What it means
Many businesses know they will need to buy raw materials, fuel, currency or other assets in the future, but do not know what they will cost. A rise in prices would cut their margins.
A long hedge protects them by taking a long position (buying) in futures that gain value when prices rise. The logic is simple.
If wheat prices rise, a bakery pays more for flour, but its long wheat futures position also gains value, so the bakery's cost stays close to the price it locked in. When the time comes to buy, it closes the futures position and buys the actual wheat at the market price.
The hedge is not perfect. Basis risk arises when the price of the futures contract and the price of the actual item you buy do not move together exactly.
The grade, location or timing may differ, so the offset is close but not exact. A long hedge also has an opportunity cost.
If prices fall, the company buys the physical goods more cheaply, but it loses on the futures position, so it ends up paying about the price it fixed. The company chose certainty over the chance of a lower cost.
Futures require margin, which is cash posted as security and adjusted daily as prices move. A hedger must have the cash to meet margin calls, even when the hedge is working as intended.
The opposite strategy, a short hedge, protects a seller against falling prices. Before using a long hedge, a company should write down its policy.
The policy should state what share of expected purchases may be hedged, who approves the trades and how results will be reported to the board. Clear rules stop a hedge from drifting into speculation.
In practice
Real-world examples.
Example
An airline expects to buy jet fuel over the next six months. It buys fuel futures to fix part of its cost. It hedges about half of its expected use and leaves the rest open. If fuel prices rise sharply, the gain on the futures helps pay the higher bills.
Example
A confectionery maker will need cocoa in four months. It buys cocoa futures now at a price that fits its budget. When the time comes, it closes the futures and buys the cocoa on the market. The gain or loss on the futures adjusts the final cost.
Example
A construction company bids for a fixed-price contract that needs 400 tonnes of copper pipe. It buys copper futures to protect against a price rise between the bid and delivery. The hedge allows it to bid with confidence. If the bid fails, it closes the futures at the market price.
Formula
Calculation
Effective purchase price = Spot price at purchase - (Futures price at closing - Futures price at entry)
A bakery plans to buy 50,000 bushels of wheat in three months. It buys 10 futures contracts of 5,000 bushels each at $6.00 per bushel. Three months later, the spot price is $6.80 and the futures price is $6.75. The futures gain is $6.75 - $6.00 = $0.75 per bushel, so the effective price is $6.80 - $0.75 = $6.05 per bushel. The total cost is 50,000 x $6.05 = $302,500, compared with $340,000 unhedged. The $0.05 difference from $6.00 is basis risk.Case study
Seen in the real world.
Harrowgate Bakeries is an illustrative, fictional food business that signed a year-long contract to supply bread to a supermarket at fixed prices. Flour was its largest cost, and a 20% rise in wheat prices would have wiped out its profit.
The finance manager bought wheat futures covering 60% of the expected needs, spread across the year. She kept 40% unhedged, because she was not certain the volume of orders would be steady, and she set aside cash to meet margin calls.
Wheat prices rose by 18% over the year. The futures gains covered most of the extra cost on the hedged portion, and the contract stayed profitable. The story is illustrative, and it shows how a long hedge can protect margin while leaving some room for error.
Watch out
Common mistakes.
- Hedging more than the expected purchase, which turns the hedge into speculation.
- Ignoring basis risk, so the hedge does not offset the price move as expected.
- Forgetting margin calls, so a hedge that works on paper creates a cash shortage.
Questions
People also ask.
Who uses a long hedge?
Businesses that must buy something later, such as manufacturers, airlines, food producers and importers, use it to fix their costs.
What is the difference between a long hedge and a short hedge?
A long hedge buys futures to protect a future purchase, while a short hedge sells futures to protect a future sale.
Does a long hedge guarantee the price?
It fixes the price approximately, but basis risk, timing differences and margin costs mean the result is not exact.
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