Cocoa producers can hedge against falling cocoa price by taking up a position in the cocoa futures market.
Cocoa producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of cocoa that is only ready for sale sometime in the future.
To implement the short hedge, cocoa producers sell (short) enough cocoa futures contracts in the futures market to cover the quantity of cocoa to be produced.
A cocoa farmer has just entered into a contract to sell 1,000 tonnes of cocoa, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of cocoa on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at GBP 1,800/ton, the cocoa farmer can enter a short position in an appropriate number of Euronext Cocoa futures contracts. With each Euronext Cocoa futures contract covering 10 tonnes of cocoa, the cocoa farmer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the cocoa farmer will be able to sell 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.
As per the sales contract, the cocoa farmer will have to sell the cocoa at only GBP 1,631/ton, resulting in a net sales proceeds of GBP 1,630,800.
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 short futures position was entered at GBP 1,800/ton, it will have gained GBP 1,800 - GBP 1,631 = GBP 169.20 per tonne. With 100 contracts covering a total of 1000 tonnes, the total gain from the short futures position is GBP 169,200
Together, the gain in the cocoa futures market and the amount realised from the sales contract will total GBP 169,200 + GBP 1,630,800 = GBP 1,800,000. This amount is equivalent to selling 1,000 tonnes of cocoa at GBP 1,800/ton.
With the increase in cocoa price to GBP 1,993/ton, the cocoa producer will be able to sell the 1,000 tonnes of cocoa for a higher net sales proceeds of GBP 1,993,200.
However, as the short futures position was entered at a lower price of GBP 1,800/ton, it will have lost 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 loss from the short futures position is GBP 193,200.
In the end, the higher sales proceeds is offset by the loss in the cocoa futures market, resulting in a net proceeds of GBP 1,993,200 - GBP 193,200 = GBP 1,800,000. Again, this is the same amount that would be received by selling 1,000 tonnes of cocoa at GBP 1,800/ton.
As can be seen from the above examples, the downside of the short hedge is that the cocoa seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling cocoa prices while still be able to benefit from a rise in cocoa price is to buy cocoa put options.
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