By Paul Chapman, 22nd March 2021
In this first blog on the fundamentals of hedging we answer the question: “What is a hedge?” In the broadest sense a hedge is any investment intended to mitigate uncontrollable financial risk to the value of a future transaction. Hedges can be divided into two main types by the way in which they work.
The key feature of a natural hedge is an investment made with the expected returns that correlate negatively with the risk being manager. For example, a solar panel manufacturer could buy a silicon mine so that increased revenue from the sale of silicon when the mineral's prices rises would offset the fall in profits when the productions cost of panels increase. In the New Zealand electricity market retail customers and generation assets naturally hedge each other: when the wholesale price is high revenue from generation offsets the fall in retail and vice versa.
Assets with inverted return profiles can require long-term and capital-intensive investment. An alternative approach is to make investments that fix the value of a future transaction (or at least constrain the range over which value may vary). For example, our solar panel manufacturer forecasting growing demand for product could contract with silicon producer to purchase a specified quantity of silicon on the day of delivery may well be the same as the contract price, it will more than likely be higher or lower. In which case either the silicon producer or the panel manufacturer would have been better off without the contract. Despite the possibility of forgoing a better deal, what each party gets from the contract is certainty. The silicon producer can commit resources knowing in advance both that the product will be sold and the revenue it will attract. Likewise, the panel maker can accept orders knowing both that supply is guaranteed, and profits will not be eroded by rising input costs.
The contract in the solar panel example is a known as a forward contract and commits the panel maker to take physical delivery of the silicon. Such a hedge provides a degree of certainty but only for a given moment in time. The panel maker may prefer to have 1/12th of the total quantity delivered every month with each delivery paid for at the agreed price. If the market for silicon is marked by volatility it is likely that on each delivery date the open market price of silicon may sit higher or lower than the contracted price at levels unforeseeable when the contract was signed. In this scenario in the months when market prices are low the contract favours the silicon producer and vice versa when prices are high.
A contract structured this way is effectively 12 one-month forward contracts for physical supply joined together (technically known as a strip). It not only avoids loading all the gain/loss against the market price on a single day but also removes the monthly cashflow volatility that would arise if monthly consignments were purchased at market prices. This underlines the second important benefit of hedging: predictable inter-period cashflow for a tradeable asset in a volatile market.
Displaying marked price lability across the day, the year and between years the New Zealand wholesale electricity (spot) market is nothing if not volatile. Since the introduction of the
spot market in 1996 a variety of contracts trading on secondary markets have evolved to provide traders with tools to hedge price risk. We will talk more about some of the more popular contract forms and associated markets in later blogs, but next time we’ll discuss in more detail volatility in the electricity spot market.
1. A hedge is an investment made to reduce the risk of adverse price movements in a future transaction.
2. The main purpose of a hedge is two-fold:
a. to provide price certainty for future transactions; and
b. reduce inter-period transactional cashflow volatility.
In the next blog we answer the question: “Why are prices in the NZ wholesale electricity market so volatile?”