Oats producers can hedge against falling oats price by taking up a position in the oats futures market.
Oats producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of oats that is only ready for sale sometime in the future.
To implement the short hedge, oats producers sell (short) enough oats futures contracts in the futures market to cover the quantity of oats to be produced.
An oats farmer has just entered into a contract to sell 500,000 bushels of oats, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of oats on the day of delivery. At the time of signing the agreement, spot price for oats is USD 2.0900/bu while the price of oats futures for delivery in 3 months' time is USD 2.1000/bu.
To lock in the selling price at USD 2.1000/bu, the oats farmer can enter a short position in an appropriate number of CBOT Oats futures contracts. With each CBOT Oats futures contract covering 5,000 bushels of oats, the oats farmer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the oats farmer will be able to sell the 500,000 bushels of oats at USD 2.1000/bu for a total amount of USD 1,050,000. Let's see how this is achieved by looking at scenarios in which the price of oats makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the oats farmer will have to sell the oats at only USD 1.8810/bu, resulting in a net sales proceeds of USD 940,500.
By delivery date, the oats futures price will have converged with the oats spot price and will be equal to USD 1.8810/bu. As the short futures position was entered at USD 2.1000/bu, it will have gained USD 2.1000 - USD 1.8810 = USD 0.2190 per bushel. With 100 contracts covering a total of 500000 bushels, the total gain from the short futures position is USD 109,500
Together, the gain in the oats futures market and the amount realised from the sales contract will total USD 109,500 + USD 940,500 = USD 1,050,000. This amount is equivalent to selling 500,000 bushels of oats at USD 2.1000/bu.
With the increase in oats price to USD 2.2990/bu, the oats producer will be able to sell the 500,000 bushels of oats for a higher net sales proceeds of USD 1,149,500.
However, as the short futures position was entered at a lower price of USD 2.1000/bu, it will have lost USD 2.2990 - USD 2.1000 = USD 0.1990 per bushel. With 100 contracts covering a total of 500,000 bushels of oats, the total loss from the short futures position is USD 99,500.
In the end, the higher sales proceeds is offset by the loss in the oats futures market, resulting in a net proceeds of USD 1,149,500 - USD 99,500 = USD 1,050,000. Again, this is the same amount that would be received by selling 500,000 bushels of oats at USD 2.1000/bu.
As can be seen from the above examples, the downside of the short hedge is that the oats seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling oats prices while still be able to benefit from a rise in oats price is to buy oats put options.
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