Businesses that need to buy significant quantities of palladium can hedge against rising palladium price by taking up a position in the palladium futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of palladium that they will require sometime in the future.
To implement the long hedge, enough palladium futures are to be purchased to cover the quantity of palladium required by the business operator.
An automaker will need to procure 10,000 troy ounces of palladium in 3 months' time. The prevailing spot price for palladium is USD 185.40/oz while the price of palladium futures for delivery in 3 months' time is USD 190.00/oz. To hedge against a rise in palladium price, the automaker decided to lock in a future purchase price of USD 190.00/oz by taking a long position in an appropriate number of NYMEX Palladium futures contracts. With each NYMEX Palladium futures contract covering 100 troy ounces of palladium, the automaker 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 automaker will be able to purchase the 10,000 troy ounces of palladium at USD 190.00/oz for a total amount of USD 1,900,000. Let's see how this is achieved by looking at scenarios in which the price of palladium makes a significant move either upwards or downwards by delivery date.
With the increase in palladium price to USD 203.94/oz, the automaker will now have to pay USD 2,039,400 for the 10,000 troy ounces of palladium. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the palladium futures price will have converged with the palladium spot price and will be equal to USD 203.94/oz. As the long futures position was entered at a lower price of USD 190.00/oz, it will have gained USD 203.94 - USD 190.00 = USD 13.94 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces of palladium, the total gain from the long futures position is USD 139,400.
In the end, the higher purchase price is offset by the gain in the palladium futures market, resulting in a net payment amount of USD 2,039,400 - USD 139,400 = USD 1,900,000. This amount is equivalent to the amount payable when buying the 10,000 troy ounces of palladium at USD 190.00/oz.
With the spot price having fallen to USD 166.86/oz, the automaker will only need to pay USD 1,668,600 for the palladium. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the palladium futures price will have converged with the palladium spot price and will be equal to USD 166.86/oz. As the long futures position was entered at USD 190.00/oz, it will have lost USD 190.00 - USD 166.86 = USD 23.14 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces, the total loss from the long futures position is USD 231,400
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the palladium futures market and the net amount payable will be USD 1,668,600 + USD 231,400 = USD 1,900,000. Once again, this amount is equivalent to buying 10,000 troy ounces of palladium at USD 190.00/oz.
As you can see from the above examples, the downside of the long hedge is that the palladium buyer would have been better off without the hedge if the price of the commodity fell.
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