Commodity Hedges during COVID-19 Crisis
In times like COVID-19 crisis, commodity trading companies are especially susceptible wild swings of commodity prices. The companies that emerged as winners are the ones that hedged their portfolios effectively with commodity hedges.
The commodity markets are made up primarily of speculators and hedgers. While speculators are all about taking on risk in the markets to make money, the function of hedgers is to reduce their risk of losing money. A hedger is an individual or company that is involved in a business that is associated with a particular commodity, either as producers or buyers.
Hedging is simply a form of insurance. It is essentially a means of securing yourself so that in the event of those bad incidents that are part of life, the effects on your finances are greatly reduced. Hedging is not limited to the trading and investment world as it occurs every day. Take, for instance, when you take insurance on your car or house, you are hedging against unforeseen disasters that might negatively affect your house or car. Professionals and institutions in the financial market, like portfolio managers, individual investors, and corporations also use hedging techniques to reduce their exposure to various risks.
How Commodity Hedges Works?
However, hedging in that field is not as simple as paying an insurance company a fee every year for coverage because mitigating investment risk means strategically using financial instruments or market strategies to offset the risk of adverse price movements. In this sphere of business, investors hedge one investment by making a trade-in another. Indeed, they can hedge against a plethora of things: stocks, commodity prices, currency and interest rates, among others.
Hedging is a key practice in financial markets because it is a way to get portfolio protection which is just as important as portfolio appreciation. It technically entails offsetting trades in securities with negative correlations. Since nothing in life is free, you will have to pay for this type of insurance in one form or another. Essentially, a reduction in risk will always mean a reduction in potential profits. That is why the primary goal of hedging, for the most part, is to reduce potential loss.T he principle is simple if the investment you are hedging against makes money, your profits are greatly reduced, BUT if the investment loses money, your hedge, if successful, will reduce that loss.
Commodity futures exchanges were originally created to enable producers and buyers of commodities to hedge against their long or short cash positions in commodities. While these exchanges require hedgers to pay upfront money to cover potential losses (margins) just like they do for speculators, hedgers have to pay less because they are perceived as less risky since they have a cash position in a commodity which offsets their futures position.
Why Hedging Is Important?
Risk is an integral aspect of investing. That is why it is important that regardless of the kind of investments you aim to delve into, basic knowledge of hedging and its strategies should be acquired. Practicing what you know about hedging might not be compulsory but having an understanding of how hedging works will always come handy as long as you are in the investment world.
EnHelix Hedge Accounting Solutions
EnHelix is an integrated ETRM and hedge accounting software that provides customers cash-flow and fair value hedge accounting solutions with an integrated trading and risk modules. The clear advantages of an integrated ETRM and hedge accounting software removed the needs for complex data interfaces between ETRM and accounting system resulting in as a much efficient and cost-effective system.
For more information about EnHelix hedge accounting features, please contact us for a demo.