Long Hedge
A long hedge is a risk management strategy in which a party buys futures contracts or other derivatives to protect against a rise in the price of an asset it plans to purchase in the future. It is the complement of a short hedge (selling futures to lock in a selling price) and is typically used by companies that need to buy commodities, foreign currencies, or financial instruments at a future date.
Key takeaways
- A long hedge locks in a purchase price for a future acquisition, providing certainty of input costs for manufacturers, processors, and other end-users of commodities.
- The long hedger owns the long futures position and profits if the price rises; this gain offsets the higher cost of purchasing the physical commodity at the elevated spot price.
- Basis risk—the difference between spot and futures prices—means the hedge will not be perfect unless the hedger's physical commodity matches exactly the commodity and location specified in the futures contract.
- Long hedges are commonly used by food processors (locking in wheat, corn, or soybean prices), airlines (hedging jet fuel costs), and manufacturers (hedging metal input costs).
- Currency long hedges are used by importers who will need to pay in a foreign currency—by buying foreign currency forwards or futures, they lock in an exchange rate regardless of subsequent spot market movements.
Explanation
A long hedge is appropriate whenever an entity has an anticipated purchase exposure—it knows it will need to buy a specific quantity of an asset in the future and faces the risk that prices will rise before the purchase is made. By buying futures contracts today, the hedger essentially locks in the current futures price as its effective purchase cost, gaining protection against upward price movements at the cost of not benefiting from favorable (downward) price movements.
The mechanics of a long hedge can be decomposed into two simultaneous positions: the 'cash' (physical) position and the futures position. In the cash market, the hedger has a 'short' position conceptually—it must buy the commodity in the future, so it benefits from falling prices and is hurt by rising prices. In the futures market, the hedger holds a long position that gains when prices rise and loses when prices fall. These two positions offset each other: if the spot price rises $0.50/bushel from hedging date to purchase date, the physical purchase costs $0.50/bushel more, but the futures position gains approximately $0.50/bushel (before basis effects), resulting in a roughly unchanged effective purchase price.
Basis risk is the principal source of hedge imperfection. The basis is defined as the spot price minus the futures price. If the basis remains unchanged from the time the hedge is established to the time it is lifted, the hedge is perfect. In practice, basis fluctuates for several reasons: the spot price reflects local supply/demand conditions that differ from the exchange delivery location, the futures price incorporates changing cost-of-carry (storage + financing + convenience yield), and quality premiums/discounts between the physical commodity and the futures contract specification affect relative prices. A hedger who is long December corn futures but needs to buy No. 2 yellow corn at a country elevator in Iowa faces basis risk reflecting local basis levels relative to Chicago delivery.
Cross-hedging involves using a futures contract in a related but not identical commodity (or asset) to hedge an exposure that lacks a matching listed contract. For example, an airline that wants to hedge jet fuel costs might use crude oil futures or heating oil futures (which are more correlated with jet fuel than crude), accepting basis risk from the jet fuel-to-crude or jet fuel-to-heating oil price differential. The effectiveness of a cross-hedge is measured by the correlation between the hedged asset's price changes and the futures price changes; higher correlation produces lower residual basis risk.
For hedge funds and institutional investors, long hedges are used in somewhat different contexts. A macro fund anticipating rising commodity prices might establish long futures positions that serve as a long hedge for an equity portfolio with significant exposure to commodity-consuming industries. A global equity fund with planned capital deployments in foreign markets might buy currency forwards (a long hedge on foreign currency) to lock in exchange rates for anticipated purchases. The risk management decision of whether to hedge and at what hedge ratio involves comparing the cost of hedging (potentially missing favorable price moves) against the benefit of reduced uncertainty.
Formula
Effective Purchase Price = Spot Price at Delivery − Gain on Futures = Futures Price at Hedge Initiation + Basis at Delivery
Example
A confectionery manufacturer needs to purchase 500,000 pounds of cocoa in three months for its holiday production season. Current spot cocoa prices are $3,200/metric ton ($1.45/pound), and the three-month cocoa futures contract trades at $3,250/metric ton. To establish a long hedge, the manufacturer buys 20 cocoa futures contracts (each representing 10 metric tonnes; 500,000 pounds ≈ 227 metric tonnes, so approximately 22.7 contracts, rounded to 20 for illustration). Three months later, the spot price of cocoa has risen to $3,600/metric ton due to a drought in West Africa. The manufacturer buys cocoa in the spot market at $3,600 and simultaneously sells its futures position (now trading at $3,550). Gain on futures = 20 contracts × 10 tonnes × ($3,550 − $3,250) = $60,000. Additional cost in spot market = 227 tonnes × ($3,600 − $3,200) = $90,800. Net additional cost after hedge = $90,800 − $60,000 = $30,800, versus $90,800 without the hedge—the hedge covered approximately 66% of the price increase, with the residual basis risk accounting for the difference.
Related terms
Basis Basis Risk Component Var Correlation Counterparty Risk Cross Hedge Delivery Double Hedging Equity Exchange Forced Liquidation Futures Contract