Hedge inventory is derived from the term ‘hedging’, which means reducing or controlling risk.
Hedge inventory is the excess inventory purchased or kept in stock as a buffer with the objective of reducing or limiting risks associated with future price fluctuations or to take the best advantage of it.
The price fluctuations could be a result of seasonal/cyclical variations or even sudden market disruptions leading to an imbalance in demand and supply, for e.g.: changes in exchange rates with international purchases, war situations, very special promotions, strike or vendor shutdown, new government policies, etc.
Hedge inventory is also said to be an inventory built up for an event that has a very rare chance of happening. Usually, this approach is avoided by most of the businesses as there is an additional investment made, which might result in a complete wastage in the end.
Example of Hedge Inventory
Let’s assume that there is a company manufacturing noodles. Now, because of quality non-adherence found in a certain sample during the factory audit, the manufacturer is enforced to shut down the production for a limited period.
But since there is a constant and unhindered demand in the end-consumers, let that be any time of the year, the retailers started filling in the product in four times the regular purchase quantity. This is what we call hedge inventory.
As noticed, the retailers only ordered stock in heavy bulk after knowing that there will be a definite shortage of supply. Not only the retailers but also the customers will do the same.
Types of Hedging
There are mainly two types of hedging:
#1 Hedge Sale
When a seller buys an inventory in cash, there are chances that he/she might sell futures of an equivalent quantity to ensure that the stocks are safe whenever there is a fall in the price. Such a sale in the futures market is called a Hedge Sale.
[Futures Market – A futures market is an auction market where the participants (often sellers) are allowed to buy or sell inventory on a specific future date.]
#2 Hedge Purchase
If a manufacturer has sold the goods in exchange for immediate cash, he/she can certainly protect the business from suffering a loss at the time of shortage or extremely high demands.
Limitations of Hedging
If a seller thinks that hedge inventory provides insurance when it comes to the price changes, it’s wrong! It’s all about how well a seller can afford the additional stock. There are chances when a seller might not be able to sell off hedge inventory. In this case, the seller would suffer a major impact on the business financials.
The limitations are below:
- Hedging of the inventory will only be successful if the prices in the cash market and the future market move hand in hand, parallelly, in a perfect flow. The probability of incurring a loss will come up the moment the prices start to vary and move in the opposite directions. Unfortunately, in such cases, the purpose of hedge inventory will fail.
- Sellers can smartly analyze the future demand of a particular product, and can accordingly bid for a price on hedge inventory that you are planning to sell off in the futures market. As said, just like how the present price and the future price of a product shouldn’t fluctuate or go in opposite directions, the same is with the demand. In this case, also, hedge inventory will fail.
- There are many futures markets where the inventories are exchanged in turn for an inventory, only. In such cases, there are high possibilities that you are again selling off hedge inventory in return of something that is again proving out to be the same thing, only a loss for your business.
The prices of the raw materials can heavily impact the hedge inventory value. This is another major reason for the prices to fluctuate. Again, making your hedge inventory to fail.