Cotton producers can hedge against falling cotton price by taking up a position in the cotton futures market.
Cotton producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of cotton that is only ready for sale sometime in the future.
To implement the short hedge, cotton producers sell (short) enough cotton futures contracts in the futures market to cover the quantity of cotton to be produced.
A cotton grower has just entered into a contract to sell 5.00 million pounds of cotton, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of cotton on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 0.4600/lb, the cotton grower can enter a short position in an appropriate number of NYMEX Cotton futures contracts. With each NYMEX Cotton futures contract covering 50,000 pounds of cotton, the cotton grower will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the cotton grower will be able to sell 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.
As per the sales contract, the cotton grower will have to sell the cotton at only USD 0.4140/lb, resulting in a net sales proceeds of USD 2,070,000.
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 short futures position was entered at USD 0.4600/lb, it will have gained USD 0.4600 - USD 0.4140 = USD 0.0460 per pound. With 100 contracts covering a total of 5000000 pounds, the total gain from the short futures position is USD 230,000
Together, the gain in the cotton futures market and the amount realised from the sales contract will total USD 230,000 + USD 2,070,000 = USD 2,300,000. This amount is equivalent to selling 5.00 million pounds of cotton at USD 0.4600/lb.
With the increase in cotton price to USD 0.5060/lb, the cotton producer will be able to sell the 5.00 million pounds of cotton for a higher net sales proceeds of USD 2,530,000.
However, as the short futures position was entered at a lower price of USD 0.4600/lb, it will have lost 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 loss from the short futures position is USD 230,000.
In the end, the higher sales proceeds is offset by the loss in the cotton futures market, resulting in a net proceeds of USD 2,530,000 - USD 230,000 = USD 2,300,000. Again, this is the same amount that would be received by selling 5.00 million pounds of cotton at USD 0.4600/lb.
As can be seen from the above examples, the downside of the short hedge is that the cotton seller would have been better off without the hedge if the price of the commodity went up.
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