Buying Hedge

From CEOpedia | Management online

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, p. 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, p. 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, p. 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, p. 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, p. 98).

Advantages of Buying Hedge

Buying hedge provides several advantages to hedgers. These include:

  • Protection against price volatility: Buying a hedge allows the user to buy an asset at a fixed price, protecting them from the potential market volatility that can occur in the future.
  • Cost savings: Hedging can often be done at a lower cost than purchasing the asset outright, allowing buyers to save money in the long run.
  • Risk management: Hedging provides hedgers with the ability to manage their risk, reducing their exposure to unexpected losses due to market volatility.
  • Transparency: Hedging contracts are often standardized, allowing buyers to know exactly what they are getting and the terms of the transaction before they enter into the agreement.

Limitations of Buying Hedge

Buying hedge strategies have some limitations:

  • First, the cost of the hedge itself can be expensive. Hedging involves taking on additional risk and making additional investments, increasing the cost of the transaction.
  • Second, hedging strategies can be complex and difficult to understand. A thorough understanding of the markets and the dynamics of the hedging instrument is required to effectively implement and manage the strategy.
  • Third, the hedging strategy may not be effective in the event of a large, adverse price movement in the underlying commodity. In this case, the losses may exceed the gains from the hedge.
  • Fourth, hedging strategies can be difficult to adjust or unwind in the event of adverse market conditions.
  • Finally, hedging strategies can be impacted by market liquidity, as it can be difficult to find buyers and sellers of the hedging instrument in times of market volatility.

Other approaches related to Buying Hedge

A Buying Hedge is only one of many approaches to managing risk in the commodities markets. Other approaches include:

  • Forward Contracts: A forward contract is an agreement between two parties to buy or sell a specific asset at a predetermined future date and price. This allows the buyer to lock in a price for the asset and protect against price fluctuations.
  • Options: Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price. This allows the buyer to hedge against potential losses due to changes in the price of the underlying asset.
  • Futures Contracts: Futures contracts are agreements between two parties to buy or sell an asset at a predetermined future date and price. These contracts are used to hedge against price movements in the underlying asset.

In conclusion, Buying Hedge is only one of many approaches to managing risk in the commodities markets. Other approaches include forward contracts, options, and futures contracts. Each of these approaches can be used to protect against potential losses due to changes in the price of the underlying asset.


Buying Hedge — recommended articles
Long Hedge — Interest Rate Collar — Alternative futures — Short Call — Zero cost collar — Options — Selling Into Strength — Variation Margin — Futures

References

Author: Urszula Bochenek

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