Hedging Against Falling Tin Prices using Tin Futures

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Using Futures to Hedge Against Shifts in Commodity Prices

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Producers and consumers of commodities use futures markets to protect against adverse price moves that could result in large financial losses. A producer of a commodity is at risk of prices moving lower while a consumer of a commodity is at risk of prices moving higher.

Hedging is an important tool when it comes to running a business from either of those perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price. A hedge will guaranty a producer a known price for their commodity output.

Advantages of Futures

Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers alike a mechanism with which to hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that closely reflect their risks. Additionally, futures contracts are liquid instruments, meaning there’s a lot of trading activity in them and they’re generally easy to buy and sell.

Aside from producers and consumers, speculators, traders, investors, and other market participants utilize these markets. The exchange requires those who hold long and short positions to post margin, which is a performance bond to cover potential losses.

Producers and consumers often receive special treatment on commodity exchanges. As hedgers, their margin rates are often lower than other market participants, who are trying to make money on trading, not protect against losses.

Reducing Risks

To hedge, it is necessary to take a futures position of approximately the same size—but opposite in price direction—from one’s own position. Therefore, a producer who is naturally long a commodity hedges by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer, who is acting as a short hedger.

A consumer who is naturally short a commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer, who is acting as a long hedger.

While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk. Producers and consumers who use futures markets to hedge transfer their price risk.

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If someone holds the physical commodity, they assume the price risk for it as well as the costs associated with holding that commodity, including insurance and storage costs. The price of a commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures is higher than nearby futures prices.

When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity, they exchange price risk for basis risk, which is the risk that the difference in the cash price of the commodity and the futures price will diverge against them.

Futures exchanges have associations that act as clearing houses, which means they become the transaction partner of a trade. They match up buyer and seller, check their creditworthiness, and ensure each one is paid what they’re owed. Therefore the clearing houses help remove credit risk from the system.

A Drawback of Hedging With Futures

Hedging in the futures market isn’t perfect. For one thing, futures markets depend upon standardization. Commodity futures contracts require certain quantities to be delivered on set dates. For example, a futures contract for corn might entail a delivery of 5,000 bushels in December 2020. And sometimes quality—for example, the purity of precious metals—comes into play.

Hedgers sometimes produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures.

Alternatives to Futures Markets

Futures markets are not the only choice for hedgers. They can also use forwards and swaps to hedge. These markets entail principal-to-principal transactions—meaning no exchange is involved—with each party assuming the risks of the other. However, these tailor-made transactions may meet the specific needs of commodity consumers or producers better than standardized futures contracts can.

How to Hedge Against Falling Stock Prices

Don’t let a falling market take down your stock portfolio.

Owning stocks in a falling market is financially challenging, as you watch the value of your stock portfolio melt away with every downward price tick. Closing out the trade will contain your loss but also decimate your trading principal. If you think the market or your particular stock is in for a long decline, you can take advantages of several hedging strategies to protect your portfolio and offset the loss.

Invest in bonds as a conservative way to hedge your falling stock trades. Bonds and stocks are inverse securities, so as your stocks fall, your bonds will increase in value. The interest payments you receive will take some of the sting out of your stock losses. Tax-free municipal bonds and high-grade corporate bonds are safe investments offering high interest rates. Check to see that the bonds have high credit ratings from a bond rating service such as Moody’s, Standard & Poor’s or Fitch.

Purchasing bond fund shares can provide better hedging than you would get with individual bonds. Bond fund portfolios can hold a variety of bonds with different interest rates and maturity terms. Bond fund managers can sell lower interest rate bonds and replace them with higher interest rate bonds to increase the fund’s return. The funds are professionally managed and pay periodic interest payments. Select funds that hold high grade corporate bonds or highly rated municipal bonds to guard against default.

Profit from falling stock prices and hedge your portfolio at the same time by purchasing put options. The more the stock price falls, the faster the put option increases in value. Not all stocks offer options trading. If your stock doesn’t allow it, you can hedge your portfolio by purchasing index options that are tied to a specific index such as the Dow Jones Industrial Average, S&P 500 and Nasdaq 100. As stock prices fall, the index falls, and the put option price goes up. Index options are traded on the major stock exchanges.

Consider investing in an inverse exchange traded fund, or ETF, to hedge your stocks. Inverse ETFs profit as the market falls and are traded along with stocks on the major exchanges. Inverse ETFs are designed to mirror a falling index while others are sector or industry specific. While some inverse ETFs use leverage to magnify their profits, this can also result in greater losses should the market move up.

Fin 330 Chapter 3 – Hedging Strategies Using Futures

Термины в модуле (22)

You hedge the future purchase of an asset by entering into a long futures contract
Cost of Asset = S2 + F1 – F2

F1 buy hedged at Time 1
F2 Sell at price F2 to offset your position
(F1-F2) Profit from hedge. Use profit to offset purchase you make at S2

S2 Final Asset Price you purchase at T2

*Each time we switch from 1 futures contract to another we incur a type of basis risk

*Start with a hedge horizon that is beyond one contract.

Pick the longest hedge possible.( As you go out open interest drops of and bid ass spreads get bigger)

N = h(Qa/Qe)
Qa = Size of position being hedged (units of underlying)
Qf = Size of one futures contract (units of underlying)

N = h(VA/VF)
VA: $ value of position being hedged (spot price x QA)
VF:$ value of one futures contract (futures price x QF)

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