More on Hedging

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, the 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.