Businesses that need to buy significant quantities of rice can hedge against rising rice price by taking up a position in the rice futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of rice that they will require sometime in the future.
To implement the long hedge, enough rice futures are to be purchased to cover the quantity of rice required by the business operator.
A rice exporter will need to procure 200,000 hundredweights of rice in 3 months' time. The prevailing spot price for rice is USD 13.71/cwt while the price of rice futures for delivery in 3 months' time is USD 14.00/cwt. To hedge against a rise in rice price, the rice exporter decided to lock in a future purchase price of USD 14.00/cwt by taking a long position in an appropriate number of CBOT Rough Rice futures contracts. With each CBOT Rough Rice futures contract covering 2000 hundredweights of rice, the rice exporter 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 rice exporter will be able to purchase the 200,000 hundredweights of rice at USD 14.00/cwt for a total amount of USD 2,800,000. Let's see how this is achieved by looking at scenarios in which the price of rice makes a significant move either upwards or downwards by delivery date.
With the increase in rice price to USD 15.08/cwt, the rice exporter will now have to pay USD 3,016,200 for the 200,000 hundredweights of rice. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the rice futures price will have converged with the rice spot price and will be equal to USD 15.08/cwt. As the long futures position was entered at a lower price of USD 14.00/cwt, it will have gained USD 15.08 - USD 14.00 = USD 1.0810 per hundredweight. With 100 contracts covering a total of 200,000 hundredweights of rice, the total gain from the long futures position is USD 216,200.
In the end, the higher purchase price is offset by the gain in the rice futures market, resulting in a net payment amount of USD 3,016,200 - USD 216,200 = USD 2,800,000. This amount is equivalent to the amount payable when buying the 200,000 hundredweights of rice at USD 14.00/cwt.
With the spot price having fallen to USD 12.34/cwt, the rice exporter will only need to pay USD 2,467,800 for the rice. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the rice futures price will have converged with the rice spot price and will be equal to USD 12.34/cwt. As the long futures position was entered at USD 14.00/cwt, it will have lost USD 14.00 - USD 12.34 = USD 1.6610 per hundredweight. With 100 contracts covering a total of 200,000 hundredweights, the total loss from the long futures position is USD 332,200
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rice futures market and the net amount payable will be USD 2,467,800 + USD 332,200 = USD 2,800,000. Once again, this amount is equivalent to buying 200,000 hundredweights of rice at USD 14.00/cwt.
As you can see from the above examples, the downside of the long hedge is that the rice buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising rice prices while still be able to benefit from a fall in rice price is to buy rice call options.
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