Businesses that need to buy significant quantities of cocoa can hedge against rising cocoa price by taking up a position in the cocoa futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of cocoa that they will require sometime in the future.
To implement the long hedge, enough cocoa futures are to be purchased to cover the quantity of cocoa required by the business operator.
A chocolate maker will need to procure 1,000 tonnes of cocoa in 3 months' time. The prevailing spot price for cocoa is GBP 1,812/ton while the price of cocoa futures for delivery in 3 months' time is GBP 1,800/ton. To hedge against a rise in cocoa price, the chocolate maker decided to lock in a future purchase price of GBP 1,800/ton by taking a long position in an appropriate number of Euronext Cocoa futures contracts. With each Euronext Cocoa futures contract covering 10 tonnes of cocoa, the chocolate maker 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 chocolate maker will be able to purchase the 1,000 tonnes of cocoa at GBP 1,800/ton for a total amount of GBP 1,800,000. Let's see how this is achieved by looking at scenarios in which the price of cocoa makes a significant move either upwards or downwards by delivery date.
With the increase in cocoa price to GBP 1,993/ton, the chocolate maker will now have to pay GBP 1,993,200 for the 1,000 tonnes of cocoa. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the cocoa futures price will have converged with the cocoa spot price and will be equal to GBP 1,993/ton. As the long futures position was entered at a lower price of GBP 1,800/ton, it will have gained GBP 1,993 - GBP 1,800 = GBP 193.20 per tonne. With 100 contracts covering a total of 1,000 tonnes of cocoa, the total gain from the long futures position is GBP 193,200.
In the end, the higher purchase price is offset by the gain in the cocoa futures market, resulting in a net payment amount of GBP 1,993,200 - GBP 193,200 = GBP 1,800,000. This amount is equivalent to the amount payable when buying the 1,000 tonnes of cocoa at GBP 1,800/ton.
With the spot price having fallen to GBP 1,631/ton, the chocolate maker will only need to pay GBP 1,630,800 for the cocoa. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the cocoa futures price will have converged with the cocoa spot price and will be equal to GBP 1,631/ton. As the long futures position was entered at GBP 1,800/ton, it will have lost GBP 1,800 - GBP 1,631 = GBP 169.20 per tonne. With 100 contracts covering a total of 1,000 tonnes, the total loss from the long futures position is GBP 169,200
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the cocoa futures market and the net amount payable will be GBP 1,630,800 + GBP 169,200 = GBP 1,800,000. Once again, this amount is equivalent to buying 1,000 tonnes of cocoa at GBP 1,800/ton.
As you can see from the above examples, the downside of the long hedge is that the cocoa buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising cocoa prices while still be able to benefit from a fall in cocoa price is to buy cocoa call options.
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