Rubber producers can hedge against falling rubber price by taking up a position in the rubber futures market.
Rubber producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of rubber that is only ready for sale sometime in the future.
To implement the short hedge, rubber producers sell (short) enough rubber futures contracts in the futures market to cover the quantity of rubber to be produced.
A rubber producer has just entered into a contract to sell 500,000 kilograms of rubber, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of rubber on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at JPY 130.00/kg, the rubber producer can enter a short position in an appropriate number of TOCOM Rubber futures contracts. With each TOCOM Rubber futures contract covering 5,000 kilograms of rubber, the rubber producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the rubber producer will be able to sell 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.
As per the sales contract, the rubber producer will have to sell the rubber at only JPY 119.70/kg, resulting in a net sales proceeds of JPY 59,850,000.
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 short futures position was entered at JPY 130.00/kg, it will have gained JPY 130.00 - JPY 119.70 = JPY 10.30 per kilogram. With 100 contracts covering a total of 500000 kilograms, the total gain from the short futures position is JPY 5,150,000
Together, the gain in the rubber futures market and the amount realised from the sales contract will total JPY 5,150,000 + JPY 59,850,000 = JPY 65,000,000. This amount is equivalent to selling 500,000 kilograms of rubber at JPY 130.00/kg.
With the increase in rubber price to JPY 146.30/kg, the rubber producer will be able to sell the 500,000 kilograms of rubber for a higher net sales proceeds of JPY 73,150,000.
However, as the short futures position was entered at a lower price of JPY 130.00/kg, it will have lost 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 loss from the short futures position is JPY 8,150,000.
In the end, the higher sales proceeds is offset by the loss in the rubber futures market, resulting in a net proceeds of JPY 73,150,000 - JPY 8,150,000 = JPY 65,000,000. Again, this is the same amount that would be received by selling 500,000 kilograms of rubber at JPY 130.00/kg.
As can be seen from the above examples, the downside of the short hedge is that the rubber seller would have been better off without the hedge if the price of the commodity went up.
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