The LME offers those at all stages of the metals supply chain the opportunity to hedge their price risk and gain protection from 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.
There are two main motivations for a company to hedge:
- to lock in a future price which is attractive, relative to an organisation’s costs
- to secure a 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. An organisation can decide on the amount of risk it is prepared to accept. It may wish to eliminate price risk entirely.
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 Official Settlement Price in order to achieve the most effective hedge and to meet the international accounting standards.
Hedging 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 on futures positions, which in turn provides market liquidity. Hedgers reduce or eliminate the chance of future losses or profits, while speculators risk losses in order to make profits.