Businesses that need to buy significant quantities of lead can hedge against rising lead price by taking up a position in the lead futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of lead that they will require sometime in the future.
To implement the long hedge, enough lead futures are to be purchased to cover the quantity of lead required by the business operator.
A battery manufacturer will need to procure 2,500 tonnes of lead in 3 months' time. The prevailing spot price for lead is USD 1,145/ton while the price of lead futures for delivery in 3 months' time is USD 1,100/ton. To hedge against a rise in lead price, the battery manufacturer decided to lock in a future purchase price of USD 1,100/ton by taking a long position in an appropriate number of LME Lead futures contracts. With each LME Lead futures contract covering 25 tonnes of lead, the battery manufacturer 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 battery manufacturer will be able to purchase the 2,500 tonnes of lead at USD 1,100/ton for a total amount of USD 2,750,000. Let's see how this is achieved by looking at scenarios in which the price of lead makes a significant move either upwards or downwards by delivery date.
With the increase in lead price to USD 1,260/ton, the battery manufacturer will now have to pay USD 3,148,750 for the 2,500 tonnes of lead. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the lead futures price will have converged with the lead spot price and will be equal to USD 1,260/ton. As the long futures position was entered at a lower price of USD 1,100/ton, it will have gained USD 1,260 - USD 1,100 = USD 159.50 per tonne. With 100 contracts covering a total of 2,500 tonnes of lead, the total gain from the long futures position is USD 398,750.
In the end, the higher purchase price is offset by the gain in the lead futures market, resulting in a net payment amount of USD 3,148,750 - USD 398,750 = USD 2,750,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of lead at USD 1,100/ton.
With the spot price having fallen to USD 1,031/ton, the battery manufacturer will only need to pay USD 2,576,250 for the lead. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the lead futures price will have converged with the lead spot price and will be equal to USD 1,031/ton. As the long futures position was entered at USD 1,100/ton, it will have lost USD 1,100 - USD 1,031 = USD 69.50 per tonne. With 100 contracts covering a total of 2,500 tonnes, the total loss from the long futures position is USD 173,750
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the lead futures market and the net amount payable will be USD 2,576,250 + USD 173,750 = USD 2,750,000. Once again, this amount is equivalent to buying 2,500 tonnes of lead at USD 1,100/ton.
As you can see from the above examples, the downside of the long hedge is that the lead buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising lead prices while still be able to benefit from a fall in lead price is to buy lead call options.
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