Feeder Cattle producers can hedge against falling feeder cattle price by taking up a position in the feeder cattle futures market.
Feeder Cattle producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of feeder cattle that is only ready for sale sometime in the future.
To implement the short hedge, feeder cattle producers sell (short) enough feeder cattle futures contracts in the futures market to cover the quantity of feeder cattle to be produced.
A feeder cattle producer has just entered into a contract to sell 5.00 million pounds of feeder cattle, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of feeder cattle on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 0.9500/lb, the feeder cattle producer can enter a short position in an appropriate number of CME Feeder Cattle futures contracts. With each CME Feeder Cattle futures contract covering 50,000 pounds of feeder cattle, the feeder cattle producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the feeder cattle producer will be able to sell 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.
As per the sales contract, the feeder cattle producer will have to sell the feeder cattle at only USD 0.8568/lb, resulting in a net sales proceeds of USD 4,284,000.
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 short futures position was entered at USD 0.9500/lb, it will have gained USD 0.9500 - USD 0.8568 = USD 0.0932 per pound. With 100 contracts covering a total of 5000000 pounds, the total gain from the short futures position is USD 466,000
Together, the gain in the feeder cattle futures market and the amount realised from the sales contract will total USD 466,000 + USD 4,284,000 = USD 4,750,000. This amount is equivalent to selling 5.00 million pounds of feeder cattle at USD 0.9500/lb.
With the increase in feeder cattle price to USD 1.0472/lb, the feeder cattle producer will be able to sell the 5.00 million pounds of feeder cattle for a higher net sales proceeds of USD 5,236,000.
However, as the short futures position was entered at a lower price of USD 0.9500/lb, it will have lost 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 loss from the short futures position is USD 486,000.
In the end, the higher sales proceeds is offset by the loss in the feeder cattle futures market, resulting in a net proceeds of USD 5,236,000 - USD 486,000 = USD 4,750,000. Again, this is the same amount that would be received by selling 5.00 million pounds of feeder cattle at USD 0.9500/lb.
As can be seen from the above examples, the downside of the short hedge is that the feeder cattle seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling feeder cattle prices while still be able to benefit from a rise in feeder cattle price is to buy feeder cattle put options.
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