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Understanding the Purpose of Hedging

This week’s column covers some familiar territory for many, but I thought some of our readers would appreciate a review of the basics of hedging.

In its simplest terms, hedging is taking equal and opposite positions in two positively correlated markets. The result of taking such a position is it establishes a firm price in one of the markets, since any losses incurred there will mean that profits are earned in the correlated market, or any gains incurred in the primary market will be offset by losses in the correlated market.

The key factor determining whether the price that a hedger establishes when he/she places a hedge (i.e. expected price) is realized is whether the difference between the prices in the two markets (i.e. the basis) behaves as expected.

The reason hedging works is, for highly correlated markets, the variation of the basis is less than the variation of the prices. It matters not to a hedger how much a price changes, as long as the relationship of the price of interest to the correlated market remains less variable and reasonably predictable.

Here’s an example:

•On Dec. 6, John has 200 pigs that will reach market weight in the first half of February.

•February Lean Hogs (LH) futures are selling for $75.95/cwt., carcass.

•John knows that over the past five years, the average western Corn Belt (WCB) 51-52% lean hog price has been $1.24/cwt. lower than the average LH futures price (i.e. the average basis is -$1.24/cwt.) NOTE: Basis levels are computed as futures price minus cash price.

John is “long” on cash hogs since he owns pigs that are not yet priced. To hedge the price of these hogs, John would take an equal-sized and opposite (“short”) position in the futures market by selling one February Lean Hogs contract. John’s expected price in February is $75.95 - $1.24 = $74.71/cwt., since the cash hog price during the first half of February is usually $1.24 below the futures price.

But prices may change between now and the day that John sells his hogs. Let’s look at the results of John’s actions if prices rise or fall by $10/cwt.

•The price of February Lean Hogs futures rises $10/cwt. to $85.95 on Feb. 10, when John sells the hogs to a nearby packing plant.

•If the basis behaves as expected, this means that the cash hog price is $84.71.

•John sells the pigs for $84.71/cwt.

•John buys back his February LH futures position at $85.95, which means he lost $10 in the futures market.

•John’s net price for his pigs is $84.71 - $10.00 = $74.71.

•Futures prices fall by $10/cwt. to $65.95 on Feb. 10, when John sells the hogs to a nearby packing plant.

• If the basis behaves as expected, the cash hog price is $64.71, so John sells the pigs for $64.71/cwt.

•John buys back his February LH futures position at $65.95, which means he gained $10 in the futures market.

•John’s net price for his pigs is $64.71 + $10.00 = $74.71

In both cases, John ends up with a net price of $74.71, exactly what he expected to receive back in December when he placed the hedge by taking equal (he owned 200 hogs and the futures contract covers roughly 200 head) and opposite positions (long hogs, short lean hogs futures) in two positively correlated markets.

What if your selling price differs from the western Corn Belt 51-52% lean price? Iowa State’s Department of Economics tracks the WCB basis for two-week time intervals and it can be downloaded at by clicking on “Basis – Lean Hog” in the box at the right of the screen. Any difference between your selling price and the WCB 51-52% price will add to your “expected” basis. If the difference between your price and the WCB price is constant, this is not a big issue. But if it varies, that variation should be considered when establishing your price expectation.

Further, hedging is not free. Brokers charge fees of from $15 to $60 per “turn,” where a turn is one selling and one buying transaction. The size of the fee depends upon the level of service provided by the broker. Lower fees are paid for simple order execution, and higher fees are paid for higher-level services, such as analysis and advice.

Finally, placing a hedge says, in effect, that you are “satisfied with the expected price.” If you will not be satisfied with that price, then do not hedge. Further, the success of a hedge must be judged by the context in which it is placed. Missing out on a price rally is painful but remember why you hedged – you were satisfied with the price, it was important to lock in a price to secure financing, the price provided an acceptable margin, etc.

Click to view graphs.

Steve R. Meyer, Ph.D.
Paragon Economics, Inc.
e-mail: [email protected]