An underlying asset is the physical product to be hedged, on which a derivatives product is based.

Derivatives are financial instruments whose prices move concurrently with the underlying asset, such as Lithium and Cobalt futures contracts. Derivatives enable market participants to dynamically manage their price exposure, reduce risk, lock in profits and protect margins.

On March 4, 2025, a merchant trader holds 200 metric tons of unsold cobalt metal inventory. Concerns arise about the potential for cobalt prices to weaken over the next two months. This presents a risk to the value of its inventory, prompting the trader to consider hedging strategies to protect against potential losses. The merchant recognizes the need to secure the value of its inventory and reduce exposure to a volatile spot market for that period.

The merchant trader faces the risk of declining cobalt prices until it can find a buyer for its material. To mitigate the risk of the inventory depreciating in value, the trader can implement a hedging strategy by selling Cobalt Metal (Fastmarkets) futures contracts. Should cobalt prices decline as feared, the trader will realize a gain on the value of their short futures contracts. This gain will serve to offset the loss incurred from selling at lower cobalt prices in the future.

The Cobalt Metal (Fastmarkets) futures contract is based on one metric ton of cobalt. Therefore, to hedge its entire 200 metric tons of unsold metal inventory against price declines, the merchant trader needs to sell 200 May 2025 Cobalt Metal (Fastmarkets) futures contracts.

On March 4, 2025, the May 2025 Cobalt Metal (Fastmarkets) futures price is $12/lb. The merchant trader executes the hedge by selling 200 May 2025 Cobalt Metal (Fastmarkets) futures contracts at the prevailing price of $12/lb. This establishes a short position in the futures market, designed to offset potential losses of the inventory value.

On April 15, 2025, the trader executes a physical sale and ships 50 metric tons of physical cobalt at a price of $10/lb. Simultaneously, it buys back 50 May 2025 Cobalt Metal (Fastmarkets) futures contracts at the then-current market price of $10/lb. This action reduces their hedge proportionally to the amount of inventory sold. The $2/lb decrease in the price of the underlying physical cobalt since the hedge was initiated is offset by an equivalent profit on its short futures position. The trader realizes a profit of $2/lb on the 50 futures contracts they bought back, effectively compensating for the decline in the physical cobalt price.

As the merchant trader continues to sell off its physical cobalt inventory, it progressively reduces the size of the hedge. The trader achieves this by buying back an equivalent amount of Cobalt Metal (Fastmarkets) futures contracts corresponding to the tonnage of cobalt metal sold. This process continues until the entirety of the cobalt inventory is sold, at which point the entire hedge is liquidated. If there is remaining inventory that the trader wishes to protect against price decreases by the expiry of the May 2025 contract, the trader can roll forward its hedge by opening a correspondingly sized short futures position in a deferred month.

If the cobalt price decreases, the trader’s short futures position will generate a profit, offsetting the lower price obtained in the physical cobalt market. Conversely, if the cobalt price increases, the trader will sell its physical cobalt at a higher price, which will offset the loss incurred on the futures position.

Irrespective of the movement in the physical spot market, the hedging strategy protects the merchant trader’s profit margin and the inventory value. In this example, the hedge enables the trader to mitigate the risk of price fluctuations while awaiting favorable market conditions.

On October 1, 2025, an original equipment manufacturer (OEM) agrees to purchase lithium-ion batteries from a battery manufacturer over a six-month period starting in January 2026. The contract terms include a formula price linked to the price of lithium Carbonate during the delivery period, meaning that the final price for the delivered batteries will fluctuate based on the realized average price of lithium Carbonate over those six months.

The OEM, wanting to maintain a predictable profit margin despite the fluctuating lithium Carbonate price, decides to hedge its risk by using the Lithium Carbonate CIF CJK (Fastmarkets) futures contracts. This allows it to effectively lock in a price for the lithium Carbonate and thereby manage an important cost component of the batteries it is purchasing.

The OEM estimates that the order size is equivalent to 100 metric tons of lithium Carbonate per month over the six- month contract period. The Lithium Carbonate CIF CJK (Fastmarkets) futures contract has a contract size of one metric ton. Therefore, to hedge the exposure, the battery manufacturer needs to purchase a strip of six times 100 Lithium Carbonate futures Contracts with expiries from January to June 2026.

On October 1, 2025, the price for a January-June 2026 strip of Lithium Carbonate futures Price is $12 per kg. The battery manufacturer is able to execute this hedge by buying 100 metric tons in each month in the period January through June 2026.

As the battery manufacturer begins delivering batteries and issuing invoices, the price charged to the OEM will fluctuate based on the current spot price of lithium Carbonate. If the price of lithium Carbonate increases, the OEM has covered its risk with the purchase of Lithium Carbonate futures contracts, which gain in value and thereby mitigate the impact of the additional cost in the physical procurement contract. If the price decreases, the OEM will purchase batteries at a lower cost, which will offset the negative PnL on the futures contract. Regardless of the direction of price, the variable price risk associated with lithium is covered with a hedge using Lithium Carbonate futures contracts, and the OEM can procure finished batteries from its supplier at a predictable cost, thereby protecting its profit margins.

On May 5, 2025, a lithium producer signs an offtake agreement with a merchant. The producer will deliver lithium chemicals to the merchant in the order of 200 tons per month over the entire next calendar year. The price for the commodity will be variable with reference to the Fastmarkets Lithium Hydroxide CIF CJK price, which also underpins the Lithium Hydroxide CIF CJK (Fastmarkets) futures contract.

The pricing term sheet signed by the counterparties does not impose any minimum or maximum price levels, so that the producer is fully exposed to any change in the lithium hydroxide market price during the contract period. While the producer is comfortable with its exposure to lithium spot prices, it wishes to be able to guarantee a minimum floor payment for each monthly shipment that will allow it to cover its production costs. In exchange, it is willing to accept a maximum cap on the monthly offtake payments. The producer can overlay a synthetic cap and floor on its physical offtake by using listed option products on Lithium Hydroxide CIF CJK (Fastmarkets) futures.

Lithium prices for January to December 2026 are currently traded at $12/kg. To create a synthetic cap and floor, the producer needs to simultaneously buy a put option at a low strike (below market) and sell a call at the high strike (above market). Ideally, the producer does not want to pay any net premium for that transaction, meaning that the cost of the put the producer is buying should be equal to that of the call it is selling

The producer is comfortable with prices dropping to $9/kg, 25% below the current market price. The option premium for that put is equal to a $15/kg call option. The producer buys the $9 puts and sells the 15$ calls for a net zero premium in 200 tons/months for each month in 2026.

When deliveries being in 2026, the producer has clarity about the payments to be received. On each monthly payment date:

• Should the market have fallen below $9/kg, the put is in the money and offsets any market price drop below that strike level, meaning that the producer receives 9$/kg for the delivered material.
• Should the market trade between $9 and $12/kg, neither call nor put are in the money, the producer receives the prevalent market price within that range.
• Should the market have rallied to above $15/kg, the short call position offsets any gains above the call strike at $15. The producer receives $15/kg but does not participate in further upside.

It is important to note that by hedging, a company is trying to mitigate risk, NOT make additional profit through speculation. Therefore, if properly hedged, adverse and favorable price fluctuations will net the same result and provide businesses higher certainty about future sales revenues and the cost of input goods.

^{* All prices and situations are theoretical}