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. This hedging activities are considered as commodity hedging.
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.
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.
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.
In commodity trading businesses, there is a need to account for physical purchase or sale of products as a commodity hedges rather than a speculative trade. This accounting practice is called Hedge Accounting.
The accounting body that governs these practices and standards is the International Accounting Standards Board.
In the context of commodity trading in United States, hedge accountants have been using FASB 133 to account for their commodity hedging. However, recently some have adopted IFRS 9 as the new hedge accounting goal.
The use of hedge accounting software is to process physical and financial trades and use accounting standards to calculate the effectiveness of the trades.