EBF 301
Global Finance for the Earth, Energy, and Materials Industries

More on Hedging

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As we learned in the previous pages, gain and lose in hedging depends on the basis. Predicting the behavior of the basis could create an opportunity for making a profit. This is called arbitrage hedging. For example from the concept of convergence, we can predict the basis to narrow over time. In a contango market, basis narrows with respect to the storage cost per time. However, in an inverted market, basis narrows at the expiration date but this rate is unpredictable.   

In a contango market (carrying charges market) when basis narrows, short hedgers make a profit and long hedgers lose. And when basis widens, long hedgers make a profit and short hedgers lose.

In an inverted market (backwardation) when basis narrows, short hedgers lose and long hedgers make a profit. And when basis widens, long hedgers lose and short hedgers make a profit.

Note that in reality, many companies use different hedging techniques to not only reduce the risk but improve the profit.

Futures contracts exist for a limited number of commodities. However, existing futures contracts could also be used to hedge the price risk of relevant commodities that have no futures contract market. This is called cross-hedging.