Businesses that need to buy significant quantities of coal can hedge against rising coal price by taking up a position in the coal futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of coal that they will require sometime in the future.
To implement the long hedge, enough coal futures are to be purchased to cover the quantity of coal required by the business operator.
A power company will need to procure 155,000 tons of coal in 3 months' time. The prevailing spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months' time is USD 74.00/ton. To hedge against a rise in coal price, the power company decided to lock in a future purchase price of USD 74.00/ton by taking a long position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1550 tons of coal, the power company will be required to go long 100 futures contracts to implement the hedge.
The effect of putting in place the hedge should guarantee that the power company will be able to purchase the 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let's see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.
With the increase in coal price to USD 81.90/ton, the power company will now have to pay USD 12,693,725 for the 155,000 tons of coal. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 81.90/ton. As the long futures position was entered at a lower price of USD 74.00/ton, it will have gained USD 81.90 - USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total gain from the long futures position is USD 1,223,725.
In the end, the higher purchase price is offset by the gain in the coal futures market, resulting in a net payment amount of USD 12,693,725 - USD 1,223,725 = USD 11,470,000. This amount is equivalent to the amount payable when buying the 155,000 tons of coal at USD 74.00/ton.
With the spot price having fallen to USD 67.01/ton, the power company will only need to pay USD 10,385,775 for the coal. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the long futures position was entered at USD 74.00/ton, it will have lost USD 74.00 - USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155,000 tons, the total loss from the long futures position is USD 1,084,225
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coal futures market and the net amount payable will be USD 10,385,775 + USD 1,084,225 = USD 11,470,000. Once again, this amount is equivalent to buying 155,000 tons of coal at USD 74.00/ton.
As you can see from the above examples, the downside of the long hedge is that the coal buyer would have been better off without the hedge if the price of the commodity fell.
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