Lead producers can hedge against falling lead price by taking up a position in the lead futures market.
Lead producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of lead that is only ready for sale sometime in the future.
To implement the short hedge, lead producers sell (short) enough lead futures contracts in the futures market to cover the quantity of lead to be produced.
A lead mining firm has just entered into a contract to sell 2,500 tonnes of lead, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of lead on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 1,100/ton, the lead mining firm can enter a short position in an appropriate number of LME Lead futures contracts. With each LME Lead futures contract covering 25 tonnes of lead, the lead mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the lead mining firm will be able to sell 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.
As per the sales contract, the lead mining firm will have to sell the lead at only USD 1,031/ton, resulting in a net sales proceeds of USD 2,576,250.
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 short futures position was entered at USD 1,100/ton, it will have gained USD 1,100 - USD 1,031 = USD 69.50 per tonne. With 100 contracts covering a total of 2500 tonnes, the total gain from the short futures position is USD 173,750
Together, the gain in the lead futures market and the amount realised from the sales contract will total USD 173,750 + USD 2,576,250 = USD 2,750,000. This amount is equivalent to selling 2,500 tonnes of lead at USD 1,100/ton.
With the increase in lead price to USD 1,260/ton, the lead producer will be able to sell the 2,500 tonnes of lead for a higher net sales proceeds of USD 3,148,750.
However, as the short futures position was entered at a lower price of USD 1,100/ton, it will have lost 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 loss from the short futures position is USD 398,750.
In the end, the higher sales proceeds is offset by the loss in the lead futures market, resulting in a net proceeds of USD 3,148,750 - USD 398,750 = USD 2,750,000. Again, this is the same amount that would be received by selling 2,500 tonnes of lead at USD 1,100/ton.
As can be seen from the above examples, the downside of the short hedge is that the lead seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling lead prices while still be able to benefit from a rise in lead price is to buy lead put options.
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