Hedging

Hedging programme

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.

The programme can be as simple or as complex as a company wants to make it, but it will depend on that company’s appetite for risk, internal practices, pricing policies and hedging motives. Not only must a hedging programme be well devised, but it must also be managed according to the changing circumstances of a company’s physical operations.

Hedging example 

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, LME Clear, 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 LME Clear, not the broker.

3. Settlement

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.

Producer benefits

LME contracts offer a number of benefits for producers, including the ability to:

1. Offer a long-term fixed sales price and lock in a profit margin
2. Use inventory financing and trade financing
3. Access lower financing cost (banks view companies that hedge as lower risk)
4. Protect the value of unsold inventory in a falling market
5. Hedge physical purchases in times of strong demand.

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Merchant benefits

LME contracts offer a number of benefits for merchants, including the ability to:

1. Hedge physical sales and purchases
2. Offer a long-term fixed sales price
3. Swap physical material on a location and grade/producer basis
4. Gain a competitive advantage by offering a fixed sales price
5. Protect the value of physical stock against a fall in price
6. Bring over-the-counter (OTC) transactions on Exchange.

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Consumer benefits

LME contracts offer a number of benefits for consumers including the ability to:

1. Lock-in a forward purchase price
2. Accurate budgeting for raw material requirement costs
3. Increased ability to commit to future sales prices

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Scrap dealer benefits

LME contracts offer a number of benefits for a scrap recycler, including the ability to:

1. Protect against price movements
2. Offer long-term fixed sales price and lock in a profit margin
3. Hedge the timing difference between scrap purchase and sale

The entire supply chain benefits from a transparent and accurate pricing mechanism.