Businesses that need to buy significant quantities of live cattle can hedge against rising live cattle price by taking up a position in the live cattle futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of live cattle that they will require sometime in the future.
To implement the long hedge, enough live cattle futures are to be purchased to cover the quantity of live cattle required by the business operator.
A meat packer will need to procure 4.00 million pounds of live cattle in 3 months' time. The prevailing spot price for live cattle is USD 0.8445/lb while the price of live cattle futures for delivery in 3 months' time is USD 0.8400/lb. To hedge against a rise in live cattle price, the meat packer decided to lock in a future purchase price of USD 0.8400/lb by taking a long position in an appropriate number of CME Live Cattle futures contracts. With each CME Live Cattle futures contract covering 40000 pounds of live cattle, the meat packer 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 packer will be able to purchase the 4.00 million pounds of live cattle at USD 0.8400/lb for a total amount of USD 3,360,000. Let's see how this is achieved by looking at scenarios in which the price of live cattle makes a significant move either upwards or downwards by delivery date.
With the increase in live cattle price to USD 0.9290/lb, the meat packer will now have to pay USD 3,715,800 for the 4.00 million pounds of live cattle. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the live cattle futures price will have converged with the live cattle spot price and will be equal to USD 0.9290/lb. As the long futures position was entered at a lower price of USD 0.8400/lb, it will have gained USD 0.9290 - USD 0.8400 = USD 0.0890 per pound. With 100 contracts covering a total of 4.00 million pounds of live cattle, the total gain from the long futures position is USD 355,800.
In the end, the higher purchase price is offset by the gain in the live cattle futures market, resulting in a net payment amount of USD 3,715,800 - USD 355,800 = USD 3,360,000. This amount is equivalent to the amount payable when buying the 4.00 million pounds of live cattle at USD 0.8400/lb.
With the spot price having fallen to USD 0.7601/lb, the meat packer will only need to pay USD 3,040,200 for the live cattle. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the live cattle futures price will have converged with the live cattle spot price and will be equal to USD 0.7601/lb. As the long futures position was entered at USD 0.8400/lb, it will have lost USD 0.8400 - USD 0.7601 = USD 0.0800 per pound. With 100 contracts covering a total of 4.00 million pounds, the total loss from the long futures position is USD 319,800
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the live cattle futures market and the net amount payable will be USD 3,040,200 + USD 319,800 = USD 3,360,000. Once again, this amount is equivalent to buying 4.00 million pounds of live cattle at USD 0.8400/lb.
As you can see from the above examples, the downside of the long hedge is that the live cattle buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising live cattle prices while still be able to benefit from a fall in live cattle price is to buy live cattle call options.
To buy or sell futures, you need a broker that can handle futures trades.
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