Managing Price Risk in Agricultural Commodities through Hedging

In previous articles we had discussed the types of risks associated with agricultural commodities, the concept of basis risk in commodities and how to manage it. Every year there are threats regarding chances of getting lower prices, or experiencing production losses. Therefore, it is understood that the growers or producers of agricultural commodities often face price risks every year.

The global trade barriers have reduced in recent decade in addition to revisions in the nation specific agricultural policies. This has enhanced the price as well as production risks of agricultural producers. Producers have started utilizing the futures market as a productive tool in reducing these risks. This activity is mainly the outcome of increasing awareness of risk management as a component of their management strategies against unexpected fluctuations in price and production levels. This time we would be covering the price risk management through the hedging strategies.

What is Hedging

Hedging is the transfer of reducing farm or business risk through transactions in the futures market. It is the process of entering simultaneously into two transactions of an opposite, but equivalent nature, in order to protect against losses against fluctuations in commodity prices.

Futures exchanges have been successful in attracting participation from hedgers as more awareness is created regarding significance of commodity exchanges in mitigating price risk. Price risk can occur for a number of reasons in agricultural commodities, for example drought, record production, sharp increase in demand, fall in international production, etc.

The commodity futures markets are beneficial in providing a means to transfer risk between persons holding the physical commodity and other hedgers or persons speculating in the market. It should be noted that hedging by the agricultural producer generally involves selling the commodity at the commodity exchange since it enables the producer to lock in a price floor (a minimum price they will receive).

Lot of participants in the commodity futures market are hedgers, who take advantage the futures market for reducing a particular risk that they experience.

For example, a wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting, can sell his crop forward. In this way he is able to lock in to a predetermined price.

Hedging does not necessarily improve the financial outcome, nor could it make the outcome worse. Hedging in fact offers transparency on the expected cash flows. Participation in hedging mechanism normally comes from big corporate, government institutions, financial institutions, trading companies. FPO’s/Growers/farmers, extractors, ginners, processors etc also take part in the hedging process, because they too face the price risk of a particular agricultural commodity.

When an individual or a company decides to use the futures markets to hedge a risk, the objective is to take a position that neutralizes the risk as much as possible. If the price of the commodity goes down, the gain on the futures position offsets the loss on the commodity. On the other hand if the price of the commodity goes up, the gain on the commodity offsets the loss on the futures position.

Hedging are of two types:

• Long Hedge: An individual trader/company willing to buy an asset in the future can hedge by taking long futures position, and this is known as long hedge. A toothpaste manufacturing firm knows it will have to purchase mentha in the future and would prefer locking in a price now. Therefore it will be beneficial for the firm to initiate a long hedge.

• Short Hedge: An individual trader/company willing to sell an asset at a particular time in the future can hedge by taking short futures position, and this is establishes a short hedge. Here the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. A soybean farmer who expects the cotton crop to be ready for sale in the next three to four months can initiate a short hedge.

Hedging in agricultural commodities illustrated by taking a short hedge strategy in Soybean

In this example a farmer/producer expects to produce around 80 MT of soybean. Normally one does not hedge 100% of his expected production, because the exact quantity can be determined only after the harvest and oil/oil cake extraction. Therefore he decides to hedge by selling 10 lots (50 MT) of November soybean at NCDEX at Rs 6900/qtl on July 1^st. At that time the spot price of soybean is Rs.7300/qtl. The new crops began arriving October end/November first week onwards, therefore prices start falling during this period.

The producer sells 50 MT of his produce in the spot market at the prevailing price of Rs 7000/qtl on November 9^th. On NCDEX he squares off his short position simultaneously at Rs 6600/qtl. In this example the producer or farmer mitigates his price risk by offsetting his loss in the spot market through earning profit in the futures market.