Businesses that need to buy significant quantities of feeder cattle can hedge against rising feeder cattle price by taking up a position in the feeder cattle futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of feeder cattle that they will require sometime in the future.
To implement the long hedge, enough feeder cattle futures are to be purchased to cover the quantity of feeder cattle required by the business operator.
A feedlot operator will need to procure 5.00 million pounds of feeder cattle in 3 months' time. The prevailing spot price for feeder cattle is USD 0.9520/lb while the price of feeder cattle futures for delivery in 3 months' time is USD 0.9500/lb. To hedge against a rise in feeder cattle price, the feedlot operator decided to lock in a future purchase price of USD 0.9500/lb by taking a long position in an appropriate number of CME Feeder Cattle futures contracts. With each CME Feeder Cattle futures contract covering 50000 pounds of feeder cattle, the feedlot operator 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 feedlot operator will be able to purchase the 5.00 million pounds of feeder cattle at USD 0.9500/lb for a total amount of USD 4,750,000. Let's see how this is achieved by looking at scenarios in which the price of feeder cattle makes a significant move either upwards or downwards by delivery date.
With the increase in feeder cattle price to USD 1.0472/lb, the feedlot operator will now have to pay USD 5,236,000 for the 5.00 million pounds of feeder cattle. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the feeder cattle futures price will have converged with the feeder cattle spot price and will be equal to USD 1.0472/lb. As the long futures position was entered at a lower price of USD 0.9500/lb, it will have gained USD 1.0472 - USD 0.9500 = USD 0.0972 per pound. With 100 contracts covering a total of 5.00 million pounds of feeder cattle, the total gain from the long futures position is USD 486,000.
In the end, the higher purchase price is offset by the gain in the feeder cattle futures market, resulting in a net payment amount of USD 5,236,000 - USD 486,000 = USD 4,750,000. This amount is equivalent to the amount payable when buying the 5.00 million pounds of feeder cattle at USD 0.9500/lb.
With the spot price having fallen to USD 0.8568/lb, the feedlot operator will only need to pay USD 4,284,000 for the feeder cattle. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the feeder cattle futures price will have converged with the feeder cattle spot price and will be equal to USD 0.8568/lb. As the long futures position was entered at USD 0.9500/lb, it will have lost USD 0.9500 - USD 0.8568 = USD 0.0932 per pound. With 100 contracts covering a total of 5.00 million pounds, the total loss from the long futures position is USD 466,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the feeder cattle futures market and the net amount payable will be USD 4,284,000 + USD 466,000 = USD 4,750,000. Once again, this amount is equivalent to buying 5.00 million pounds of feeder cattle at USD 0.9500/lb.
As you can see from the above examples, the downside of the long hedge is that the feeder cattle buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising feeder cattle prices while still be able to benefit from a fall in feeder cattle price is to buy feeder cattle call options.
To buy or sell futures, you need a broker that can handle futures trades.
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