21^st Century Business Herald: Diversified Hedging Strategies of Zinc Enterprises under the Prevalence of Pricing

Updated on: August 31, 2017

By Chen Zhi, Journalist from 21^st Century Business Herald

Many zinc traders said that the pricing model had accounted for half of the domestic zinc trade market so far, which also brought a wide range of hedging strategy options to the downstream enterprises.

Zinc price rose by more than 60% in the past year, unexpectedly boosting the hedging business.

According to the data of Shanghai Futures Exchange (SHFE), in the first half of the year, the number of institutions participating in zinc futures hedging surged by 60.56% year on year, and the average daily positions and average daily trading volume of the hedging business increased by 58.13% and 48.16% respectively year on year.

As for the reasons, on the one hand, a shortage of zinc ingots kept the spot premium rising. As a result, some traders stocked up with goods, waiting for price increase, which forced the downstream enterprises to lock in orders and purchase price through hedging in the futures market; on the other hand, the increasing prevalence of the pricing model led to great hedging demand among the upstream and downstream enterprises.

However, how to plan an appropriate hedging strategy poses a new challenge to the upstream and downstream enterprises in the zinc industry.

In the view of industry insiders, the current results of zinc hedging shall be analyzed from the perspective of the integrated profit and loss of the spot and futures markets. However, this means that there should be significant adjustment in business performance assessment mechanism.

Diversified hedging strategies under the prevalence of pricing

Bi Youzhen, Deputy Head of Futures Department of Chihong Industry Development (Shanghai) Co., Ltd. (600497.SH), was surprised to find that the pricing model became prevalent quietly as zinc price continued to increase.

Pricing rose between traders, and now it has quickly extended to the trade links of the upstream and downstream enterprises in the zinc industry. It is noteworthy that different from the pricing model in the international market that allows repeated pricing of buyers and repeated trading, the domestic model is characterized by pricing for both buyers and sellers.

Many zinc traders said that the pricing model had accounted for half of the domestic zinc trade market so far, which also brought a wide range of hedging strategy options to the downstream enterprises.

For example, a trader needs to buy a batch of zinc ingots after three months. Considering that currently the premium for spot zinc price is between 400 yuan/ton and 500 yuan/ton, he can buy futures contracts with nearby delivery month and liquidate positions when the delivery month comes to get hedging income instead of paying a premium for spot zinc. In the first half of the year, the difference rate between futures price and spot price after the zinc futures contract expired was only 0.44%, which means that the downstream enterprises can gain more than 400 yuan per ton from price difference and thus reduce purchase cost, and they can lock in the purchase price through pricing when zinc price drops.

In addition, based on the trend that zinc price will drop although currently it is high, many downstream enterprises bought contracts with nearby delivery month and sold contracts with forward delivery month to lock in an intertemporal arbitrage income of about 5%, which can also further reduce their purchase cost.

However, the prevalence of the pricing model has brought great hedging pressure on the upstream enterprises. That is, before the downstream enterprises set the purchase price, the upstream enterprises have to put the spot goods on the futures market for selling hedge and liquidate positions after the downstream enterprises set the price; if the price of selling hedge is too low, the upstream enterprises will be faced with the risk of hedging loss in the case of rising zinc price; on the contrary, if the price of selling hedge is too high, there will be few buyers, and it will be difficult to implement the overall hedging strategy.

Bi Youzhen said that identifying the nature of exposure was the key to the success of pricing-based hedging operations.

A person responsible for hedging business of a zinc enterprise introduced that pricing-based hedging operations could be divided into two categories, namely short hedge for inventory with fixed price and undetermined purchase amount, and long hedge for inventory with fixed purchase amount and undetermined price.

Enterprises adjust hedging assessment according to the specific situation

The journalist from the 21^st Century Business Herald learned that many companies still set a strict futures positions limit despite the diversified pricing-based hedging strategies. Its main purpose is to prevent enterprises from converting hedging into a speculative tool.

"The company requires that futures positions should not exceed the spot hedging demand because to some extent it is afraid that production fluctuation will lead to a delivery gap in short positions, which will bring additional losses." Bi Youzhen said bluntly.

As the several-year zinc bear market comes to an end and a rising cycle starts, how to develop up-to-date hedging assessment standards becomes a new test for enterprises.

Many zinc traders revealed that in the past enterprises usually considered the unilateral hedging profit of futures as an internal assessment criterion, but it may not be suitable for the current environment. As zinc price rose, selling hedge in the futures market usually suffered losses, so the profits of the spot market should be included in assessment to fully reflect the overall benefits of hedging.

Bi Youzhen said that if hedging effect was measured based on the unilateral profit and loss of futures, hedging operations will became speculative. The company also noted the problem and it optimized the hedging assessment standards through establishing a futures-spot hedging account. Specifically, each futures position of the company must correspond to the same amount of spot goods to ensure that the futures position is a real hedging position, each spot position should also correspond to the corresponding futures position, and hedging effect is comprehensively assessed based on the measurement of profit and loss between futures and spot goods.

An industry insider pointed out that it was not easy to establish a futures-spot hedging account.

The main reason is that several departments of many zinc enterprises are involved in different strategy-based hedging business, the information asymmetry between them usually lead to an overall mismatch between the futures and spot positions of the enterprises, ineffectiveness of the futures-spot hedging strategy or other problems.

In the opinion of Bi Youzhen, it really is a great challenge. CHIHONG Zinc&Ge took two steps to address it. First, traders need to send screenshot of daily execution to business risk management personnel after the close of a futures trading day, the latter will gather the trading information and prepare the daily exposure report, and the relevant department of the head office will conduct full and dynamic risk monitoring of the status of uncovered positions; second, during the authorization of hedging operations to different business departments, the maximum risk exposure and stop-loss limits will be set for each department to ensure that the overall hedging exposure of the company is under control.