The Perfect Hedge
When someone references a 'perfect hedge', it does not mean that they believe a hedge they have executed is amazing and they are so proud of it. They are saying that they have executed a hedge for the exact same volume at the exact same price as their physical deal, down to the last kilogram, hence eliminating all price risk from their physical contract.
Given the name of this page, what I'm about to write is slightly ironic. The perfect hedge does not actually exist, at least not in practice. Companies will often say that they assume a perfect hedge. They state this to alleviate concerns of investors, or their financing banks that they are taking unnecessary risks on the underlying price movements of their physical contracts. On the face of it, they are hedging their outright price risk on their physical contracts. However, the complexities of how their hedging is executed across their books are a little more involved.
Commodity futures trade in set quantities. Base metal contracts on the LME for example trade in quantities of exactly 25mt (aluminum, copper, lead, zinc), 20mt (aluminum alloy, nasaac), 10mt (steel), 6mt (nickel), 5mt (tin), and 1mt (cobalt). On the CME, copper trades in 25,000lb lot sizes (or ~11.34mt for those on the metric system). Aluminum, lead, and zinc trade in 25mt lots, and cobalt trades in 2204.62lb lots (equal to exactly 1mt). This means you can only buy or sell futures contracts in multiples of those lot sizes. It is also worth noting that most of the time, futures are quoted in the number of lots, not tonnage. For example, if you wanted to sell 750mt of copper futures on the LME, you would ask to sell 30 lots, not 750mt. When prices are moving rapidly you don't want to waste time having to clarify orders - I suggest you memorize these lot sizes and become familiar with the 25, 20, 6, and 5 multiplication tables.
Physical contracts are typically booked in round numbers - 100mt/200mt/500mt/1000mt/etc. However, the chances of you actually receiving or delivering these exact contractual tonnages are essentially zero. Whatever method is used to ship metal, be it by truck, container vessels, break bulk vessels, barges, or even metal released in-warehouse, final tonnages never end up at round numbers. Due to this fact, tolerances are built into physical contracts. Industry-standard is plus or minus 2% from contractual tonnage, but 3%, 5%, or even 10% tolerances are not unheard of. If for example, you purchase 1,000mt of refined Zinc with a 2% tolerance, you will likely receive something like 997.534mt, or 1,004.456mt, within the 2% contractual tolerance, but not the round 1,000mt the contract was booked at.
In this example, if you have sold 40 lots of zinc futures (1,000mt), but you actually receive 1,004.456mt, you are technically under-hedged by 4.456mt. The larger the physical contract, the larger the outright tonnage tolerance can be and the further away from being perfectly hedged you risk being. Because you cannot sell a zinc futures contract for 4.456mt, this means you are unable to mitigate the price risk on the difference between your futures tonnage, and the exact tonnage of the physical contract.
If in this example, the price of zinc decreases from $2,500/mt to $2,400/mt between the time of the physical purchase and sale, the 4.456mt exposure would lead to a loss of $100/mt on those 4.456mt as shown in the table below:
Resulting cash flow of an imperfect hedge
This does not mean that the hedge was executed incorrectly, it is simply a reflection of the fact that hedging can only get us so close to perfectly hedged, and there will always be an element of price risk that is unavoidable when trading metals due to the difference between physical contract tonnages and futures contract lot sizes on relevant exchanges.
On the above deal, the loss was only $445.60 on a 1,000mt contract, which may not seem like a huge issue, and given we don't know which direction prices are going to move it could also have ended up in a small gain. However, most trading companies aren't only trading 1,000mt of a commodity, they are trading hundreds of thousands, if not millions of tons of a commodity annually. If left to chance, these losses have the potential to increase substantially and their impact grow exponentially over time. This is a risk commodity firms cannot afford to take and where proper management becomes key to long-term profitability.
As discussed above, commodity companies assume a perfect hedge of their physical contracts to mitigate the underlying price risk of those metal contracts. However, due to the round lot sizes futures contracts trade in on metal exchanges vs the non-round tonnages that physical contracts are finalized at, this creates an inherent risk that left unchecked would lead to heavy losses over time.
Companies navigate this risk by utilizing hedge cards, sometimes known as risk cards. A hedge card is a relatively simple tool that compares a company's combined futures position with their combined priced physical contracts to give a net risk position - either long or short futures. Typically hedge cards are run company-wide, encompassing an entire global book for each commodity being traded. For example, a company that trades refined copper on the LME in Europe, Africa, and Asia would create a hedge card that collected all trading activity from those regions to give one net physical and futures position. However, hedge cards can be separated by region if a company wishes, particularly if hedging is handled by different desks in different regions, or if profit centers are isolated between different companies within the same overall group. Companies should also use a separate hedge card for each exchange that they utilize to price their physical contracts (LME, CME, SHFE, etc.).
The aim of a commodity firm that assumes a perfect hedge is to keep its overall risk position within one half-lot of zero. If the net result of their priced physical contracts vs. their combined futures position is within one half-lot of zero, they are as perfectly hedged as they can be. Let's look at a very basic hedge card of a company that trades refined Aluminum. The below example hedge card shows the company's physical trades, their net futures position as a result of their hedges, and a net position combining the physical and futures.
An example of a simple hedge card for LME Aluminum
The physical contracts are listed in the hedge card only once they have had their price fixed. Before price fixing, they should not have a corresponding futures trade established so they should not be included in the company's hedge report for this purpose. You will also see that some of these contracts are round numbers, telling us that they have been priced before the contract has a final tonnage. Some purchases and sales have the exact same weight, suggesting those contracts are allocated to each other.
The sum of the priced physical contracts is net long 2,549.042MT - this means that the company has currently priced 2,549.042MT more physical purchases than they have physical sales. Their net futures position as a result of the corresponding hedges is net short 2,550.000. This gives them a net position of short 0.958MT. They are within one half-lot, which for LME Aluminum would be +/- 12.5MT so they do not need to take any market action to square their position. Even though they are very slightly short, since the lot size for LME Aluminum is 25MT, if they were to buy one lot of Aluminum then they would now be running a net long position of 24.042MT. In this scenario, they are as perfectly hedged as possible, given all known information.
There are a few things that can impact the net position of a hedge card. A new physical contract could be priced, which should change the priced physical position, and the net futures positions. A physical contract could also be adjusted from a provisional tonnage to a final tonnage based on final weights being received. The hedge card's job is to capture these changes and constantly compare them as they are made. Typically hedge cards are run daily but they can usually be run as often as a company wishes to effectively capture this risk. As soon as a change is made that creates a net combined position that is greater than one-half lot either short or long, a futures trade can be executed to bring the company risk back within one-half lot of zero.
Hedge cards are also a great way to capture errors, be it missed pricings, missed hedges, or operator error changes in physical contracts. If a physical contract gets priced, but there is no offsetting hedge in the futures position, then the next time the hedge card is run, it will immediately show a large swing in the net position of the book. Let's say a physical purchase of 1,000MT gets priced, but no hedge is executed, the physical total is going to get 1,000MT longer, but the net futures position will remain the same. Therefore the combined net position is going to get 1,000MT longer.
The card would also capture if a hedge was executed but a physical contract was not priced. Only in this example, the net combined position would get 1,000MT shorter because the futures trade would be to sell 1,000MT, but there would be no offsetting physical length hitting the position.
These scenarios would immediately trigger alarm bells and cause questions to be asked. In the first example, was this contract actually priced with the customer and they did miss the hedge? Or was the contract priced by mistake and there was actually no hedge required? In the second example, was a hedge instructed in error and the physical contract didn't actually price? Or do they simply need to update the physical contract with the price from the fix? Whatever the answer is, the mistakes were captured and can be rectified quickly. As mentioned in previous posts, the quicker you can identify a mistake and take corrective action, the lower the chance of a serious loss.
This example is a very basic one but it shows how when used correctly, the hedge card is an extremely powerful tool used in the risk management of a company. And how failure to use one correctly can lead to serious negative consequences.
Risk cards can be as complex as a company wishes. As well as capturing outright price risk they can be designed to capture spread risk where these risk cards would now include un-priced physical contracts so they can effectively manage their spread exposure based on forward-booked business. They can be used cross-exchange to capture arbitrage risks. They are also used to capture foreign exchange risk in a very similar way to outright price risk.
