price risks.
Hedging operations can be carried out by trading agricultural and/or financial derivatives on futures exchanges.
How did financial hedging start?
Hedging originated in agricultural markets in the United States. In the middle of the 19th century, farmers and ranchers were looking for a way to reduce the risk of sudden price drops. So, they started using price fixing to trade agricultural commodities.
Over time, the technique became so popular that it came to be used in other asset categories. Today, hedging is commonly used throughout the agro market chain, as well as the energy sector, and with currencies.
What is hedging best for?
The main reason for conducting hedging operations is to manage the riches that the commodities market involves. It’s a way to provide more security to businesses and achieve more predictability.
Those who choose to implement hedging strategies end up enjoying greater confidence to carry out transactions on stock exchanges, due to greater stability.
What are the main types of hedging?
There are several main ways to carry out hedging operations. Everything depends on which type of market you want to operate in. hEDGEpoint features activities in the areas of commodities (both agricultural and energy) and currencies.
Commodity hedging is usually carried out in futures markets. By buying and selling futures contracts, producers can fix prices for goods, which will be paid in the future when the goods are delivered. This type of strategy is quite common in agricultural markets, for example.
Currency hedging is based on the use of the dollar as a hedging strategy for other assets or transactions. However, there are other ways you can go. In addition to trading dollar futures contracts, it’s also possible to invest in exchange funds, trade dollar options, buy bonds denominated in foreign currencies, and even purchase currencies in cash.
Where is hedging applied?
Hedging transactions can be traded in different markets, including the stock exchange. In the exchange, it’s possible to carry out hedging operations in stocks through the trading of options on stocks, futures contracts based on stock indexes, or index funds (ETFs).
However, other forms of hedging, such as Foreign Exchange hedging, are traded in specific FX or FX derivative markets, where foreign currency futures contracts, FX options, FX funds, and other related instruments are all offered.
Likewise, commodity hedging can be traded in specific commodity markets. This is the case of the “Bolsa de Mercadorias e Futuros” (BM&F) in Brazil, where futures contracts are offered for commodities such as soybeans, coffee, and oil, among others.
Although the stock exchange is a place where some hedging operations are performed, it’s important to keep in mind that different types of hedging can be done in specific markets, according to the assets and instruments involved in the protection strategy.
In what types of operations can you use hedging?
It’s possible for you to take advantage of hedging in the following operations:
spot purchase/sale, forward purchase/sale, long/short basis (accompanied by commodity and currency hedging), frame, and barter.
Which are the main commodities that hedging can be applied to?
It’s viable to hedge trades in any commodity. In the case of hEDGEpoint, we operate with agricultural commodities such as grains (soybeans, corn, and wheat), animal protein, cotton, sugar, coffee, and cocoa, as well as energy, such as oil, natural gas, ethanol, and biofuels.
At what moment can you apply hedging?
Hedging can be applied at different times, depending on your needs and objectives. Take a look at some examples:
To anticipate risks: Hedging can be used before the occurrence of an event that may negatively affect your business. For example, an agricultural producer may decide to hedge before the start of the harvest season to protect against price volatility.
During risk exposure: Hedging can also be applied while a position or exposure is at risk.
Continuously over time: It can be performed on an ongoing basis as market conditions change and risks evolve. This involves adjusting and rebalancing hedging strategies as new information and events occur.
In response to unforeseen events: It can also be applied in response to significant changes in market conditions. For example, a company may decide to hedge a currency in response to a sudden devaluation of its national currency.
Who can use a hedging strategy?
Hedging techniques are recommended for all those who’re exposed to price risks and would like to reduce the chance of loss and damage resulting from them.
This may be the case for those who produce physical assets, for example. But all those who operate in the commodity chain need some protection against variations in price, exchange rates, and volatility.
Those who work with negotiations in foreign currencies are commonly exposed to exchange rate fluctuations. Even in national scenarios, with so much political and economic instability, hedging is an alternative to find more solidity.
There are relatively simple structures aimed at the dimensions of different assets. That is, everyone can enter this universe in search of a mechanism to feel more secure: from managers with limited experience to entrepreneurs carrying out large transactions.
hEDGEpoint is a commodity risk management company that uses all kinds of financial tools to protect producers, consumers, buyers, sellers, and other market agents from price fluctuations. To offer these products, technology and market intelligence are used to better base decision-making on market fundamentals.
The hEDGEpoint team is highly qualified and possesses the necessary knowledge to map future trends, and thus deliver the best forecasts.
hEDGEpoint is present globally, and always ready to serve you at any time, in any place. Get in touch with an expert today to find out more about how to use this instrument to favor your business.
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