Corn producers can hedge against falling corn price by taking up a position in the corn futures market.
Corn producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of corn that is only ready for sale sometime in the future.
To implement the short hedge, corn producers sell (short) enough corn futures contracts in the futures market to cover the quantity of corn to be produced.
A corn grower has just entered into a contract to sell 5,000 tonnes of corn, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of corn on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at EUR 130.00/ton, the corn grower can enter a short position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the corn grower will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the corn grower will be able to sell 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.
As per the sales contract, the corn grower will have to sell the corn at only EUR 116.33/ton, resulting in a net sales proceeds of EUR 581,625.
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 short futures position was entered at EUR 130.00/ton, it will have gained EUR 130.00 - EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5000 tonnes, the total gain from the short futures position is EUR 68,375
Together, the gain in the corn futures market and the amount realised from the sales contract will total EUR 68,375 + EUR 581,625 = EUR 650,000. This amount is equivalent to selling 5,000 tonnes of corn at EUR 130.00/ton.
With the increase in corn price to EUR 142.18/ton, the corn producer will be able to sell the 5,000 tonnes of corn for a higher net sales proceeds of EUR 710,875.
However, as the short futures position was entered at a lower price of EUR 130.00/ton, it will have lost 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 loss from the short futures position is EUR 60,875.
In the end, the higher sales proceeds is offset by the loss in the corn futures market, resulting in a net proceeds of EUR 710,875 - EUR 60,875 = EUR 650,000. Again, this is the same amount that would be received by selling 5,000 tonnes of corn at EUR 130.00/ton.
As can be seen from the above examples, the downside of the short hedge is that the corn seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling corn prices while still be able to benefit from a rise in corn price is to buy corn put options.
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