What is a Hedger?
Hedgers are primary participants in the futures markets. A hedger is any individual or firm that buys or sells the actual physical commodity. Many hedgers are producers, wholesalers, retailers or manufacturers and they are affected by changes in commodity prices, exchange rates, and interest rates. Changes to any of these variables can impact a firm’s bottom line when they bring goods to the market. To minimize the effects of these changes hedgers will utilize futures contracts. Unlike speculators who assume market risk for profit, hedgers use the futures markets to manage and offset risk.
Corn Hedger Example
Let’s look at an example of a corn farmer. In the spring, the farmer is concerned about the price for his crops when he sells in the fall. If prices drop at harvest, the farmer will have to sell the crop at a lower price.
One way the farmer could hedge his exposure would be to sell a corn futures contract. When harvest rolls around and the price of corn drops, he will see a loss in price when he sells his crop in the local market, however that lose would be offset by a trading gain the futures market. If prices rallied at harvest, the farmer would have a trading loss in the futures market but his crop would be sold at a higher price in the local market.
In either scenario, the hedged farmer has added protection against adverse price movements. The use of futures enabled him to establish a price level well before the he sells the crop in his local market.
Types of Hedgers
There are several types of hedgers in the commodities markets:
- Buy-side Hedgers: Concerned about rising commodity prices
- Sell-side Hedgers: Concerned about falling commodity prices
- Merchandisers: They both buy and sell commodities. Their risk is different than the directional risk of a traditional buying and selling hedger. Their risk is the spread or difference between the purchase and selling prices that determines their profitability.
Many industries now use the risk management potential of futures contracts for a variety of assets. The profitability of a construction company partially depends on the cost of building materials. By purchasing a steel futures contract, the firm is able to secure a price at which it acquires steel. Conversely, steel mills worried about a decline in building demand and the drop in steel prices can sell steel futures contracts to protect against that price movement.
Airlines now hedge against rising fuel costs through the use of crude oil futures. And jewelry manufacturers can hedge against gold and silver price movement by utilizing precious metals futures contracts.
When it comes to hedging, there are a variety of market participants who buy and sell physical commodities, and they may benefit from the added price protection offered by futures and options contracts.
Definition taken from: CME Group