Commodity and Commercial Forwards · Forwards Trading Guide
Two prices for the same named commodity may represent different exposures. Location, quality, timing and delivery terms can leave a gap after hedging.
Define what is actually being bought
A metal quote may refer to a particular purity, warehouse location and delivery arrangement. A fuel benchmark may differ from the grade used by a transport business. The relevant business price includes the agreed physical specification. Hedging a recognisable global benchmark without mapping those terms can leave a material part of the bill exposed.
Separate reference and local basis
Suppose a customer’s local price is a reference benchmark plus a regional premium. At the planning date, the benchmark is $100 and the premium is $8. A financial forward fixes the reference at $100. At purchase, the benchmark is $120 but the premium has widened to $15. The customer pays $135 locally and receives $20 from the matching reference hedge, leaving an effective $115 cost.
Interpret the residual correctly
The hedge has offset the benchmark move but not the $7 widening in the regional premium. That is basis risk in this example. A physical forward specifying an all inclusive delivered price can cover more components, depending on its clauses. Taxes, transport changes, quality penalties and force majeure provisions may still alter the final economics.
Build a basis record
Track the actual invoice series alongside the proposed hedge reference on matching dates and units. Compare differences during shortages, transport disruptions and seasonal peaks rather than relying only on an average correlation. A hedge ratio estimated during calm periods can fail when supply conditions change. Document the residual that management accepts instead of describing an approximate hedge as perfect protection.
Try it yourself
A reference hedge fixes $70 while the physical premium rises from $4 to $9. At settlement the benchmark is $80. What is the effective purchase cost after a matching cash hedge?
Show the worked answer
$79: the physical price is $89 and the hedge pays $10. The $5 premium increase remains unhedged.
Further reading
- Iowa State University: Commodity marketing workbook
- CFA Institute: Pricing and valuation of forward commitments
Educational material. Numerical examples are hypothetical and exclude costs unless stated. Forward contracts create binding obligations and may require collateral or credit approval. Actual terms, access and risks depend on the agreement and jurisdiction.
