Aluminum producers can hedge against falling aluminum price by taking up a position in the aluminum futures market.
Aluminum producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of aluminum that is only ready for sale sometime in the future.
To implement the short hedge, aluminum producers sell (short) enough aluminum futures contracts in the futures market to cover the quantity of aluminum to be produced.
An aluminum mining firm has just entered into a contract to sell 2,500 tonnes of aluminum, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of aluminum on the day of delivery. At the time of signing the agreement, spot price for aluminum is USD 1,470/ton while the price of aluminum futures for delivery in 3 months' time is USD 1,500/ton.
To lock in the selling price at USD 1,500/ton, the aluminum mining firm can enter a short position in an appropriate number of LME Aluminum futures contracts. With each LME Aluminum futures contract covering 25 tonnes of aluminum, the aluminum mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the aluminum mining firm will be able to sell the 2,500 tonnes of aluminum at USD 1,500/ton for a total amount of USD 3,750,000. Let's see how this is achieved by looking at scenarios in which the price of aluminum makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the aluminum mining firm will have to sell the aluminum at only USD 1,323/ton, resulting in a net sales proceeds of USD 3,307,500.
By delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,323/ton. As the short futures position was entered at USD 1,500/ton, it will have gained USD 1,500 - USD 1,323 = USD 177.00 per tonne. With 100 contracts covering a total of 2500 tonnes, the total gain from the short futures position is USD 442,500
Together, the gain in the aluminum futures market and the amount realised from the sales contract will total USD 442,500 + USD 3,307,500 = USD 3,750,000. This amount is equivalent to selling 2,500 tonnes of aluminum at USD 1,500/ton.
With the increase in aluminum price to USD 1,617/ton, the aluminum producer will be able to sell the 2,500 tonnes of aluminum for a higher net sales proceeds of USD 4,042,500.
However, as the short futures position was entered at a lower price of USD 1,500/ton, it will have lost USD 1,617 - USD 1,500 = USD 117.00 per tonne. With 100 contracts covering a total of 2,500 tonnes of aluminum, the total loss from the short futures position is USD 292,500.
In the end, the higher sales proceeds is offset by the loss in the aluminum futures market, resulting in a net proceeds of USD 4,042,500 - USD 292,500 = USD 3,750,000. Again, this is the same amount that would be received by selling 2,500 tonnes of aluminum at USD 1,500/ton.
As can be seen from the above examples, the downside of the short hedge is that the aluminum seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling aluminum prices while still be able to benefit from a rise in aluminum price is to buy aluminum put options.
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