Hedging
When dealing with large volumes of material, price changes can affect the seller in a negative manner. Hedging is a strategy designed to minimise exposure to an unwanted business risk, while still allowing the business to profit from investment activity. Hedging provides a way of looking forward to determine what prices may be in the future.
Hedging transfers risk by taking the opposite position in the underlying asset. For example, a commodity provider and a commodity user can enter into a futures contract to exchange cash for the commodity in the future. Both parties have reduced a future risk. The provider has removed the uncertainty of the price. The user has ensured the availability of the commodity.
When marketing mining products (for example, with sales, purchase, or tolling contracts), hedging involves operations in the relevant commodity markets (for example, copper, gold, silver, coal). These hedging operations reduce the risk associated with unknown prices. That is, when prices are determined by a quotation on the relevant commodity market at a predefined quotation period (QP), and not at the time the contract is signed or the material is despatched.
Hedging can also reduce the risk of currency exchange rate fluctuations. Hedging operations in foreign exchange (FX) markets lock in a known exchange rate between currencies for a future transaction.
Simple Commodity Hedging Example
Assume the current month is January. Copper is needed for a project in July. The simplest way to fix the price of copper for July is to buy copper futures contract for a July delivery at the January price. However, the market evolves after the trade, the price of the copper is now known and there is no risk involved in the transaction.
Commodity Sale Price Hedging Example
In January, a coal producing company signs an index-based contract (for example, API4) for delivery in July. The actual price of the coal to be shipped in July is unknown, creating an associated risk. The company hedges the risk by taking a hedge position in the futures market for coal. To do this, the company sells future contracts for July at the January price (hence fixing the coal price) and later on, buys coal at the July price to offset the sale to the customer. For this to work, the quantity traded in all contracts must be the same.
In practice, the company engages a broker or counter-party to sell a derivative product. That is, it will sell a swaps contract where the company pays a fixed price and receives the average of the index price during a given period, usually a quarter.
Strategic Commodity Hedging Example
A company that is selling its own copper production has a strategy of selling all copper at the price of the month of production. If the production is steady, this results in an average price equal to the annual average of the London Metal Exchange (LME) market, and protects the company against price volatility.
In the company's contracts with customers, the contract terms define the quotation periods (QPs) for the price.
One contract has a QP of MOS(2,0), the average of the second month after the month of shipment. For the production in the month of January, shipping in February, the resulting QP from the contract is April. The company hedges by selling copper futures in January (at the January price for April delivery) and buying the same quantity of copper on the spot market in April.
In summary, the situation is as follows.
|
Operation |
Quantity |
Pricing Month |
|---|---|---|
|
Sales Contract |
+250 t |
April |
|
Sell Futures (Short Position) |
+250 t |
January |
|
Buy Futures (Long Position) |
-250 t |
April |
The net result is that the price has been brought from April to January.
If this operation is done throughout all the company’s contracts, the annual price average can be reproduced, reducing the risk of temporary price fluctuations.
Foreign Exchange Hedging Example
In March, a US company raises a sales invoice of 125,000 EUR with a June due date. The actual exchange rate of EUR/USD in June is unknown, creating an associated risk. In order to reduce the risk of fluctuating exchange rates, the company sells futures contracts with a June maturity date for 125,000 EUR at a rate of 1.1995 USD/EUR. No matter which way the currency market moves, the company has locked in receipt of 149,937.50 USD (minus brokerage) in June.
Hedging in MineMarket
In MineMarket, the upcoming demands or deliveries in sales or purchase contracts can be associated with hedge positions. A despatch order or quota is hedged when it is associated with one or more hedge positions. This association relates the despatch orders or quotas to material market commodities. Hedging can be used for contracts with product pricing or analyte pricing.
MineMarket also includes hedging against currency exchange rate fluctuations. An invoice instalment is hedged when it is associated with one or more hedge positions. This association relates the invoice instalment to the currency commodity.
Hedging in MineMarket involves:
- Defining market commodities for physical commodities or currency commodities
- Hedging operations:
- Creating hedge positions
- Optionally grouping the hedge positions in hedge action groups
- Allocating despatch orders or quotas to hedge positions; or allocating invoice instalments in despatch snapshots to FX hedge positions
- Managing exposure
- Calculating valuations and settlements for individual hedge positions; or running a hedge revaluation to create the valuations and settlements
- Creating journal entries for hedging profit or loss
- Considering the impact of hedged quantities in QP Profile reports
