Live Cattle producers can hedge against falling live cattle price by taking up a position in the live cattle futures market.
Live Cattle producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of live cattle that is only ready for sale sometime in the future.
To implement the short hedge, live cattle producers sell (short) enough live cattle futures contracts in the futures market to cover the quantity of live cattle to be produced.
A feedlot operator has just entered into a contract to sell 4.00 million pounds of live cattle, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of live cattle on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 0.8400/lb, the feedlot operator can enter a short position in an appropriate number of CME Live Cattle futures contracts. With each CME Live Cattle futures contract covering 40,000 pounds of live cattle, the feedlot operator will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the feedlot operator will be able to sell 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.
As per the sales contract, the feedlot operator will have to sell the live cattle at only USD 0.7601/lb, resulting in a net sales proceeds of USD 3,040,200.
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 short futures position was entered at USD 0.8400/lb, it will have gained USD 0.8400 - USD 0.7601 = USD 0.0800 per pound. With 100 contracts covering a total of 4000000 pounds, the total gain from the short futures position is USD 319,800
Together, the gain in the live cattle futures market and the amount realised from the sales contract will total USD 319,800 + USD 3,040,200 = USD 3,360,000. This amount is equivalent to selling 4.00 million pounds of live cattle at USD 0.8400/lb.
With the increase in live cattle price to USD 0.9290/lb, the live cattle producer will be able to sell the 4.00 million pounds of live cattle for a higher net sales proceeds of USD 3,715,800.
However, as the short futures position was entered at a lower price of USD 0.8400/lb, it will have lost 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 loss from the short futures position is USD 355,800.
In the end, the higher sales proceeds is offset by the loss in the live cattle futures market, resulting in a net proceeds of USD 3,715,800 - USD 355,800 = USD 3,360,000. Again, this is the same amount that would be received by selling 4.00 million pounds of live cattle at USD 0.8400/lb.
As can be seen from the above examples, the downside of the short hedge is that the live cattle seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling live cattle prices while still be able to benefit from a rise in live cattle price is to buy live cattle put options.
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