Businesses that need to buy significant quantities of kerosene can hedge against rising kerosene price by taking up a position in the kerosene futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of kerosene that they will require sometime in the future.
To implement the long hedge, enough kerosene futures are to be purchased to cover the quantity of kerosene required by the business operator.
A kerosene distributor will need to procure 5,000 kiloliters of kerosene in 3 months' time. The prevailing spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months' time is JPY 46,000/kl. To hedge against a rise in kerosene price, the kerosene distributor decided to lock in a future purchase price of JPY 46,000/kl by taking a long position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, the kerosene 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 kerosene distributor will be able to purchase the 5,000 kiloliters of kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let's see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.
With the increase in kerosene price to JPY 50,281/kl, the kerosene distributor will now have to pay JPY 251,405,000 for the 5,000 kiloliters of kerosene. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 50,281/kl. As the long futures position was entered at a lower price of JPY 46,000/kl, it will have gained JPY 50,281 - JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total gain from the long futures position is JPY 21,405,000.
In the end, the higher purchase price is offset by the gain in the kerosene futures market, resulting in a net payment amount of JPY 251,405,000 - JPY 21,405,000 = JPY 230,000,000. This amount is equivalent to the amount payable when buying the 5,000 kiloliters of kerosene at JPY 46,000/kl.
With the spot price having fallen to JPY 41,139/kl, the kerosene distributor will only need to pay JPY 205,695,000 for the kerosene. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the long futures position was entered at JPY 46,000/kl, it will have lost JPY 46,000 - JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters, the total loss from the long futures position is JPY 24,305,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the kerosene futures market and the net amount payable will be JPY 205,695,000 + JPY 24,305,000 = JPY 230,000,000. Once again, this amount is equivalent to buying 5,000 kiloliters of kerosene at JPY 46,000/kl.
As you can see from the above examples, the downside of the long hedge is that the kerosene buyer would have been better off without the hedge if the price of the commodity fell.
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