Businesses that need to buy significant quantities of rubber can hedge against rising rubber price by taking up a position in the rubber futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of rubber that they will require sometime in the future.
To implement the long hedge, enough rubber futures are to be purchased to cover the quantity of rubber required by the business operator.
A tire manufacturer will need to procure 500,000 kilograms of rubber in 3 months' time. The prevailing spot price for rubber is JPY 133.00/kg while the price of rubber futures for delivery in 3 months' time is JPY 130.00/kg. To hedge against a rise in rubber price, the tire manufacturer decided to lock in a future purchase price of JPY 130.00/kg by taking a long position in an appropriate number of TOCOM Rubber futures contracts. With each TOCOM Rubber futures contract covering 5000 kilograms of rubber, the tire manufacturer 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 tire manufacturer will be able to purchase the 500,000 kilograms of rubber at JPY 130.00/kg for a total amount of JPY 65,000,000. Let's see how this is achieved by looking at scenarios in which the price of rubber makes a significant move either upwards or downwards by delivery date.
With the increase in rubber price to JPY 146.30/kg, the tire manufacturer will now have to pay JPY 73,150,000 for the 500,000 kilograms of rubber. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 146.30/kg. As the long futures position was entered at a lower price of JPY 130.00/kg, it will have gained JPY 146.30 - JPY 130.00 = JPY 16.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms of rubber, the total gain from the long futures position is JPY 8,150,000.
In the end, the higher purchase price is offset by the gain in the rubber futures market, resulting in a net payment amount of JPY 73,150,000 - JPY 8,150,000 = JPY 65,000,000. This amount is equivalent to the amount payable when buying the 500,000 kilograms of rubber at JPY 130.00/kg.
With the spot price having fallen to JPY 119.70/kg, the tire manufacturer will only need to pay JPY 59,850,000 for the rubber. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 119.70/kg. As the long futures position was entered at JPY 130.00/kg, it will have lost JPY 130.00 - JPY 119.70 = JPY 10.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms, the total loss from the long futures position is JPY 5,150,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rubber futures market and the net amount payable will be JPY 59,850,000 + JPY 5,150,000 = JPY 65,000,000. Once again, this amount is equivalent to buying 500,000 kilograms of rubber at JPY 130.00/kg.
As you can see from the above examples, the downside of the long hedge is that the rubber buyer would have been better off without the hedge if the price of the commodity fell.
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