Futures are both an effective and essential asset class that is used by companies, financial institutions and individual traders to hedge risk.
In today’s financial landscape of widely fluctuating prices, hedging is an essential function that both producers and consumers participate in to reduce their risk exposure and lock in margins.
This is done by taking an offsetting position using a futures contract in a closely related product, security or currency. Hedging can be done across a variety of products including commodities, index securities and currencies.
Companies that are producers or consumers of commodities utilise futures to reduce any potential price fluctuations that might cause a negative financial impact on their business operations.
Effective use of futures for hedging allows you to mitigate price uncertainty, especially in highly volatile markets.
In this article, we will take you through the essentials of futures hedging and what you should know about utilising them to reduce risk in your business.
5 Things About Hedging With Futures Contracts To Know
1. Hedge Across Industries With Futures Contracts
From agriculture to manufacturing, every industry has its own production and consumption needs that place them at risk in a highly volatile market.
Manufacturers of finished products require both the ability to hedge their purchase of the raw materials they consume as well as the products that they sell.
For example, an oil refinery will hedge their production of gasoil and consumption of crude oil by utilising futures contracts.
Industries will be able to hedge across a spectrum of commodities that include:
- Oil (Crude, Palm oil, Gasoil etc)
- Base metals (Iron ore, Copper, Nickel, Aluminium etc)
- Precious metals (Gold, Silver etc)
- Agricultural products (Soybeans, Corn, wheat etc)
In addition, financial institutions can also utilise futures to hedge their positions in equities and bonds. These include:
- Index futures (Hang Seng, Nikkei, Dow Jones etc)
- Individual securities Futures (DBS, Capitaland, Bosch etc)
2. Hedging Against Currency Risks
Currency risk is another big factor that companies face, especially if they do business around the world.
There will be many instances where the cost of goods might originate in one specific currency while the sale could be concluded in another currency. This opens up the possibility of currency risk when converting foreign money back into domestic currency and vice versa.
The Forex market is one that is dynamic and can be volatile. Companies that conduct a substantial amount of business overseas can hedge against changing exchange rates by utilising currency futures.
These futures contracts span across a variety of major and minor currency pairs including:
- EUR/USD futures
- NZD/USD futures
- GBP/USD futures
- EUR/JPY futures
- USD/CNH futures
By hedging their currency exposure with futures, companies will be able to better lock in margins that might otherwise be eroded from fluctuations in the exchange rate.
Financial institutions can also reduce their risk exposure by hedging their international ETF holdings with currency futures.
3. Types Of Hedgers (Sell-side & Buy-side)
There are two main types of hedgers, buy-side hedgers and sell-side hedgers.
Buy-side hedgers are companies concerned about the rise in prices while sell-side hedgers are concerned about the fall in prices.
On the buy-side, for example, a company that utilises silver for the production of solar panels will hedge against their future cost of purchase of physical silver.
They do this by buying silver futures to lock in their purchase price, thereby minimising any potential risk in a spike in silver prices.
Similarly, on the sell-side, a mining company that produces silver will want to lock in its margins.
To effectively hedge against a potential price decline of silver months down the road, which will affect their profits, they can hedge using futures contracts.
They can do this by selling silver futures, which will offset any losses they might incur on their physical silver sales should the market price fall in the future.
It is very common for companies today to use futures to mitigate risk in both the buy-side and sell-side.
An example is an oil refinery that will hedge their crude oil consumption while hedging their oil products such as gasoil.
4. Futures Exchanges To Hedge
There are many futures exchanges globally that companies can hedge their exposures across a spectrum of commodities, securities and currencies.
In the west, these include:
- The Chicago Board of Trade (CBOT)
- The Chicago Mercantile Exchange (CME)
- The London Metal Exchange (LME)
In Asia, the exchanges include:
- The Singapore Exchange (SGX)
- HongKong Futures Exchange (HKFE)
- Asia Pacific Exchange (APEX)
In China, the exchanges include:
- Shanghai International Energy Exchange (INE)
- Dalian Commodity Exchange (DCE)
- Zhengzhou Commodity Exchange (ZCE)
5. Basic Mechanics Of Futures For Hedging
Futures are a derivative product and their value is based on the value of the underlying asset they represent.
Because they are a leveraged instrument, the potential for big gains and losses are present. Companies should be aware of the three main features of a futures contract to ensure they correctly mitigate the right amount of risk in the desired time frame.
These are the expiry date, the contract size and the margins required.
Expiry date: This is when the contract will end and the position will be either settled in cash or physical delivery.
Contract size: This is the quantity of the underlying asset the contract represents. This will differ depending on the commodity, security or currency. Oil for example will be in barrels while gold will be denominated in ounces.
Margins: This is the amount of upfront cash required to be deposited and kept on hand to open a contract. Depending on the exchange, it can range anywhere from 3-12% of the contract’s notional value.
Access The International Futures Markets For Your Hedging Needs
At Orient Futures, we provide you with access to both the international futures markets as well as China’s derivatives markets to hedge your exposures.
You can find out more about the exchanges and futures products you can access here.
Additionally, we are an official MAS regulated broker as well as an official overseas intermediary. This allows you to access a spectrum of futures in Chinese exchanges including the INE, DCE and ZCE.
With us, you can enjoy direct access to trading, clearing and settlement. Our parent company, Shanghai Orient Futures, is the largest broker in terms of aggregated volume across the five regulated exchanges in China.
Learn more about hedging with Orient Futures here.