Rice producers can hedge against falling rice price by taking up a position in the rice futures market.
Rice producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of rice that is only ready for sale sometime in the future.
To implement the short hedge, rice producers sell (short) enough rice futures contracts in the futures market to cover the quantity of rice to be produced.
A rice grower has just entered into a contract to sell 200,000 hundredweights of rice, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of rice on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 14.00/cwt, the rice grower can enter a short position in an appropriate number of CBOT Rough Rice futures contracts. With each CBOT Rough Rice futures contract covering 2,000 hundredweights of rice, the rice grower will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the rice grower will be able to sell 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.
As per the sales contract, the rice grower will have to sell the rice at only USD 12.34/cwt, resulting in a net sales proceeds of USD 2,467,800.
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 short futures position was entered at USD 14.00/cwt, it will have gained USD 14.00 - USD 12.34 = USD 1.6610 per hundredweight. With 100 contracts covering a total of 200000 hundredweights, the total gain from the short futures position is USD 332,200
Together, the gain in the rice futures market and the amount realised from the sales contract will total USD 332,200 + USD 2,467,800 = USD 2,800,000. This amount is equivalent to selling 200,000 hundredweights of rice at USD 14.00/cwt.
With the increase in rice price to USD 15.08/cwt, the rice producer will be able to sell the 200,000 hundredweights of rice for a higher net sales proceeds of USD 3,016,200.
However, as the short futures position was entered at a lower price of USD 14.00/cwt, it will have lost 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 loss from the short futures position is USD 216,200.
In the end, the higher sales proceeds is offset by the loss in the rice futures market, resulting in a net proceeds of USD 3,016,200 - USD 216,200 = USD 2,800,000. Again, this is the same amount that would be received by selling 200,000 hundredweights of rice at USD 14.00/cwt.
As can be seen from the above examples, the downside of the short hedge is that the rice seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling rice prices while still be able to benefit from a rise in rice price is to buy rice put options.
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