Protect your business against price changes
Several techniques and financial instruments allow you to protect yourself against an unfavourable evolution in commodity prices. They are all examples of ‘hedging’. Hedging is a complex matter, but the general principle is simple: you want to cover yourself against possible price risks by locking in the commodity price at maturity, so as to prevent commodity price fluctuations from affecting your earnings.
The number and variety of hedging possibilities are practically limitless. The most common instruments are commodity forwards, swaps and options.
Keep the cost of your purchases under control
A commodity forward is a type of financial contract, in which two parties agree to sell/buy a set volume of commodities at a fixed price at a specified date in the future. At the settlement date, the buyer pays the agreed price to the seller, regardless of how the commodity’s market price has developed in the meantime.
You can buy or sell in the forwards market to lock in the price of a commodity, which you will then sell or buy later in the physical market. Possible losses in the forward market are offset by the higher or lower price in the physical market.
You can also use forwards to secure an acceptable margin between the purchase cost of raw materials and the selling price of your products.
A forward is a contract tailored to the specific needs of a counterparty in terms of timing and volumes. Such contracts are also referred to as ‘OTC (over the counter) contracts’.
Hedge against commodity price risks by exchanging cash flows
The commodity swap is one of the most popular hedging instruments to lock in a fixed price for a given commodity (e.g. gold, silver, nickel, copper, wheat or coffee).
Commodity users agree a fixed price with the bank over a specified period. If, at the settlement date, the physical market price is lower than the price agreed on, the user pays the hedge provider (i.e. the bank) the difference between the floating price and the agreed price. If the floating price is higher, the user receives the difference from the bank.
The net result is that the price the user pays for the commodity is fixed, no matter what happens in the marketplace.