Businesses that need to buy significant quantities of rapeseed can hedge against rising rapeseed price by taking up a position in the rapeseed futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of rapeseed that they will require sometime in the future.
To implement the long hedge, enough rapeseed futures are to be purchased to cover the quantity of rapeseed required by the business operator.
A biodiesel maker will need to procure 5,000 tonnes of rapeseed in 3 months' time. The prevailing spot price for rapeseed is EUR 292.50/ton while the price of rapeseed futures for delivery in 3 months' time is EUR 290.00/ton. To hedge against a rise in rapeseed price, the biodiesel maker decided to lock in a future purchase price of EUR 290.00/ton by taking a long position in an appropriate number of Euronext Rapeseed futures contracts. With each Euronext Rapeseed futures contract covering 50 tonnes of rapeseed, the biodiesel maker 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 biodiesel maker will be able to purchase the 5,000 tonnes of rapeseed at EUR 290.00/ton for a total amount of EUR 1,450,000. Let's see how this is achieved by looking at scenarios in which the price of rapeseed makes a significant move either upwards or downwards by delivery date.
With the increase in rapeseed price to EUR 321.75/ton, the biodiesel maker will now have to pay EUR 1,608,750 for the 5,000 tonnes of rapeseed. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the rapeseed futures price will have converged with the rapeseed spot price and will be equal to EUR 321.75/ton. As the long futures position was entered at a lower price of EUR 290.00/ton, it will have gained EUR 321.75 - EUR 290.00 = EUR 31.75 per tonne. With 100 contracts covering a total of 5,000 tonnes of rapeseed, the total gain from the long futures position is EUR 158,750.
In the end, the higher purchase price is offset by the gain in the rapeseed futures market, resulting in a net payment amount of EUR 1,608,750 - EUR 158,750 = EUR 1,450,000. This amount is equivalent to the amount payable when buying the 5,000 tonnes of rapeseed at EUR 290.00/ton.
With the spot price having fallen to EUR 263.25/ton, the biodiesel maker will only need to pay EUR 1,316,250 for the rapeseed. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the rapeseed futures price will have converged with the rapeseed spot price and will be equal to EUR 263.25/ton. As the long futures position was entered at EUR 290.00/ton, it will have lost EUR 290.00 - EUR 263.25 = EUR 26.75 per tonne. With 100 contracts covering a total of 5,000 tonnes, the total loss from the long futures position is EUR 133,750
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rapeseed futures market and the net amount payable will be EUR 1,316,250 + EUR 133,750 = EUR 1,450,000. Once again, this amount is equivalent to buying 5,000 tonnes of rapeseed at EUR 290.00/ton.
As you can see from the above examples, the downside of the long hedge is that the rapeseed buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising rapeseed prices while still be able to benefit from a fall in rapeseed price is to buy rapeseed call options.
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