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Physical and financial hedging – a beginner’s guide

July 2020

When we read about trading in financial markets in the news it’s often the big gains and dramatic losses that make the headlines. This can give the impression that trading is gambling, more akin to poker than to risk management. However, a large proportion of trading activity in commodities markets comes from the needs of market participants to manage their price exposure to an underlying physical product. Another factor adding to this misperception is our industry’s seemingly impenetrable jargon. When a trader talks about carries, lending, borrowing, contango, backwardation or even kerb trading, many people simply do not understand. In this LME Insight article, we look at the very basics of physical and financial hedging. We try to use plain English, avoiding jargon whenever possible, and explain specific terms where necessary. We are by no means attempting to provide a complete description of all aspects of hedging. Many matters, such as trade booking, accounting practices, trade clearing and trade reporting have not been included in order to focus on hedging. Our aim is to provide a basic understanding of the interactions between the physical and financial market sides of a hedged transaction, and of the related payment obligations.

WHAT IS HEDGING?

When the price of metal changes it can create either a profit or a loss and affect the bottom line. Companies that make metal (producers) or companies that make things out of metal (consumers) often bear these metal price fluctuations. People commonly refer to this as metal price “exposure”. The purpose of hedging is to mitigate this price exposure and to insulate a company’s performance from market movements.

In the normal course of business, a company can see its price exposure change frequently. For example, holding additional inventory exposes a company to the risk of a financial loss if its value falls, following a drop in market prices. On the other hand, if a company agrees to future sales, at a fixed price, it exposes itself to the risk that metal input costs rise.

A company can decide to bear these risks, or take a more active approach and manage them. This “risk management” can incorporate the use of physical or financial hedges.

Physical hedging involves the pricing of bought or sold physical material to match the pricing of future production and sales. This is called “back-to-back” pricing.

Financial hedging is the action of managing price risk by using a financial derivative (like a future or an option) to offset the price movement of a related physical transaction.

Let’s take a closer look at both physical and financial hedging.

PHYSICAL AND FINANCIAL HEDGING

In order to secure a client order, producers and consumers of metal often need to commit to a fixed price for their finished product, for delivery in the future. Most producers and consumers aim to avoid large inventories and for that reason they will only produce the finished product closer to the delivery time. But this leaves them exposed to risk.

The price of the metal they need in order to make their finished product may rise (or fall) between the date they agreed the fixed-priced sale and the date they buy the metal. If the price of metal increases in this period, it can lead to significant losses for the company.

Let’s use the example of the fictitious aluminium equipment manufacturer, ABC Corp.

ABC Corp agrees to sell aluminium cases to XYZ Ltd, basis a fixed price of US$1900 per metric tonne (mt), for delivery in six months.

The physical hedging options for ABC Corp are:

  • a) Buy metal in the spot market, where you take delivery almost immediately. This may not be ideal, as it leaves ABC Corp with large inventories and the associated costsof financing, storing and insuring.
  • b) Create a fixed-price agreement with a physical aluminium supplier for delivery in the future. This may also not be the best solution as physical suppliers may charge more for assuming the price risk. Furthermore, physical fixed-price delivery agreements are subject to the risk that a supplier does not honour the agreement (performance risk) if market prices move too much in favour of ABC Corp.

In both these examples of physical hedging, ABC Corp does not bear price risk but needs to consider other issues like, as mentioned, performance risk and inventory costs.

ABC Corp could instead:

  • c) Buy the required metal in the spot market, just before the start of production.
  • d) Agree today with a supplier, a future delivery of metal priced at whatever the going rate is at the time of delivery – often this is basis the LME Official Settlement Price1 .

But in both scenarios ABC Corp will still have exposure to the metal price, until the metal is procured. In such a situation, financial hedging can be useful.

In our examples c) and d), the risk arises from the timing mismatch between XYZ Ltd’s fixed-price order and the time when ABC Corp procures the physical metal. The following graph illustrates this:

Fig 1

The graph below gives an idea of the magnitude of changes in the LME Aluminium Official Settlement Price since 2006:

Fig 2

The graph illustrates the potential risk of loss arising from such a commitment and the need to think about how to manage risk effectively. A closer look at the data confirms this picture.

Over the last 15 years the largest price variation over a four-month (120 calendar-day) period varied between -48.1% and +42.1%. On average, the price variation over a four-month period is virtually flat at -0.2%, but the standard deviation from that number is 12.5%. This illustrates how large price movements can be.

Fig 3

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