Hedging Against Falling Coffee Prices using Coffee Futures
Coffee producers can hedge against falling coffee price by taking up a position in the coffee futures market.
Coffee producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of coffee that is only ready for sale sometime in the future.
To implement the short hedge, coffee producers sell (short) enough coffee futures contracts in the futures market to cover the quantity of coffee to be produced.
Coffee Futures Short Hedge Example
A coffee producer has just entered into a contract to sell 1,000 tonnes of coffee, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of coffee on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 1,600/ton, the coffee producer can enter a short 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 coffee producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the coffee producer will be able to sell 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.
Scenario #1: Coffee Spot Price Fell by 10% to USD 1,483/ton on Delivery Date
As per the sales contract, the coffee producer will have to sell the coffee at only USD 1,483/ton, resulting in a net sales proceeds of USD 1,483,200.
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 short futures position was entered at USD 1,600/ton, it will have gained USD 1,600 - USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1000 tonnes, the total gain from the short futures position is USD 116,800
Together, the gain in the coffee futures market and the amount realised from the sales contract will total USD 116,800 + USD 1,483,200 = USD 1,600,000. This amount is equivalent to selling 1,000 tonnes of coffee at USD 1,600/ton.
Scenario #2: Coffee Spot Price Rose by 10% to USD 1,813/ton on Delivery Date
With the increase in coffee price to USD 1,813/ton, the coffee producer will be able to sell the 1,000 tonnes of coffee for a higher net sales proceeds of USD 1,812,800.
However, as the short futures position was entered at a lower price of USD 1,600/ton, it will have lost 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 loss from the short futures position is USD 212,800.
In the end, the higher sales proceeds is offset by the loss in the coffee futures market, resulting in a net proceeds of USD 1,812,800 - USD 212,800 = USD 1,600,000. Again, this is the same amount that would be received by selling 1,000 tonnes of coffee at USD 1,600/ton.
Risk/Reward Tradeoff
As can be seen from the above examples, the downside of the short hedge is that the coffee seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling coffee prices while still be able to benefit from a rise in coffee price is to buy coffee put options.
Related Articles
- Coffee Futures Basics
- Buying Coffee Futures to Profit from a Rise in Coffee Prices
- Selling Coffee Futures to Profit from a Fall in Coffee Prices
- Coffee Options Basics
- Coffee Call Option Trading Basics
- Coffee Put Option Trading Basics
- Hedging Against Rising Coffee Prices with Coffee Futures
