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Hedging Against Changes In Commodity Prices

Companies selling or buying raw materials for delivery in future periods are subject to commodity price risk. The rise or decline in prices may make the production or extraction unprofitable. Access to the futures markets provide an opportunity to hedge the risks associated with the company's core operations.

Can we consider the futures price to be forecast price? On the one hand - yes, because the futures price at any given time reflects the price expectations of both buyers and sellers relative to the date of delivery in the future. Thus, the futures price helps to establish a balance between production and consumption. On the other hand - no, as the futures price is a price forecast, which is subject to continuous change. Adjustment of futures prices reflect additional information about the change in demand and supply, as soon as such information becomes available.

The word "hedge” means "protection." In terms of futures trading is the definition accurately captures the essence of the hedge as a balancing of the transaction, which sets the position in the futures market opposite to the current position in the cash market. Hedging is based on the fact that the change in prices in the cash market and the futures market is interconnected. Price movements are not necessarily identical, but, as a rule, are so similar that it is possible to reduce the risk of losses in the cash market, taking the opposite position in the futures market. Taking opposite position in one market, can compensate the loss at the expense of profits on the other. Thus, the hedger can make a transaction in the cash market at a fixed price which will actually be carried out only after a few months.

Example

Suppose now is July and you are planning to buy corn in November. On the cash market in July, the price of corn delivered in November, is € 221 per ton, but you think that by the time of the purchase price may increase. To protect yourself from possible price increases, you buy December corn futures at € 221 per tonne. What will be the result if, by November, corn prices will rise by EUR 20 per tonne?

  Cash Market Futures market
July, 2013 Corn is trading at € 221 per tone on the cash market. Purchase of corn futures at € 221per tonne with execution in December
November, 2013 Buy corn at € 241 per tone in cash market Sale of corn futures at € 241 per tonne with execution in December
Result Loss of € 20 per tonne Profit of € 20 per  tonne
Purchase of corn in the cash market € 241/ t
Profit from the futures position – €20/ t
Net purchase price € 221/ t

In this example, the higher cost of corn in the cash market is offset by gains in the futures market.

Conversely, if by November, corn price falls by EUR 20 per tonne, the lower the cost of corn in the cash market would be offset by losses in the futures market. Net purchase price would be equal to 221 euros per tonne.

  Cash Market Futures Market
July, 2013 Corn is trading at € 221 per tone on the cash market. Purchase of corn futures at € 221per tonne with execution in December
November, 2013 Buy corn at € 201 per tone in cash market Sale of corn futures at € 201 per tonne with execution in December
Result Profit of € 20 per tonne Loss of € 20 per  tonne
Purchase of corn in the cash market € 201/ t
Loss from the futures position + €20/ t
Net purchase price € 221/ t

*In all examples and calculations, data is for guidance only and may be different from the actual market data.

Similarly, you can use futures for other agricultural products, metals, precious metals, oil products etc. List of all available futures contracts, and their trading commission.