Businesses that need to buy significant quantities of pork bellies can hedge against rising pork bellies price by taking up a position in the pork bellies futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of pork bellies that they will require sometime in the future.
To implement the long hedge, enough pork bellies futures are to be purchased to cover the quantity of pork bellies required by the business operator.
A meat packer will need to procure 4.00 million pounds of pork bellies in 3 months' time. The prevailing spot price for pork bellies is USD 0.8470/lb while the price of pork bellies futures for delivery in 3 months' time is USD 0.8500/lb. To hedge against a rise in pork bellies price, the meat packer decided to lock in a future purchase price of USD 0.8500/lb by taking a long position in an appropriate number of CME Frozen Pork Bellies futures contracts. With each CME Frozen Pork Bellies futures contract covering 40000 pounds of pork bellies, 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 pork bellies at USD 0.8500/lb for a total amount of USD 3,400,000. Let's see how this is achieved by looking at scenarios in which the price of pork bellies makes a significant move either upwards or downwards by delivery date.
With the increase in pork bellies price to USD 0.9317/lb, the meat packer will now have to pay USD 3,726,800 for the 4.00 million pounds of pork bellies. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the pork bellies futures price will have converged with the pork bellies spot price and will be equal to USD 0.9317/lb. As the long futures position was entered at a lower price of USD 0.8500/lb, it will have gained USD 0.9317 - USD 0.8500 = USD 0.0817 per pound. With 100 contracts covering a total of 4.00 million pounds of pork bellies, the total gain from the long futures position is USD 326,800.
In the end, the higher purchase price is offset by the gain in the pork bellies futures market, resulting in a net payment amount of USD 3,726,800 - USD 326,800 = USD 3,400,000. This amount is equivalent to the amount payable when buying the 4.00 million pounds of pork bellies at USD 0.8500/lb.
With the spot price having fallen to USD 0.7623/lb, the meat packer will only need to pay USD 3,049,200 for the pork bellies. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the pork bellies futures price will have converged with the pork bellies spot price and will be equal to USD 0.7623/lb. As the long futures position was entered at USD 0.8500/lb, it will have lost USD 0.8500 - USD 0.7623 = USD 0.0877 per pound. With 100 contracts covering a total of 4.00 million pounds, the total loss from the long futures position is USD 350,800
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the pork bellies futures market and the net amount payable will be USD 3,049,200 + USD 350,800 = USD 3,400,000. Once again, this amount is equivalent to buying 4.00 million pounds of pork bellies at USD 0.8500/lb.
As you can see from the above examples, the downside of the long hedge is that the pork bellies buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising pork bellies prices while still be able to benefit from a fall in pork bellies price is to buy pork bellies call options.
To buy or sell futures, you need a broker that can handle futures trades.
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