Businesses that need to buy significant quantities of corn can hedge against rising corn price by taking up a position in the corn futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of corn that they will require sometime in the future.
To implement the long hedge, enough corn futures are to be purchased to cover the quantity of corn required by the business operator.
An ethanol producer will need to procure 5,000 tonnes of corn in 3 months' time. The prevailing spot price for corn is EUR 129.25/ton while the price of corn futures for delivery in 3 months' time is EUR 130.00/ton. To hedge against a rise in corn price, the ethanol producer decided to lock in a future purchase price of EUR 130.00/ton by taking a long position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the ethanol producer 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 ethanol producer will be able to purchase the 5,000 tonnes of corn at EUR 130.00/ton for a total amount of EUR 650,000. Let's see how this is achieved by looking at scenarios in which the price of corn makes a significant move either upwards or downwards by delivery date.
With the increase in corn price to EUR 142.18/ton, the ethanol producer will now have to pay EUR 710,875 for the 5,000 tonnes of corn. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 142.18/ton. As the long futures position was entered at a lower price of EUR 130.00/ton, it will have gained EUR 142.18 - EUR 130.00 = EUR 12.18 per tonne. With 100 contracts covering a total of 5,000 tonnes of corn, the total gain from the long futures position is EUR 60,875.
In the end, the higher purchase price is offset by the gain in the corn futures market, resulting in a net payment amount of EUR 710,875 - EUR 60,875 = EUR 650,000. This amount is equivalent to the amount payable when buying the 5,000 tonnes of corn at EUR 130.00/ton.
With the spot price having fallen to EUR 116.33/ton, the ethanol producer will only need to pay EUR 581,625 for the corn. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 116.33/ton. As the long futures position was entered at EUR 130.00/ton, it will have lost EUR 130.00 - EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5,000 tonnes, the total loss from the long futures position is EUR 68,375
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the corn futures market and the net amount payable will be EUR 581,625 + EUR 68,375 = EUR 650,000. Once again, this amount is equivalent to buying 5,000 tonnes of corn at EUR 130.00/ton.
As you can see from the above examples, the downside of the long hedge is that the corn buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising corn prices while still be able to benefit from a fall in corn price is to buy corn 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!
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