Buying Hedge

Buying Hedge
See also

Buying hedge is "a fixed-price exchange market transaction that provides hedgers with temporary protection against an increase in the price of a commodity not currently owned that will be bought later in a separate transaction in the commercial market" (Collins P. S., 2011, s. 72).

This concept also occurs under many other names including:

  • an input hedge;
  • a long hedge;
  • a purchasers hedge;
  • a purchasing hedge.

It should be mentioned that buying hedges are speculative trades, so they carry the risk of being on the wrong side of the market.

Uses of buying hedge

Buying hedge involves taking up a long position in futures to reduce incertitude about future prices. If the prices of basic commodities increase, the gain in the value of the long futures position will be able to balance the increase in purchasing costs. Through this strategy, the buyer is being protected from price increases by means of investing futures contracts. It is also often used (hedging) strategy when manufacturers and producers need to lock in the price of goods to be bought some time in the future (Chatnani N. N., 2010, s. 133).

This tactic is likewise used in the following cases:

  • to reduce the uncertainty connected with the future prices for goods needed for company (or production) - often used for commodities like hogs, oil or wheat;
  • when another investor has already taken a short position - buying hedge is used to hedge against - in this case the point is to reduce the loss in purchasing costs and gain a profit in the futures market;
  • if investors foresee/expect price fluctuations, but they also want to buy commodities in the future - buying hedge gives the possibility to purchase commodity at a fixed price (James T., Fusaro P. 2006, s. 114).

The effective buying price

The effective buying price (in buying hedges) is "the futures price when entering the hedge minus the basis when unwinding the hedge. A larger-than-expected basis increases the cost of purchasing with a buying hedge. Basis risk for futures buying hedge is, therefore, the risk of a larger-than-expected basis when unwinding the hedge" (Uri N., Gill M., Vesterby M., Bull L., Taylor H., Delvo H. W., 1990, s. 50).

Example of using the buying hedge strategy

For example, company ABC wants to sell a company DEF furniture for delivery some months from now. However, ABC does not have enough furniture to secure by buying enough futures contracts to cover the sale of furniture. In this situation, the company adds processing costs to the current price of the furniture to get the base price for furniture. A commitment to sale at a price without purchasing furniture expose him to risk that he can reduce by buying the futures contract (Kulkarni B. 2011, s. 98).

References

Author: Urszula Bochenek