My course on “Agricultural Futures and Options” is 15 weeks of painfully dull lectures. With glassy eyes, my students endure talks on basis and carrying charges, speculation and spreading, balance sheets and options. Of all the topics covered, however, none is more important than hedging with futures contracts.
Hedging is such a simple concept. Here is the long and the short of hedging (pun intended) in 54 words.
To hedge is to buy or sell futures contracts as temporary substitutes for intended later transactions in the cash market. The short hedge involves the sale of futures against cash ownership to protect against falling prices. The long hedge involves the purchase of futures contracts against cash market sales to protect against rising prices.
While technically correct, this explanation of hedging misses the point. The “long and short” approach oversimplifies a topic that is rich with examples that help you understand markets.
For a deeper understanding of hedging, I turn to the writings of Holbrook Working (1895–1985), a professor of economics at Stanford University and a legend in the futures industry. Of Working’s earlier papers, I think it is fair to say that one does not “read” Holbrook Working. Rather, one slogs his way through a dense thicket of thorny words and deep thoughts. Hey, it’s not easy to develop cutting-edge theories on futures prices, storage and hedging.
To better understand hedging, my students examine one of Working’s most readable works titled, “New Concepts Concerning Futures Markets and Prices” (1962). In one section, Working examines a number of different forms of hedging, including risk avoidance, storage, operational, selective and anticipatory hedging. This is good stuff, and much better than the long and short approach because Working explores what motivates the grain handler or processor in placing a hedge.
He starts by addressing risk-avoidance hedging: hedging to protect against rising or falling prices. The loss in a cash position is offset by a gain in a futures position. Too simple! Here’s the reality. Hedgers replace flat price risk (Will corn price surge to $9, or collapse to $4?) with basis risk (Will the corn basis reach 10 cents under?). Despite no shortage of opinions, price levels and direction are unknowns. However, unlike prices, the basis for grains follows a similar pattern from year to year. Dedicated hedgers trade the basis according to their opinion.
Grain merchandisers and handlers with grain storage (most farmers) can use a storage hedge. This is your classic short hedge where, in addition to hedging against lower prices, the trader captures the carry (the higher price often seen for deferred contracts) and basis improvement. This is more than avoiding risk – this is earning a return to storage.
Operational hedging is long hedging that facilitates the operations of a merchandising or processing business. Flour millers, for example, routinely price wheat flour with customers six to twelve months out. Will the flour be produced from Kansas HRW wheat, or low protein HRS wheat from the Dakotas? Will there be an opportunity to blend in a modest amount of soft wheat? The long hedge does more than avoid price risk. It buys time and flexibility – operational convenience, if you will - to answer these questions.
Storage and operational hedging are standard operating procedure in the grain handling, exporting and (some) processing industries. This is hedging in its purest form, where long and short hedges are placed regardless of price expectations or market opinion.
Next month, I’ll explore other forms of hedging that are not standard operating procedure.