Businesses that need to buy significant quantities of copper can hedge against rising copper price by taking up a position in the copper futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of copper that they will require sometime in the future.
To implement the long hedge, enough copper futures are to be purchased to cover the quantity of copper required by the business operator.
A copper fabricator will need to procure 2,500 tonnes of copper in 3 months' time. The prevailing spot price for copper is USD 3,171/ton while the price of copper futures for delivery in 3 months' time is USD 3,200/ton. To hedge against a rise in copper price, the copper fabricator decided to lock in a future purchase price of USD 3,200/ton by taking a long position in an appropriate number of LME Copper 'A' Grade futures contracts. With each LME Copper 'A' Grade futures contract covering 25 tonnes of copper, the copper fabricator 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 copper fabricator will be able to purchase the 2,500 tonnes of copper at USD 3,200/ton for a total amount of USD 8,000,000. Let's see how this is achieved by looking at scenarios in which the price of copper makes a significant move either upwards or downwards by delivery date.
With the increase in copper price to USD 3,488/ton, the copper fabricator will now have to pay USD 8,720,250 for the 2,500 tonnes of copper. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the copper futures price will have converged with the copper spot price and will be equal to USD 3,488/ton. As the long futures position was entered at a lower price of USD 3,200/ton, it will have gained USD 3,488 - USD 3,200 = USD 288.10 per tonne. With 100 contracts covering a total of 2,500 tonnes of copper, the total gain from the long futures position is USD 720,250.
In the end, the higher purchase price is offset by the gain in the copper futures market, resulting in a net payment amount of USD 8,720,250 - USD 720,250 = USD 8,000,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of copper at USD 3,200/ton.
With the spot price having fallen to USD 2,854/ton, the copper fabricator will only need to pay USD 7,134,750 for the copper. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the copper futures price will have converged with the copper spot price and will be equal to USD 2,854/ton. As the long futures position was entered at USD 3,200/ton, it will have lost USD 3,200 - USD 2,854 = USD 346.10 per tonne. With 100 contracts covering a total of 2,500 tonnes, the total loss from the long futures position is USD 865,250
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the copper futures market and the net amount payable will be USD 7,134,750 + USD 865,250 = USD 8,000,000. Once again, this amount is equivalent to buying 2,500 tonnes of copper at USD 3,200/ton.
As you can see from the above examples, the downside of the long hedge is that the copper buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising copper prices while still be able to benefit from a fall in copper price is to buy copper call options.
To buy or sell futures, you need a broker that can handle futures trades.
OptionsHouse is a full fledged Futures Commission Merchant that provides a streamlined access to the futures markets at extremely reasonable contract rates.Click here to open a futures trading account at OptionsHouse.com now!