Palladium producers can hedge against falling palladium price by taking up a position in the palladium futures market.
Palladium producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of palladium that is only ready for sale sometime in the future.
To implement the short hedge, palladium producers sell (short) enough palladium futures contracts in the futures market to cover the quantity of palladium to be produced.
A palladium mining firm has just entered into a contract to sell 10,000 troy ounces of palladium, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of palladium on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 190.00/oz, the palladium mining firm can enter a short position in an appropriate number of NYMEX Palladium futures contracts. With each NYMEX Palladium futures contract covering 100 troy ounces of palladium, the palladium mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the palladium mining firm will be able to sell 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.
As per the sales contract, the palladium mining firm will have to sell the palladium at only USD 166.86/oz, resulting in a net sales proceeds of USD 1,668,600.
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 short futures position was entered at USD 190.00/oz, it will have gained USD 190.00 - USD 166.86 = USD 23.14 per troy ounce. With 100 contracts covering a total of 10000 troy ounces, the total gain from the short futures position is USD 231,400
Together, the gain in the palladium futures market and the amount realised from the sales contract will total USD 231,400 + USD 1,668,600 = USD 1,900,000. This amount is equivalent to selling 10,000 troy ounces of palladium at USD 190.00/oz.
With the increase in palladium price to USD 203.94/oz, the palladium producer will be able to sell the 10,000 troy ounces of palladium for a higher net sales proceeds of USD 2,039,400.
However, as the short futures position was entered at a lower price of USD 190.00/oz, it will have lost 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 loss from the short futures position is USD 139,400.
In the end, the higher sales proceeds is offset by the loss in the palladium futures market, resulting in a net proceeds of USD 2,039,400 - USD 139,400 = USD 1,900,000. Again, this is the same amount that would be received by selling 10,000 troy ounces of palladium at USD 190.00/oz.
As can be seen from the above examples, the downside of the short hedge is that the palladium seller would have been better off without the hedge if the price of the commodity went up.
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