Define long hedges and short hedges, distinguish them, and identify when each is suitable.
The idea
A short hedge sells futures. It suits a hedger who owns an asset, or will receive it and sell it later, and fears a price fall, such as a farmer before harvest, an oil producer, or a fund holding bonds. A long hedge buys futures. It suits a hedger who will have to buy the asset later and fears a price rise, such as an airline buying fuel, a manufacturer needing copper, or a fund expecting cash to invest in shares. The test is which way the price move hurts the hedger, not whether the firm has sold or bought something. A fixed-price sale of an asset not yet owned leaves purchase cost exposed, so it needs a long hedge. Where exposures offset, hedge only the net amount.
A practice question
Which of the following firms is most naturally a candidate for a short hedge?
- A wheat farmer who will sell the harvest in four months at market price - correct
- A bakery that will buy flour in four months at market priceWhy not: A planned purchase at market price is hurt by a price rise, which calls for a long hedge, not a short one.
- An airline committed to buying jet fuel each month at spotWhy not: Buying a commodity later at spot is a long-hedge situation; confuses a commodity user with a commodity holder.
- A jeweller who must buy gold next quarter for an order already pricedWhy not: A fixed sale price with an unknown purchase cost is exposed to a price rise, so it needs a long hedge.
A short hedge sells futures to protect an asset that will be sold (or is held) against a price fall. The farmer is long wheat and loses if the price falls. The other three firms will be buyers and need long hedges.
A harder one
A jewellery maker has agreed to deliver 1,000 ounces of gold in six months at a price fixed today. It does not yet own the gold. Which statement about its hedging need is correct?
- It needs a short hedge, because it has sold gold forward and should sell futuresWhy not: Reads the forward sale as a short exposure; the price risk lies in the unbought gold, which hurts when the price rises.
- No hedge is needed, because the selling price is already fixedWhy not: The selling price is fixed but the purchase cost is not, so the margin is still exposed to the gold price.
- It needs a long hedge: buying gold futures covers the unknown cost of acquiring the gold - correct
- It needs a long hedge, but only if it expects gold prices to riseWhy not: A hedge is dictated by the exposure, not by a market view; hedging only on a view makes it a speculative position.
With a fixed selling price and a floating purchase cost, a rise in gold hurts the firm, so it buys futures (long hedge). The need exists whatever the firm expects prices to do.
The hardest tier
A distributor holds 10,000 units of inventory that will be sold at the market price in three months. It has also contracted to deliver 4,000 units it does not yet own at a fixed price in three months, and will buy those units at the market price then. Which futures position best hedges the net price exposure?
- Sell futures on 10,000 unitsWhy not: Hedges the inventory only and ignores that the committed purchase offsets part of the price-fall exposure.
- Sell futures on 6,000 units - correct
- Buy futures on 4,000 unitsWhy not: Hedges only the committed purchase and leaves most of the inventory exposure unhedged.
- Sell futures on 14,000 unitsWhy not: Adds the purchase commitment to the inventory instead of netting; the two exposures are opposite.
Inventory loses if prices fall (long 10,000); the delivery commitment, filled at the market price, loses if prices rise (short 4,000). Net exposure is 10,000 - 4,000 = 6,000 units long, so sell futures on 6,000 units.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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