Simply stated, commercial producers produce the commodity. They understand the fundamentals of production very well; they know how much it costs to produce a commodity, and probably know how much money they can get for it too. They also know what their supply is, and they know what market demand is. They may be very good at locking in high prices for their raw product, but they are not perfect; no one is. To hedge, they short futures, with the option of offsetting their positions by delivering against the shorts rather than buying them back. If the commercials are producers of the raw commodity and have established a futures trading account as a hedger, then by law they are required to show that they are involved in the cash market.
Commercial producers of the underlying raw commodity should always be short the futures (opposite of the commercial consumer) when hedging, because this reduces their exposure to the risk of falling commodity prices. By shorting futures, commercial producers can lock in a price for their product.
In the agricultural commodities, it is easy to identify a producer (e.g., an oat farmer or a soybean farmer). But what about the financial markets such as currency futures? A commercial producer of, say, Canadian dollars would be a U.S. corporation that does business in Canada. It produces Canadian dollars as a result of its sales in Canada.
Let’s take the hypothetical example of XYZ Corporation, a U.S. company that sells goods and/or services outside the United States. XYZ needs to convert the foreign currency it receives (produces) from its sales into U.S. dollars. For XYZ to control and manage the risk associated with varying exchange rates and the prices of their goods and/or services, XYZ would use the futures market to lock in a predetermined exchange rate. This limits XYZ’s exposure to risk due to unforeseen fluctuations in currency rates between the U.S. dollar and the foreign currencies involved.
In this example, XYZ sells goods in Canada and receives Canadian dollars. To limit its exposure to exchange rates, XYZ (being a producer) would sell short a certain number of Canadian dollar futures contracts traded on the Chicago Mercantile Exchange (CME), thereby locking in an exchange rate for the physical Canadian dollars (CD) received. Let’s assume XYZ sells short at a price of 6400 (or 64 cents U.S. for every $1.00 CD). This also equates to $1.00 U.S. for every $1.36 CD collected as a direct result of sales in Canada.
With the exchange rate locked in, XYZ Corporation has removed its exposure to risk of changes in the currency market that could adversely affect the corporation’s compensation for the goods and services sold in Canada. Moreover, XYZ knows for sure exactly how much it will receive— in U.S. dollars—for its goods and/or services sold in Canada. XYZ likely would have taken into account the current exchange rate available through futures, which would be used to help determine the pricing of their goods and services in Canada. The prices paid in Canadian dollars would then be converted to U.S. dollars at a predetermined conversion rate, as set by the short sale of Canadian dollar futures.
Subsequent delivery of the agreed payment in Canadian dollars could be used to meet the delivery obligations of the short futures position. At delivery, XYZ would receive U.S. dollars at a rate of $1.00 for every $1.3600 delivered in Canadian dollars, based on the entry price of the short sale of futures.
To recap, XYZ essentially produced Canadian dollars in the United States, as a result of its sales in Canada. It used the futures market to hedge currency risk that could negatively impact its bottom line. And, no matter what happens to currency prices, XYZ delivers Canadian dollars at the predetermined exchange rate of $1.00 U.S. for every $1.36 CD collected.
Read More : Trading Behavior Of The Producer
