When I was a commodities specialist in a bank, a lot of my friends thought that most of my customers had bought commodities to tap on the commodity supercycle.
Actually that is not true; more than 70% of the customers then was hedgers and only 30% are speculators.
This is the same reason why our commodity desk was very profitable then.
Why?
If the customer is a speculator, most likely he is trading 1 – 5 lots of copper. The customer knows that trading futures is risky, so he is trading within his means. While for an institution in a manufacturing or physical trading business, he will be trading 40 – 100 lots of copper to hedge his physical positions.
In addition, since futures trading is a speculative activity, over time the losers will be gone and only the winners stay. So this speculative group of customers will become smaller over time. But in hedging, the same customers will come again, because as long as their business is running, they will need to hedge for risk management purposes. As good words spread of this team, most hedgers will come in.
The knowledge of hedging and risk management was very crucial in my job then. Here was a common senario from a corporate customer (hedger):
The customer called me and told me that:
He had bought 2000 metric tons of copper from his supplier based on September average price, delivery in early October.
At the same time, he had already sold 500 metric tons at $7300 to a customer, delivery in mid October. If price rises higher in mid October, he does not want to miss the opportunity on the price appreciation.
He asked me what should he do to hedge his risk.
i) Current price of copper was trading $7000
ii) September average price is unknown, we will only know the price at the close of September trading day (30th September).
iii) Contract size for 1 lot of LME Copper is 25 metric tons of copper (LME represents London Metal Exchange)
————————————————————————-
My answer to my customer would be:
a) Since he had bought 2000 mt of copper from his supplier based on September average price, he should short the same amount of contract size in the futures market. This would mean short 2000 / 25 = 80 lots of copper futures.
By 1 October, the customer will have a short position on 80 lots of copper futures at September average price. At the same time the customer had fixed the cost of his physical copper at September average price. So this physical trade is hedged.
b) The customer also mentioned that he had sold 500 metric tons at $7300 to a customer. To hedge his risk, he should buy copper futures at market rate based on the same contract size, which is 500 / 25 = 20 lots of copper futures.
In the event that copper price raises to $7700 by mid October which is the delivery date, he should have profited 7700 – 7000 = 700 x 25 = US$17,500 from the futures market.
At the same time he lost the opportunity to sell his phyical good at higher price of 7700, opportunity loss is 7700 – 7300 = 400 x 25 = US$10,000. So this physical trade is hedged as well.
Rising commodities price can reduce profit margin of your business. Hedging is a strategy designed to minimize exposure to an unwanted business risk.
Be the first to comment