Reducing price risk — from exposure to locked-in outcome

Hedging Explained

Hedging offsets the price risk of a physical or commercial position with an opposite paper position. In ETRM, the exposure report shows unhedged volume; traders hedge based on it. Wrong exposure → wrong hedging → unintended speculation.

Physical − Hedged Exposure formula
Paper desk Hedges physical exposure
EoD Exposure calculated overnight
Wrong exposure → Wrong hedging

What is hedging?

Hedging is a risk management strategy that offsets potential losses (or gains) from a physical or commercial position by taking an opposite position in a related instrument (futures, options, swaps, forwards).

The goal is not to make a profit from the hedge itself but to reduce volatility and lock in a more predictable outcome (e.g. effective price or cash flow).

In commodity/energy trading: the physical desk has exposure (e.g. buying 1M bbl crude for March).

The paper (hedging) desk trades derivatives to offset that exposure so the firm is not left speculating on price.

The exposure formula

The ETRM exposure report answers “how long or short are we?” — the volume (and optionally value) of commodity that is unhedged and exposed to market moves.

Core formula
Exposure (unhedged volume) = Physical volume − Hedged volume Exposure amount = Unhedged volume × Market price

Example: 1M bbl physical purchase − 800k bbl futures bought = 200k bbl unhedged exposure.

The paper desk hedged 80%; 200k bbl remains exposed to price moves.

Who does what

Physical desk Creates exposure (e.g. buys 1M bbl Brent for March).
Paper (hedging) desk Trades futures, swaps, or options to offset that exposure.
ETRM Paper trades flow in and are allocated to physical trades so the firm sees one view of exposure (physical + paper).
Trade reconciliation Matches exchange/clearer reports to ETRM positions.

Why accuracy matters

The exposure report is built per book (e.g. Natural Gas, Crude, OTC Power) or by geography and is calculated in the overnight EoD process.

It must be accurate and on time (e.g. by 7 AM).

If exposure is wrong, the amount hedged is wrong: the firm may think it is hedging but is effectively speculating without knowing it.

Market moves can then cause large, unintended losses.

Limitations

Basis risk: The hedging instrument (e.g. WTI futures) may not move 1:1 with the physical price (e.g. Brent).

Hedging limits upside: Locking in a price protects against adverse moves but caps gains if the market moves in your favour.

Correlation and tenor: Hedge effectiveness depends on correlation and matching delivery/tenor; ETRM must capture pricing terms and dates correctly for exposure and P&L.