Client:

An automobile manufacturer with a long-term contract to purchase 10,000 metric tons of Aluminum over the coming year.

Challenge:

Hedging future Aluminum purchases without incurring added storage costs and protecting profit margin against supply constrained price increases.

Solution:

Use COMEX Aluminum futures (AL) to hedge Aluminum purchases.

Overview

A trader at a U.S. based automobile manufacturer is tasked with managing the risk associated with volatile Aluminum markets.  Historical volatility has always been a factor in determining hedging programs, however, recent supply chain disruptions have increased the uncertainty and magnitude of price fluctuations.

While Aluminum prices peaked in February 2022, geopolitical conflict remains a driving force behind price movement.

The automobile manufacturer is now faced with elevated Aluminum prices, and the risk of further price increases when the time comes to purchase Aluminum from the producer.

Instead of immediately purchasing all the Aluminum in anticipation of rising prices, and incurring extra storage costs, the automobile manufacturer has decided to purchase 1,000 metric tons of Aluminum every month, beginning in June.   

Approach

In February, an automobile manufacturer agrees to purchase 10,000 metric tons of Aluminum throughout the upcoming year.  Spot market Aluminum is currently priced at approximately $3,400 per metric ton.

COMEX Aluminum futures allow participants the ability to protect profit margin while minimizing the risk associated with adverse price movements.

To limit the risk of rising Aluminum prices while not incurring unnecessary storage costs, the automobile manufacturer could purchase equal amounts of Aluminum futures beginning in June and every month thereafter through March.  This would equate to 1,000 metric tons per month, or 40 futures contracts per month, for a total of 400 futures contracts (10,000 metric tons).

June Aluminum futures are offered at $3,517.  The automobile manufacturer could either lift the on-screen offer of $3,517 for 40 lots or reach out to a broker and negotiate a price, and then clear the trade via CME ClearPort as a block trade.  Additionally, the automobile manufacturer would buy 40 lots each for every month through March.

Results

In June, the automobile manufacturer buys 1,000 metric tons of Aluminum from the producer at $3,600 per metric ton, and simultaneously sells 40 June COMEX Aluminum futures contracts at $3,717.  The increase in cost of the underlying is offset by the increase in the price of the futures, as the price of the underlying commodity drives the price of the derivative.  The $200 per metric ton profit on the derivative should compensate for the increase in the price of the underlying commodity.

As the automobile manufacturer continues to purchase Aluminum from the producer, it reduces the amount needed to hedge, and can sell the equivalent amount of COMEX Aluminum futures contracts until all the needed material is purchased, and the entire hedge is liquidated.

If the price increases, the automobile manufacturer has covered their risk with the purchase of COMEX Aluminum futures contracts, which they can sell at a profit to compensate for the increase in the underlying price.

If the price decreases, the automobile manufacturer can buy the metal from the producer at a lower price, which should compensate for the loss on the futures contract.

Regardless of the price direction, the risk of adverse price movements is covered with a hedge using COMEX Aluminum futures contracts. The automobile manufacturer has not incurred additional costs due to rising prices nor have they incurred unnecessary storage costs.

Profit margin is protected

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 can net the same result.

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