Commodity Hedging

The theories in the  commodity Hedging of commodities by using futures contract is formally divide into three main theories:

Traditional theory

emphasizes on traditional Theory risk aversion with the use of the existing potential in the futures market. Hedgers will take a position on the futures market which is equal in size but opposite position in the cash market. Traditional theory recommends the application of the full strategy of hedging. This traditional theory many get criticism because it uses the wrong guesses that the futures price rise or fall in the amount equal to the rise or fall in the spot price.

Profit maximization Working's

Working taking different perspectives of looking at hedging using futures contracts. Working dubious view that hedgers pure risk minimizes. In contrast, working believe that behaves as well as hedgers a speculator, who decide to hedge or not to hedge their expectations regarding changes to the appropriate spot-futures price relations. In this case, traders do hedging more selectively and not regularly according to the expectations of change base.

The Portfolio Theory

Portfolio Theory is a combination of traditional theory and Working. Both these theories were combine by they apply the portfolio theory approach to

integrating Working's profit maximization with risk avoidance of traditional theory. By using this approach, Johnson and Stein was able to explain why the hedgers want to have stock of commodities are hedged and un-hedged.

This portfolio Theory treats the futures contract as an asset, where in this case the trader can potentially add them into the portfolio along with underlying cash instruments. Johnson and theoretical frameworks which exposes the Stein hedgers to the futures market for the same reason with the investors who enter into any market, i.e. to achieve the highest return for a certain level of risk.

The quantity than the futures contract that is enter into the portfolio will vary to match when would maximize the return from your portfolio or minimizing risk or variant than return portfolio. Using the methodology did a study on futures market, which in the study indicates that even for risk minimizes, full hedging strategy is not the best approach, but there is optimum hedging ratio (which is often more than one) which has the smallest risk levels.