Rapeseed producers can hedge against falling rapeseed price by taking up a position in the rapeseed futures market.
Rapeseed producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of rapeseed that is only ready for sale sometime in the future.
To implement the short hedge, rapeseed producers sell (short) enough rapeseed futures contracts in the futures market to cover the quantity of rapeseed to be produced.
A rapeseed farmer has just entered into a contract to sell 5,000 tonnes of rapeseed, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of rapeseed on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at EUR 290.00/ton, the rapeseed farmer can enter a short position in an appropriate number of Euronext Rapeseed futures contracts. With each Euronext Rapeseed futures contract covering 50 tonnes of rapeseed, the rapeseed farmer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the rapeseed farmer will be able to sell 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.
As per the sales contract, the rapeseed farmer will have to sell the rapeseed at only EUR 263.25/ton, resulting in a net sales proceeds of EUR 1,316,250.
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 short futures position was entered at EUR 290.00/ton, it will have gained EUR 290.00 - EUR 263.25 = EUR 26.75 per tonne. With 100 contracts covering a total of 5000 tonnes, the total gain from the short futures position is EUR 133,750
Together, the gain in the rapeseed futures market and the amount realised from the sales contract will total EUR 133,750 + EUR 1,316,250 = EUR 1,450,000. This amount is equivalent to selling 5,000 tonnes of rapeseed at EUR 290.00/ton.
With the increase in rapeseed price to EUR 321.75/ton, the rapeseed producer will be able to sell the 5,000 tonnes of rapeseed for a higher net sales proceeds of EUR 1,608,750.
However, as the short futures position was entered at a lower price of EUR 290.00/ton, it will have lost 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 loss from the short futures position is EUR 158,750.
In the end, the higher sales proceeds is offset by the loss in the rapeseed futures market, resulting in a net proceeds of EUR 1,608,750 - EUR 158,750 = EUR 1,450,000. Again, this is the same amount that would be received by selling 5,000 tonnes of rapeseed at EUR 290.00/ton.
As can be seen from the above examples, the downside of the short hedge is that the rapeseed seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling rapeseed prices while still be able to benefit from a rise in rapeseed price is to buy rapeseed put options.
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