|
Through its trading members, the LME offers those at all stages of the metals or plastics supply chain, including both buyers and sellers, the opportunity to hedge their material price risk, and therefore gain protection from future adverse price movements.
Hedging is the process of offsetting the risk of price movements in the physical market by locking-in a price for the same commodity in the futures market. The reasons for doing this are clear: for a converter, for example, it allows for better control of their raw material costs and for a producer, better management of product pricing.
There are predominantly two motivations for a company to hedge:
- To lock-in a future price which is attractive, relative to an organisation’s costs
- To secure a commodity price fixed against an external contract
When hedging, an organisation starts with price risk exposure from its physical operations, and will buy or sell a futures contract to offset that price exposure in the futures market. The ability to hedge means that an organisation can decide on the amount of risk it is prepared to accept. It may wish to eliminate price risk entirely and it can generally do so quickly and easily on the LME.
Hedging by trade and industry is the opposite of speculation as its primary purpose is to offset risk. Speculators, however, come to the futures market with no initial risk; they assume risk by taking futures positions. Hedgers reduce or eliminate the chance of future losses or profits, while speculators risk losses in order to make profits.
To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the LME settlement price in order to achieve the most effective hedge and to meet the requirements for international accounting standards. The programme can be as simple or as complex as a company wants to make it, but it will be unique depending on that company’s appetite for risk, internal practices, pricing policies and hedging motives. Not only must a hedging programme be well devised, but it must also be managed continuously in line with the changing circumstances of a company’s physical operations.
|
