“Hedging losses” is a fairly common term used in analysis and commentaries about the Indian financial and commodity markets. It is also frequently used in foreign exchange market commentary. A hedge protects against a risk (for a certain price), and when a loss results from that act of protection, it is a double whammy. So it has been, for those hedgers who bought (termed being long) MCX crude oil April contracts to protect against their crude oil price exposure, and who seem to have suffered losses of as much as ₹2,900 per barrel of oil they were hedging.

How this happened has already been explained in detail. So instead, let’s try to understand the term “hedging losses”, its implications and whether there are alternative risk management instruments that can avoid such losses.

Opportunity loss

One may wonder how losses can arise in “hedging” something.

Actually, what is meant by “hedging losses” is “opportunity losses”. In this case, for example, despite spot crude oil going at much lower levels than those at which they were hedged, users of the commodity will have an effective raw material price that is ₹2,900 per barrel higher.

They have “lost” the opportunity to consume crude oil at the much lower spot prices as the “loss” on their act of hedging has to be accounted for in their actual raw material cost. The fact that there will be an immediate cash loss for the hedger in this case will make it easy for him to understand that this is a significant economic loss — it hits his economics or his profit-and-loss account directly.

Many times, in the financial and commodity markets, (specifically in the over-the-counter or OTC market) though a hedger suffers significant opportunity losses (because of large market swings), there will be no immediate cash loss. The recognition of the cash loss or even a book loss is postponed to the statutory financial reporting date, when hedge contracts may have to be marked to market. Consequently, the adverse economic impact is also not recognised or appreciated in such situations.

As against the OTC market, in the exchange-traded markets, there is instant or day-to-day recognition of opportunity losses (and therefore cash or economic losses) in the form of mark-to-market margining in a specific hedging product that is pre-dominantly in use, viz the futures contract.

Futures vs options

If you are forced to recognise cash losses on a day-to-day basis and also to move farther away from the market price (as in the MCX crude oil case) because of your hedging actions — implemented pre-dominantly through the futures contract — would you not look at alternatives to such a hedging instrument?

Such a hedging instrument is the option contract. An option contract gives the buyer the option to buy or sell a commodity (or any financial asset) at a particular price on or before a particular date — but the buyer of the option is under no obligation to buy at the contract price (or strike price as it is called).

If the prevailing market price is more advantageous to the holder of the option, he will obviously go by that market price to buy or sell the commodity.

Correspondingly, his option or “right” will either have little value or be worthless. But, as a hedger, the option buyer cannot be concerned about his right expiring worthless, as he is not suffering any opportunity or economic loss in the entire sequence of events. He is buying or selling the commodity in question at the price most favourable or beneficial to him.

Now, can this be said of the MCX futures hedger? As pointed out above, his effective cost will be plus ₹2,900 per barrel. If he had bought crude call options, those options would have expired worthless but the crude cost would be ₹2,900 lower.

Despite this big advantage (and other technical features), it is unfortunate that most Indian commodity hedgers predominantly use only the futures contract. SEBI data shows that on the MCX, in 2019/20 up to February, energy options (call + put) turnover was only ₹51,000 crore versus an energy futures turnover of ₹35,11,000 crore (energy options need not be done only on the MCX; they can also be done in international exchanges).

The problem basically is lack of awareness all across the ecosystem — whether it is actual hedgers, the broking community or in corporate finance.

The author is a Chennai-based financial consultant

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