Hedging concept

Concepts of Hedging
Hedging is a price risk management process. It can be defined as, "the establishing of a position in the futures market that is equal and opposite the position, or intended position, in the cash market with an objective of transferring cash price risk." In the process of hedging, a hedger gives away the price risks and assumes basis risk which are smaller and often manageable. Investor or speculator assumes the price risk in anticipation of greater profits.

Concepts of Hedging
Basis = spot price futures price The principle is fluctuations in basis is relatively less compared with the fluctuations in price itself. Hence, hedger who are risk averse, tends to accept basis risk in lieu of price risk through hedging. This is done by operating in both the cash market as well as futures markets and by taking positions in one market that is equal and opposite to position in the other market

Concepts of Hedging
So, hedging using futures
Locks in the price and brings about certainty to the user on the cost of material It may result in letting go of potential profits at times, however, the idea is to bring about certainty Hedging using futures addresses only price risk, it does not address quality risks and quantity risks Hedging is done not-for-profit but to bring about certainty. Hedging is not speculation or taking a call on the prices. Not hedging is speculation.

Case Study Hedging Aluminium price risks using MCX futures

Background
A Bangalore based muti-locational manufacturing firm requires on an average 25 tons per month of aluminium sheets. The company purchases its requirement on a monthly basis. Currently, the producers (aluminium manufacturers) review the prices on a fortnightly basis and come out with revised price list on 15th and 30th of every month. For the company, the recent volatilities in aluminium and therefore aluminium sheets have resulted in procurement price overshooting the budgeted price. The company desires to bring in certainty in to its key raw material (aluminium sheets being one of them) purchase price, so that it can plan its business better.
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Defining the problem

Key concerns of the company are achieving stability in input purchase prices (in this case aluminium) and deriving stable margins from operations. Since the core concern is on price of input purchases, the issue can be delinked from procurement function and viewed as a finance function. Such unbundling gives the required flexibility to manage costs as well as meeting the physical requirements. Other dimensions of purchase such as quality, timeliness, consistency can be addressed through procurement function.

Exploring options
To achieve these, the company can look at the following options. 1. 2. 3. 4. Go for a long-term fixed price manufacturer. Develop alternatives to aluminium help it to manage costs better Go for hedging price risk at exchanges Go for hedging price risk using traded at MCX of India. contract with the sheets which can the international aluminium futures

Evaluation of options
1. Long-term contracts Manufacturers are keen to enter into such contracts. However, these days given the volatility, the contracts are done on price un-fixed basis. Therefore it may not really result in stable prices for the company. The purchase quantity of the company is not very big from the primary manufacturers perspective. Therefore, the negotiation will not be in favour of the company, even if any manufacturer agrees to enter into long-term supply contract.

Evaluation of options
2. Alternatives to aluminium Alternatives are good option for medium-to-long term. However, it does not address the current issue. Product usage and new product introduction is also linked to suitability, promotion, marketing and such other factors. Therefore, substitution should not be looked at only from price perspective. Lastly, as substitutes become popular they too start exhibiting similar volatility, defeating the very purpose of price stability.

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Evaluation of options
3. Hedging price risks using aluminium futures traded at International exchanges LME trades Aluminium forwards. It is regarded as the benchmark. Therefore, it is well serve the companys purpose. However, there are some limitations.
The companys requirement is very small when compared with the volumes traded at LME. So, to get a competitive quote at times could be difficult. As per the current regulatory framework, only companies with actual exposure through direct import or export are eligible to hedge their price exposure in the international exchanges. Price risk is well-addressed; however currency risk is not RBI compliance is mandatory and would entail additional costs.

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Evaluation of options
4. Hedging price risks using aluminium futures traded at MCX of India
This looks to be very promising especially when viewed from achieving the objective. Since the contracts are traded in India in rupees, it obviates the need for foreign exchange management and so on. The size of aluminium contract (2 tons per contract) traded at MCX is small. It gives flexibility to company to under hedge, if required.

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Suitability of MCX Al contracts

The company buys aluminium sheets, however the contracts traded at MCX is aluminium ingots. Sheets are value-added products of aluminium. However, the price trends in aluminium sheets closely follows price trend in aluminium ingot, so it is fine to use aluminium contracts traded at MCX for hedging price exposures in aluminium sheets.

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Summary of evaluation
Option (4), that is, hedging price risks using aluminium futures contract traded at MCX looks to be best suited for achieving the stated objective of managing and achieving price stability.

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Hedging price risks in aluminium - approach

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Hedging process
Hedging process comprises three phases
Initiating the hedge Monitoring the hedge Lifting the hedge The following slides will illustrate the above phases through an example. For this example, we have considered the period from January June 2006. The price as on January 4, 2006 of aluminium is Rs.102.75 per kg . It is assumed that the company is comfortable with this price and would like to lockin its aluminium purchase price around this level for its purchases from February to June. It is assumed that the company buys 25 mt every month from the physical markets as is being done currently. Also, since the contracts in aluminium is recently launched, the farthest contract is of 3-month maturity, necessitating roll-over.
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Hedging process - implementation

Initiating the hedge
It is assumed that we commence hedging on January 4, 2006. The hedge will cover physical purchases for consumption between February and June. It is assumed that the company has not purchased its requirement for the hedge period. It is also assumed that the price on January 4, 2006, that is, 102.75 is acceptable to the company, so it would like to locks itself to that price by buying futures. Gross exposure @25 mt per month, would be 125 mt for 5 months. Since each aluminium contract at MCX is for 2 tons, complete hedging would entail buying 75 contracts. Since the farthest contract is of 3-month maturity, all exposure is taken in March 2006 contract (please note we are on January 4, 2006) The exchange levies 5% initial margin. The margins are calculated on the purchase value of the contract. As a safeguard, it has been planned to keep 15% additional margin for meeting the day-to-day pay out (if occurred).

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Hedging process - implementation

Monitoring the hedge
It mainly consists of checking for adequacy of the margins and managing cash-flows. Monitoring is also important to plan roll-over. Markets from time-to-time provide opportunities such as a favourable backwardation which can be used for roll-over. At times, it would warrant removing the hedge prematurely should there be some systemic issues. Such cases are rare. However, monitoring is as important as initiating a hedge for ensuring hedge performance.

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Hedging process - implementation

Closing a hedge
Closing a hedge is very important. Since the company is not interested in taking delivering from the exchange, here it refers only to off-setting the buy initiated earlier with a sell. Off-setting is often coordinated with the actual physical procurement. It is assumed that the company has off-set its position in the futures and on the same day taken physical delivery for consumption for the next month. For instance, in the present example, it is assumed that the company would purchase its February requirement of 25 mt on January 28, 2006, while simultaneously closing out its position in the futures to the extent of 25 mt.

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Hedging process - implementation

Roll-over
Since the hedge initiated in March contract will expire in March 31, 2006, we need to roll-over the hedge to cover the period up to June, 2006. Hence, on March 31, 2006 outstanding positions (that is 50 tons) are shifted to May contract. May was chosen as June contract was not active. Also, the hedge for june physical purchase will be lifted on May 30, 2006, being the date of purchase of physical aluminium for June consumption. On March 31, 2006, the market was in contango. Contango refers to a condition wherein forward prices are higher than the spot prices. This increases the roll-over cost by Rs. 2 per kg.

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Hedging process - summary

A buy position was initiated in March futures Aluminium contract traded at MCX for 125 mt on January 4, 2006 at 102.75 per kg. The objective of this buy is to lock-in the price for February June 2006 physical purchase price at around 102.75 per kg. On January 28, 2006, 25 mt was purchased from physical market to meet the need for February. Simultaneously, 25 mt position in the exchange was closed out through offsetting sell transaction. Step-2 was repeated in February and March end also. In addition, on March 31, 2006 all outstanding contracts (amounting to 50 mt) was rolled over to May 2006 contract. Subseqently, the contracts were off-set at April end and May end, coinciding with the physical purchases for May and June respectively. Cost of fund on the margin (initial margin of 5% and maintenance margin of 15%) is assumed to be 12%. Brokerage on both buy and sell transactions is assumed to be Rs. 300 per lakh.

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Summary of outcome
Average unit price in Rs./kg Unhedged 100% hedged without transaction costs 100% hedged with transaction costs Budget 117.82

104.57

107.97 102.75

Transaction costs include cost of money & brokerage

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Conclusions
Hedging of aluminium sheet price exposures through MCX Aluminium contract is feasible and the deviations are minimal.

As the market mature, the deviation from the intended target price can be reduced below 3% from the current level of 5%.

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