# Hedging with forward contract

I am wondering what strategies that can be used in hedging with forward contracts in commodities market.

I only need to buy the forward contract (long position), let's say a one month contract. So my profit/loss depends on the spot price at maturity ($$S_t - K$$).

So should I base my decision only on spot price forecast at the maturity date? Or there is something else?

The decision by a company to hedge (or not to hedge) is a complicated one. It is important that the decision is made carefully according to a written Hedging Policy that has been discussed and approved by the responsible decision makers. The policy should specify how to determine what is to be hedged (i.e. the company exposure) and whether/how it is to be hedged. The hedging could be unconditional (ex: an airline could have a policy of always hedging its fuel cost for the next 6 months), or conditional based on a specified mechanism. For example the hedging could be based on a forecast of $$S_T$$; some would say that already this is not hedging but speculation, but it may be OK if it is clear who within the company makes this forecast and who approves it. The conditionality might be based on other explicit factors also, but must avoid subjective factors like "I have a feeling the price of oil is going to go up". The forecast must be explicit and its reliability must be evaluated over time.

Keep in mind that in some cases the price will go in the opposite direction of what is feared (the airline could find that the price of fuel goes down instead of up), making the hedge counterproductive. Or (as is happening today) the airline could have to cancel many flights, making the purchase of large amounts of fuel in the forward market extremely regrettable, to say the least. It is very important in those circumstances that everyone involved understands how the decision to hedge was made and what policy changes may have to be made in the future. (There are many case studies of disasters where people accused each other of making the wrong decision, but no clear account of what the process was supposed to be or why they were hedging).

Anyway, these are the main considerations about hedging that would be covered in a Corporate Finance course. Apologies if it was already obvious to you.

• For a fun Case Study of very successful oil hedging by a small group of Mexican official you might read this article bloomberg.com/news/features/2017-04-04/… But such forecasting ability is extremely rare. – noob2 May 5 at 17:42
• Thank you for your answer, it was helpful. Im wondering if one month forecast accuracy of R^2 = 40% is reliable to make a hedging? Or the accuracy needs to be much higher? – BalticOY May 5 at 19:28