Businesses that need to buy significant quantities of gasoline can hedge against rising gasoline price by taking up a position in the gasoline futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of gasoline that they will require sometime in the future.
To implement the long hedge, enough gasoline futures are to be purchased to cover the quantity of gasoline required by the business operator.
A motor fuel distributor will need to procure 5,000 kiloliters of gasoline in 3 months' time. The prevailing spot price for gasoline is JPY 31,820/kl while the price of gasoline futures for delivery in 3 months' time is JPY 32,000/kl. To hedge against a rise in gasoline price, the motor fuel distributor decided to lock in a future purchase price of JPY 32,000/kl by taking a long position in an appropriate number of TOCOM Gasoline futures contracts. With each TOCOM Gasoline futures contract covering 50 kiloliters of gasoline, 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 5,000 kiloliters of gasoline at JPY 32,000/kl for a total amount of JPY 160,000,000. Let's see how this is achieved by looking at scenarios in which the price of gasoline makes a significant move either upwards or downwards by delivery date.
With the increase in gasoline price to JPY 35,002/kl, the motor fuel distributor will now have to pay JPY 175,010,000 for the 5,000 kiloliters of gasoline. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the gasoline futures price will have converged with the gasoline spot price and will be equal to JPY 35,002/kl. As the long futures position was entered at a lower price of JPY 32,000/kl, it will have gained JPY 35,002 - JPY 32,000 = JPY 3,002 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of gasoline, the total gain from the long futures position is JPY 15,010,000.
In the end, the higher purchase price is offset by the gain in the gasoline futures market, resulting in a net payment amount of JPY 175,010,000 - JPY 15,010,000 = JPY 160,000,000. This amount is equivalent to the amount payable when buying the 5,000 kiloliters of gasoline at JPY 32,000/kl.
With the spot price having fallen to JPY 28,638/kl, the motor fuel distributor will only need to pay JPY 143,190,000 for the gasoline. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the gasoline futures price will have converged with the gasoline spot price and will be equal to JPY 28,638/kl. As the long futures position was entered at JPY 32,000/kl, it will have lost JPY 32,000 - JPY 28,638 = JPY 3,362 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters, the total loss from the long futures position is JPY 16,810,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the gasoline futures market and the net amount payable will be JPY 143,190,000 + JPY 16,810,000 = JPY 160,000,000. Once again, this amount is equivalent to buying 5,000 kiloliters of gasoline at JPY 32,000/kl.
As you can see from the above examples, the downside of the long hedge is that the gasoline buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising gasoline prices while still be able to benefit from a fall in gasoline price is to buy gasoline call options.
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