Hedging Using Commodity Futures

Producers of agricultural commodities are faced with price risk and production risk over a period of time and within a marketing year. In case of agricultural commodities, price risk can occur for a number of reasons like drought, floods, uncertain rainfall, natural calamities, near record production, increase in demand, decrease in international prices, etc. One way of reducing this risk is through the commodity futures exchange markets. Agricultural producers can use commodity futures to hedge the potential costs of commodity price volatility.

Hedging in the futures market involves a two-step process. Depending upon the hedger's cash market position, he will either buy or sell futures initially. For example, a firm which owns or plans to purchase or produce a cash commodity will sell futures to hedge this cash position. A long hedge involves a firm purchasing futures to protect itself against a price increase in a commodity prior to purchasing it in either the spot or forward market. In the second stage, once the cash market transaction materializes, the futures position is no longer required and hence the hedger will close his futures position, i.e., if he has gone long on a contract, he will sell it. Alternatively, if he has initially sold a futures contract, he will buy one. It should be noted that both the opening and closing positions must be for the same commodity, same number of contracts and delivery month.