You are a trader with a contract to import corn or soymeal, or a crush operator who has bought soybeans for crushing. The crops will be delivered on, and paid for at prevailing prices, at a future date. In futures terminology, you have a natural ‘short’ position in the physical market. Commodities buyers are vulnerable to unexpected price increases. Your hedging strategy therefore involves buying the respective futures contracts.
The agriculture market is especially volatile recently, given China’s implementation of tariffs against U.S. soybean imports. You are exposed to the price fluctuations in soybean and soymeal due to uncertainties in the global soybean trade pattern.
The principles of hedging with futures are quite straightforward. The idea is that when a trader buys a futures contract (the futures terminology is to ‘open a long position’), he must offset it later by ‘closing the long position’. The second futures transaction takes place when the trader takes delivery of the crop, i.e. the cash market transaction occurs. The futures contract is closed out as the price protection is no longer needed after the physical delivery is made.
For example, let us assume that it is now March, and you have a contract to take a shipment of corn in the month of June1. Corn harvests this season are expected to be abundant, but unexpected geopolitical events might cause corn prices to spike higher when the corn is shipped in June. You can lock in the price for your corn now to protect your profit margin against a potential rise in corn prices.
Let us say that it is now March 1, 2018. The price for the CBOT July corn future contract is $3.93 per bushel at this time. You are comfortable with this price level as an importer, and you buy the CBOT July corn futures now, to lock in the $3.93 price you will eventually pay for your physical corn. In futures terminology, you have taken a ‘long hedge’ position.
It is now June 14, and the tariff war did not have an adverse effect on the corn market. Both the cash price and July futures price of corn fell to $3.63, at the time you made payment to the seller. You therefore accepted the shipment of your corn at $3.63. You originally expected to pay $3.93, so you have made a gain of $0.30 from the physical transaction.
You now concurrently close out your long corn futures position by selling the July futures contract at the prevailing price of $3.63. As you had opened your long futures position at $3.93, you made a $0.30 loss ($3.63 – $3.93) in the futures market. This loss in the futures transaction offsets the gain in the cash market, and the net result is that you have achieved his original target of buying corn at $3.93.
Of course, had the importer not engaged in a hedging strategy, he might have received an additional $0.30 per bushel profit on the purchase. However, he would also have been exposed to the risk of making a loss on his purchases had corn prices spiked up during that same period.
This is the essence of hedging. The key objective is to make an importer’s profit margin more consistent by locking in his purchase price, and he is prepared to forego the potential gain from unexpected favorable price movements in order to reduce his overall price risk.
|Date: Mar 1, 2018||Jul-18 Futures price = $3.93|
|Bought Jul-18 futures at $3.93|
|Date: June 14, 2018||Scenario 1 Corn cash prices fell to $3.63||Scenario 2 Corn cash prices rose to $4.10|
|Physical position||Took physical shipment at $3.63 Made $0.30 gain in cash market||Took physical shipment at $4.10 Made $0.17 loss in the cash market|
|Futures position||Sold Jul-18 futures at $3.30 Made $0.30 loss in futures market||Sold Jul-18 futures at $4.10 Made $0.17 gain in futures market|
|Net result||Paid $3.93 for the corn||Paid $3.93 for the corn|
Read more on how buyers and sellers of grains and oilseeds utilize futures and options to hedge their position to manage price risk. The course will enhance the hedger’s understanding of the different strategies available as well as how the basis affects prices.