Fundamentals of Commercial Hedging - Ultimate Guide

Hedging is an advantageous risk management strategy that businesses can enlist to protect themselves against the financial impacts of unpredictable market conditions. Commercial hedging, in particular, tackles these impacts and ensures businesses with stability and predictability for effective financial planning and risk management. 

If you’re unsure of what commercial hedging entails, this article will provide you with all the fundamental knowledge you need.

What is Commercial Hedging?

Fundamentally, commercial hedging is the use of financial instruments by businesses to reduce the risk of price fluctuations in commodity prices, currencies, or other assets in their operations. It does so by taking a position in one market to offset exposure to price movements in another market.

Enlisting this strategy is to prioritize stability over profit generation. It seeks to protect the value of assets to prevent unexpected losses, provide predictability for budgeting and planning as well as to safeguard profit margins by maintaining a business’s financial health against volatile markets. In theory, it acts as a form of insurance for businesses and minimizes potential losses.

Example of Commercial Hedging

An example of commercial hedging is airlines hedging fuel costs. Since airlines are particularly vulnerable to the volatility of jet fuel prices at an operating expense, they enlist crude oil futures and options to lock in fuel prices. 

In terms of physical commodities, farmers and agricultural producers tend to enlist the use of futures contracts on agricultural exchanges such as the Chicago Mercantile Exchange (CME) to lock in favorable crop prices and defend their businesses against fluctuations in crop prices. 

Multinational businesses enlist forward contracts or currency options to lock in the most favorable exchange rates so that their revenue from foreign countries maintains their earnings and does not create losses.

How Commercial Hedging Works?

Commercial hedging can be applied through the following contracts, futures, options, forwards and swaps.

1. Futures are standardized contracts traded on exchanges. They obligate either the buyer or seller to transact at a predetermined price and date. 

2. Options are contracts that give the right but not the obligation to buy or sell an asset at a predetermined price before expiration. 

3. Forwards are customized contracts between two parties to buy or sell an asset at a specific price on a future date, traded over-the-counter (OTC) and not on exchanges.

4. Swaps are agreements to exchange cash flows based on underlying asset prices or interest rates. They are most commonly used for interest rate hedging or currency exchange.

   
   

Read also: Option Contracts: Definition, Types, and Benefits

Hedging Strategies

1. Natural Hedging: Minimizing Risk Through Operational Alignment

   • Adjusting business operations to naturally offset risks without using financial instruments.

   • Example: Generating revenue and sourcing raw materials in the same currency to avoid exchange rate fluctuations.

     
     

2. Short Hedging: Protecting Against Price Declines

   • This strategy involves taking a short position in the futures market to safeguard assets from potential price drops.

   • Example: A farmer selling wheat futures contracts to secure a stable selling price even if market prices decline.

   
   

3. Long Hedging: Securing Future Prices

   • This strategy involves taking a long position in the futures market to hedge against price increases in assets to be purchased.

   • Example: A manufacturer buying metal futures to lock in raw material costs and mitigate the impact of price fluctuations.

Risks in Commercial Hedging

While commercial hedging is generally beneficial, it does come with its own set of risks, such as over hedging, hedging more than the actual exposure, under hedging, inadequate coverage that leaves businesses vulnerable, and market risks, where hedging instruments themselves can fluctuate in value. Other forms of risks include price risks, currency risks, interest rate risks, equity risks, and credit risks.

Costs Associated with Hedging

The cost of hedging can be divided into transaction costs, which are the fees for using hedging instruments, and opportunity costs, which are the potential gains forfeited if market conditions become more favorable.

To evaluate the overall effectiveness of a hedge, businesses must measure the reduction in cash flow and profit volatility and compare the actual financial outcome with the intended hedge objective.

How Straits Financial Helps in Commercial Hedging?

Straits Financial offers customized hedging strategies where we collaborate with clients to develop tailored hedging solutions that target their specific risk exposures and business objectives. Our team of professionals works closely with our clients to efficiently and effectively identify potential risks and implement the necessary measures to mitigate threats to their businesses. 

Additionally, we provide expert advice on utilizing various financial instruments such as exchange-traded futures and options, cash and forward-market contracts, and customized over-the-counter (OTC) products that will effectively manage and hedge against commodity price volatility. 

Our Straits Financial Structured Products Division has extensive working experience working with clients on designing OTC product strategies that will protect commercial hedgers from adverse risk exposure. We aim to assist our clients in stabilizing their operating expenses, protecting profit margins, and most importantly, achieving their financial goals amidst challenging market conditions.

Read also: Commodity Hedging as a Business Strategy