Businesses that need to buy significant quantities of lean hogs can hedge against rising lean hogs price by taking up a position in the lean hogs futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of lean hogs that they will require sometime in the future.
To implement the long hedge, enough lean hogs futures are to be purchased to cover the quantity of lean hogs required by the business operator.
A meat distributor will need to procure 4.00 million pounds of lean hogs in 3 months' time. The prevailing spot price for lean hogs is USD 0.6015/lb while the price of lean hogs futures for delivery in 3 months' time is USD 0.6000/lb. To hedge against a rise in lean hogs price, the meat distributor decided to lock in a future purchase price of USD 0.6000/lb by taking a long position in an appropriate number of CME Lean Hogs futures contracts. With each CME Lean Hogs futures contract covering 40000 pounds of lean hogs, the meat 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 meat distributor will be able to purchase the 4.00 million pounds of lean hogs at USD 0.6000/lb for a total amount of USD 2,400,000. Let's see how this is achieved by looking at scenarios in which the price of lean hogs makes a significant move either upwards or downwards by delivery date.
With the increase in lean hogs price to USD 0.6617/lb, the meat distributor will now have to pay USD 2,646,600 for the 4.00 million pounds of lean hogs. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.6617/lb. As the long futures position was entered at a lower price of USD 0.6000/lb, it will have gained USD 0.6617 - USD 0.6000 = USD 0.0617 per pound. With 100 contracts covering a total of 4.00 million pounds of lean hogs, the total gain from the long futures position is USD 246,600.
In the end, the higher purchase price is offset by the gain in the lean hogs futures market, resulting in a net payment amount of USD 2,646,600 - USD 246,600 = USD 2,400,000. This amount is equivalent to the amount payable when buying the 4.00 million pounds of lean hogs at USD 0.6000/lb.
With the spot price having fallen to USD 0.5414/lb, the meat distributor will only need to pay USD 2,165,400 for the lean hogs. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.5414/lb. As the long futures position was entered at USD 0.6000/lb, it will have lost USD 0.6000 - USD 0.5414 = USD 0.0587 per pound. With 100 contracts covering a total of 4.00 million pounds, the total loss from the long futures position is USD 234,600
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the lean hogs futures market and the net amount payable will be USD 2,165,400 + USD 234,600 = USD 2,400,000. Once again, this amount is equivalent to buying 4.00 million pounds of lean hogs at USD 0.6000/lb.
As you can see from the above examples, the downside of the long hedge is that the lean hogs buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising lean hogs prices while still be able to benefit from a fall in lean hogs price is to buy lean hogs call options.
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