Commodity Forward Hedging Requires an Approved Policy
Summary
The document considers whether a company hedging commodity costs with a long forward should base its decision only on a forecast of the spot price at maturity. The answer emphasizes that corporate hedging should follow a written policy approved by responsible decision makers. Such a policy defines which exposures to hedge and whether hedging is unconditional or tied to explicit criteria.
A forecast-based rule can make the forward position speculative in effect, so the forecast’s ownership and reliability should be made clear and evaluated over time. The answer also notes that prices can move opposite to the feared direction, and that business conditions can change enough to leave a company with an unwanted commitment. It offers governance guidance rather than a pricing or forecasting model; the appropriate policy depends on the company’s actual exposure and circumstances.
Key ideas
- A company should define its exposure and hedging approach in an approved written policy.
- A hedging policy can require fixed coverage or specify explicit conditions for taking a hedge.
- Using a spot price forecast to decide whether to hedge can introduce speculation into the decision.
- Forecast quality and responsibility for the forecast should be reviewed over time.
- Price reversals and changes in operating needs can make a forward hedge counterproductive.
Tags
Full text
# Hedging with forward contract # Hedging with forward contract I am wondering what strategies that can be used in hedging with forward contracts in commodities market. I only need to buy the forward contract (long position), let's say a one month contract. So my profit/loss depends on the spot price at maturity ($S_t - K$). So should I base my decision only on spot price forecast at the maturity date? Or there is something else? ## Answer by nbbo2 (score 1) https://quant.stackexchange.com/a/53879 The decision by a company to hedge (or not to hedge) is a complicated one. It is important that the decision is made carefully according to a written Hedging Policy that has been discussed and approved by the responsible decision makers. The policy should specify how to determine what is to be hedged (i.e. the company exposure) and whether/how it is to be hedged. The hedging could be unconditional (ex: an airline could have a policy of always hedging its fuel cost for the next 6 months), or conditional based on a specified mechanism. For example the hedging could be based on a forecast of $S_T$; some would say that already this is not hedging but speculation, but it may be OK if it is clear who within the company makes this forecast and who approves it. The conditionality might be based on other explicit factors also, but must avoid subjective factors like "I have a feeling the price of oil is going to go up". The forecast must be explicit and its reliability must be evaluated over time. Keep in mind that in some cases the price will go in the opposite direction of what is feared (the airline could find that the price of fuel goes down instead of up), making the hedge counterproductive. Or (as is happening today) the airline could have to cancel many flights, making the purchase of large amounts of fuel in the forward market extremely regrettable, to say the least. It is very important in those circumstances that everyone involved understands how the decision to hedge was made and what policy changes may have to be made in the future. (There are many case studies of disasters where people accused each other of making the wrong decision, but no clear account of what the process was supposed to be or why they were hedging). Anyway, these are the main considerations about hedging that would be covered in a Corporate Finance course. Apologies if it was already obvious to you.
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