Meaning
Risk management strategy involving the use of futures and options contracts to lock in prices for non ferrous metals traded on a global exchange. London metal exchange hedging provides price certainty for manufacturers who use copper, aluminium or zinc in their production lines. It offsets the risk of market volatility between the time a purchase order is placed and when the physical metal is delivered.
Price Locking
Contracts allow a buyer to fix the cost of raw materials months in advance of the actual smelting or fabrication. Effective london metal exchange hedging requires a clear understanding of the contango and backwardation states of the market.
Margin Requirement
Executing these trades involves posting collateral to cover potential losses in the value of the derivative position. Because london metal exchange hedging uses standardized contracts, the liquidity for these instruments is typically high enough to support large industrial volumes.
Physical Alignment
Coordinating the paper trade with the physical arrival of metal is necessary to avoid a speculative exposure. A failed london metal exchange hedging strategy occurs when the timing of the contract expiry does not match the production schedule. The cost of a mismatch includes cash flow strain and the potential for realized losses on the exchange while physical costs remain high.
