Managing trading risk
A London International Financial Futures and Options Exchange case study

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Page 4: Ways of managing risk

London International Financial Futures And Options 4 Image 4In the commodity futures market there are three main types of activities which take place.

  • hedging
  • speculation
  • arbitrage.

Hedging accounts for the majority of traded volume, followed closely by speculation, whilst arbitrage accounts for only a small percentage of trading activity.

Hedging

Most large organisations buying particular commodities know that they will need a regular supply of the products over a long period of time. These organisations may need to replenish supplies on a regular basis with cover for three, six or nine months. Of course, in three, six or nine months time, the price of that commodity may have substantially increased due to, for example, a harvest failure or a natural disaster in a key supplier country. In order to take some of the risk out of future purchases, it is possible to hedge.

Hedging involves matching the sale or purchase of commodities with an opposite transaction (i.e. the purchase or sale of a similar quantity of the same product) on the futures market. Here is a very simple example:

A company contracts to sell potatoes in six months time at the current spot price, being the price currently obtainable. However, the company is concerned that when the time comes to honour the contract, the price of potatoes will have risen. As a result, the company will lose money, either because it could have sold its potatoes at the higher price or because it will itself have to buy potatoes at the higher price to honour its contract. To protect itself against that possible loss, the company contracts to buy a similar amount of potatoes at the price that the market thinks will be obtainable in six months time (in other words, it buys a six months 'future' in potatoes). So, whether the price of potatoes rises or falls, the company will not lose money (nor, of course, will it make money if the price rises - other than the profit built into the original contract).

'Perfect hedging' assumes that the futures price is the same as the future 'spot price'. Usually there is a slight variation but occasionally, due to some unforeseeable event, the variation can be considerable. Hedging of course is only possible because many dealers (particularly speculators) are willing to take an 'uncovered' risk, agreeing to a contract without themselves setting up an identical and opposite contract.

Most commodity futures contracts take the cost of warehousing, transporting and financing a product into account and therefore will have a slightly higher price than a product purchased on the spot market. Oil, for example, may have a price of $20 per barrel on spot but may cost, say, $20.50 traded on a future to accommodate the above differences.

Speculators

Speculators are a key feature of many modern markets. Speculators try to make a profit by predicting future changes in prices. Speculators play a major part in international currency and financial futures markets as well as in commodity trading. A speculator is not concerned with the physical delivery of anything - they would not want 10,000 tonnes of potatoes! Instead, the speculator is more concerned about buying / selling on the contracts that they make in international exchanges at a considerable gain. A speculator fits into the category of the 'risk lover'. They seek to make a quick profit through successful futures transactions.

Arbitrage

The third type of activity carried out in the futures market is called arbitrage. It involves the simultaneous purchase of an instrument in one market against the sale of the same or similar commodity in another market to exploit pricing differentials.

London International Financial Futures and Options Exchange | Managing trading risk
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