Businesses that need to buy significant quantities of cotton can hedge against rising cotton price by taking up a position in the cotton futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of cotton that they will require sometime in the future.
To implement the long hedge, enough cotton futures are to be purchased to cover the quantity of cotton required by the business operator.
A textile mill will need to procure 5.00 million pounds of cotton in 3 months' time. The prevailing spot price for cotton is USD 0.4600/lb while the price of cotton futures for delivery in 3 months' time is USD 0.4600/lb. To hedge against a rise in cotton price, the textile mill decided to lock in a future purchase price of USD 0.4600/lb by taking a long position in an appropriate number of NYMEX Cotton futures contracts. With each NYMEX Cotton futures contract covering 50000 pounds of cotton, the textile mill 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 textile mill will be able to purchase the 5.00 million pounds of cotton at USD 0.4600/lb for a total amount of USD 2,300,000. Let's see how this is achieved by looking at scenarios in which the price of cotton makes a significant move either upwards or downwards by delivery date.
With the increase in cotton price to USD 0.5060/lb, the textile mill will now have to pay USD 2,530,000 for the 5.00 million pounds of cotton. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the cotton futures price will have converged with the cotton spot price and will be equal to USD 0.5060/lb. As the long futures position was entered at a lower price of USD 0.4600/lb, it will have gained USD 0.5060 - USD 0.4600 = USD 0.0460 per pound. With 100 contracts covering a total of 5.00 million pounds of cotton, the total gain from the long futures position is USD 230,000.
In the end, the higher purchase price is offset by the gain in the cotton futures market, resulting in a net payment amount of USD 2,530,000 - USD 230,000 = USD 2,300,000. This amount is equivalent to the amount payable when buying the 5.00 million pounds of cotton at USD 0.4600/lb.
With the spot price having fallen to USD 0.4140/lb, the textile mill will only need to pay USD 2,070,000 for the cotton. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the cotton futures price will have converged with the cotton spot price and will be equal to USD 0.4140/lb. As the long futures position was entered at USD 0.4600/lb, it will have lost USD 0.4600 - USD 0.4140 = USD 0.0460 per pound. With 100 contracts covering a total of 5.00 million pounds, the total loss from the long futures position is USD 230,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the cotton futures market and the net amount payable will be USD 2,070,000 + USD 230,000 = USD 2,300,000. Once again, this amount is equivalent to buying 5.00 million pounds of cotton at USD 0.4600/lb.
As you can see from the above examples, the downside of the long hedge is that the cotton buyer would have been better off without the hedge if the price of the commodity fell.
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