The below example provides an overview of a typical offset hedge strategy conducted on the LME.
An offset hedge is designed to remove the basis price risk of the physical operation by offsetting it with an equal and opposite sale or purchase of a futures contract on the Exchange. Any risk of price volatility that arises from the physical transaction is thereby eliminated.
An offset hedge is a financial operation in which the hedger (the company hedging) maintains a ‘balanced book’ with each physical transaction being offset by an LME transaction. In this example both the buyer and the seller choose to hedge their price risk. However, it is not necessary for both parties to the physical transaction to hedge; this will depend entirely on their organisation’s internal practices and approach to risk management.
There are three main stages to the process:
1. Physical Transaction
A producer agrees to sell a specific quantity of physical material to a consumer for a delivery date in the future. For hedging to be successful for either party, the contract must be agreed basis the current LME Official Settlement Price.
Both the producer and the consumer are likely to be exposed to a change in price over the life span of the physical contract because the delivery date is in the future. Each company has the ability to hedge this exposure on the LME.
2. Financial Transaction
Once the physical transaction has been agreed the hedger will instruct their broker to open a futures contract on the LME. This will be made up of an equal and opposite position for the same delivery date as their physical transaction. This allows the hedger to lock in the future price and delivery date to match the physical contract already agreed.
Once an LME contract, or trade, has been entered and matched by the broker, a process known as ‘novation’ takes place. This is when the clearing house, LCH.Clearnet, becomes the counterparty to both sides of the trade. The brokers are now no longer exposed to the credit worthiness of each other and the financial risk of default is taken on by the clearing house.
When entering into a futures contract a hedger is required to make margin payments to their broker. This includes an initial margin at the outset and variation margin throughout the life of the contract. Variation margins are a form of collateral which provide daily security against any adverse price movements of a futures position. Margins are a regulatory requirement and are calculated by LCH.Clearnet, not the broker.
Two days before the delivery date, the hedger will instruct their broker to financially settle the LME position by buying or selling back the original futures contract at the current LME Official Settlement Price.
In parallel to the financial transaction, the producer makes the physical sale of material to the consumer as agreed at the outset. Provided that this is agreed basis the current LME Official Settlement Price, the price risk of the base product over the period is eliminated for both parties, as the profits from one transaction offsets the losses from the other, and vice versa.