Businesses that need to buy significant quantities of coffee can hedge against rising coffee price by taking up a position in the coffee futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of coffee that they will require sometime in the future.
To implement the long hedge, enough coffee futures are to be purchased to cover the quantity of coffee required by the business operator.
A coffeehouse chain will need to procure 1,000 tonnes of coffee in 3 months' time. The prevailing spot price for coffee is USD 1,648/ton while the price of coffee futures for delivery in 3 months' time is USD 1,600/ton. To hedge against a rise in coffee price, the coffeehouse chain decided to lock in a future purchase price of USD 1,600/ton by taking a long position in an appropriate number of Euronext Robusta Coffee (No. 409) futures contracts. With each Euronext Robusta Coffee (No. 409) futures contract covering 10 tonnes of coffee, the coffeehouse chain 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 coffeehouse chain will be able to purchase the 1,000 tonnes of coffee at USD 1,600/ton for a total amount of USD 1,600,000. Let's see how this is achieved by looking at scenarios in which the price of coffee makes a significant move either upwards or downwards by delivery date.
With the increase in coffee price to USD 1,813/ton, the coffeehouse chain will now have to pay USD 1,812,800 for the 1,000 tonnes of coffee. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,813/ton. As the long futures position was entered at a lower price of USD 1,600/ton, it will have gained USD 1,813 - USD 1,600 = USD 212.80 per tonne. With 100 contracts covering a total of 1,000 tonnes of coffee, the total gain from the long futures position is USD 212,800.
In the end, the higher purchase price is offset by the gain in the coffee futures market, resulting in a net payment amount of USD 1,812,800 - USD 212,800 = USD 1,600,000. This amount is equivalent to the amount payable when buying the 1,000 tonnes of coffee at USD 1,600/ton.
With the spot price having fallen to USD 1,483/ton, the coffeehouse chain will only need to pay USD 1,483,200 for the coffee. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,483/ton. As the long futures position was entered at USD 1,600/ton, it will have lost USD 1,600 - USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1,000 tonnes, the total loss from the long futures position is USD 116,800
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coffee futures market and the net amount payable will be USD 1,483,200 + USD 116,800 = USD 1,600,000. Once again, this amount is equivalent to buying 1,000 tonnes of coffee at USD 1,600/ton.
As you can see from the above examples, the downside of the long hedge is that the coffee buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising coffee prices while still be able to benefit from a fall in coffee price is to buy coffee call options.
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