The Definition of Hedging and Risk Management Glossary
Hedging. Contango. Backwardation. You’ve probably heard these and many other risk management terms. What do they really mean, and how do they relate to your business? This glossary explains the terminology you need to know to better understand commodity hedging and interest rate risk management.
Hedging is a risk management strategy. The goal of hedging is to limit or reduce exposure to adverse price movements to a commodity or interest rate. This is typically done by taking a position that reacts inversely to the commodity or interest rate being hedged.
Companies hedge commodities and interest rates to increase certainty of their inventory values, cost of goods sold, or financing costs. A company’s commodity hedging strategy or interest rate hedging strategy is tailored to its unique situation. There are many different hedging instruments which can be used to execute a hedging strategy. These may include futures, forwards, options and swaps, among others.
An example of a hedge – bullion dealer hedging gold
A gold dealer owns 1,000 oz physical gold inventory. The dealer may hedge by selling short gold futures contracts. An alternative hedging strategy may see the dealer buy put options on gold instead of selling futures contracts.
An example of a hedge – company with debt hedging interest rates
A company has a revolving credit line with its bank for $25mm. Company borrowings on the line range between $18-$23mm at most times. The company is concerned that if interest rates rise, its interest costs will rise, and lower their profitability. Consequently, the company may hedge by selling eurodollar futures.
What is contango?
Contango simply means that the futures price is higher than the spot market price. Or, that further dated futures are priced higher than shorter dated futures. Why would someone agree to buy a futures contract at a price higher than spot? The answer is often driven by the cost of storing and insuring the commodity in question. For perishable commodities, the cost of spoilage can also be a big factor. Contango also tends to include the opportunity cost of money. If an investor buys a physical commodity and stores it, they must pay for the commodity at the time of purchase. If instead the investor buys a futures contract, they put up margin but do not need to pay for the commodity until taking delivery. Therefore, the investor may invest that money and could potentially earn interest.
What is backwardation?
Backwardation is simply the opposite of contango. It means that the futures prices are lower than the spot price. Alternatively, that further dated futures are priced lower than shorter dated futures.
What are futures?
Futures are contracts to buy or sell something in the future. Key aspects like the settlement date, quantity, location and quality of the underlying asset are standardized. Futures are standardized contracts traded on a regulated exchange. Settlement takes place through a clearinghouse. Just like the stock market, the futures prices are available to all users. All users can access the same transparent quoted prices. There are futures contracts for all kinds of commodities and interest rates. For example, there are futures for gold, Libor, coffee, and copper to name just a few.
What are forwards?
Forwards are contracts to buy or sell something in the future. Key aspects like the settlement date, quantity, location and quality of the underlying asset are negotiated. In contrast to futures, forwards and swaps are privately negotiated, bilateral contracts between two parties. This usually means a company and its bank. A noted benefit of forwards is the ability to tailor the specific terms like payment dates and maturities.
Want to learn more about the relative merits of using futures or forwards for hedging? See our analysis here.
Let’s talk hedging and risk management
We hope you’ve found this definition of hedging and risk management glossary helpful. Please let us know if you have any suggestions on how we can improve it. Equally, if you would find it helpful to talk through your specific situation please contact us. Let’s talk through the various commodity hedging or interest rate risk management tools available to companies like yours.