Lean Hogs producers can hedge against falling lean hogs price by taking up a position in the lean hogs futures market.
Lean Hogs producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of lean hogs that is only ready for sale sometime in the future.
To implement the short hedge, lean hogs producers sell (short) enough lean hogs futures contracts in the futures market to cover the quantity of lean hogs to be produced.
A lean hogs producer has just entered into a contract to sell 4.00 million pounds of lean hogs, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of lean hogs on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 0.6000/lb, the lean hogs producer can enter a short position in an appropriate number of CME Lean Hogs futures contracts. With each CME Lean Hogs futures contract covering 40,000 pounds of lean hogs, the lean hogs producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the lean hogs producer will be able to sell 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.
As per the sales contract, the lean hogs producer will have to sell the lean hogs at only USD 0.5414/lb, resulting in a net sales proceeds of USD 2,165,400.
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 short futures position was entered at USD 0.6000/lb, it will have gained USD 0.6000 - USD 0.5414 = USD 0.0587 per pound. With 100 contracts covering a total of 4000000 pounds, the total gain from the short futures position is USD 234,600
Together, the gain in the lean hogs futures market and the amount realised from the sales contract will total USD 234,600 + USD 2,165,400 = USD 2,400,000. This amount is equivalent to selling 4.00 million pounds of lean hogs at USD 0.6000/lb.
With the increase in lean hogs price to USD 0.6617/lb, the lean hogs producer will be able to sell the 4.00 million pounds of lean hogs for a higher net sales proceeds of USD 2,646,600.
However, as the short futures position was entered at a lower price of USD 0.6000/lb, it will have lost 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 loss from the short futures position is USD 246,600.
In the end, the higher sales proceeds is offset by the loss in the lean hogs futures market, resulting in a net proceeds of USD 2,646,600 - USD 246,600 = USD 2,400,000. Again, this is the same amount that would be received by selling 4.00 million pounds of lean hogs at USD 0.6000/lb.
As can be seen from the above examples, the downside of the short hedge is that the lean hogs seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling lean hogs prices while still be able to benefit from a rise in lean hogs price is to buy lean hogs put options.
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