Businesses that need to buy significant quantities of ethanol can hedge against rising ethanol price by taking up a position in the ethanol futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of ethanol that they will require sometime in the future.
To implement the long hedge, enough ethanol futures are to be purchased to cover the quantity of ethanol required by the business operator.
A motor fuel distributor will need to procure 2.90 million gallons of ethanol in 3 months' time. The prevailing spot price for ethanol is USD 1.5800/gal while the price of ethanol futures for delivery in 3 months' time is USD 1.6000/gal. To hedge against a rise in ethanol price, the motor fuel distributor decided to lock in a future purchase price of USD 1.6000/gal by taking a long position in an appropriate number of CBOT Ethanol futures contracts. With each CBOT Ethanol futures contract covering 29000 gallons of ethanol, the motor fuel distributor 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 motor fuel distributor will be able to purchase the 2.90 million gallons of ethanol at USD 1.6000/gal for a total amount of USD 4,640,000. Let's see how this is achieved by looking at scenarios in which the price of ethanol makes a significant move either upwards or downwards by delivery date.
With the increase in ethanol price to USD 1.7380/gal, the motor fuel distributor will now have to pay USD 5,040,200 for the 2.90 million gallons of ethanol. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.7380/gal. As the long futures position was entered at a lower price of USD 1.6000/gal, it will have gained USD 1.7380 - USD 1.6000 = USD 0.1380 per gallon. With 100 contracts covering a total of 2.90 million gallons of ethanol, the total gain from the long futures position is USD 400,200.
In the end, the higher purchase price is offset by the gain in the ethanol futures market, resulting in a net payment amount of USD 5,040,200 - USD 400,200 = USD 4,640,000. This amount is equivalent to the amount payable when buying the 2.90 million gallons of ethanol at USD 1.6000/gal.
With the spot price having fallen to USD 1.4220/gal, the motor fuel distributor will only need to pay USD 4,123,800 for the ethanol. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.4220/gal. As the long futures position was entered at USD 1.6000/gal, it will have lost USD 1.6000 - USD 1.4220 = USD 0.1780 per gallon. With 100 contracts covering a total of 2.90 million gallons, the total loss from the long futures position is USD 516,200
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the ethanol futures market and the net amount payable will be USD 4,123,800 + USD 516,200 = USD 4,640,000. Once again, this amount is equivalent to buying 2.90 million gallons of ethanol at USD 1.6000/gal.
As you can see from the above examples, the downside of the long hedge is that the ethanol buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising ethanol prices while still be able to benefit from a fall in ethanol price is to buy ethanol call options.
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