Businesses that need to buy significant quantities of silver can hedge against rising silver price by taking up a position in the silver futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of silver that they will require sometime in the future.
To implement the long hedge, enough silver futures are to be purchased to cover the quantity of silver required by the business operator.
A silverware company will need to procure 3.00 million grams of silver in 3 months' time. The prevailing spot price for silver is JPY 30.23/gm while the price of silver futures for delivery in 3 months' time is JPY 30.00/gm. To hedge against a rise in silver price, the silverware company decided to lock in a future purchase price of JPY 30.00/gm by taking a long position in an appropriate number of TOCOM Silver futures contracts. With each TOCOM Silver futures contract covering 30000 grams of silver, the silverware company 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 silverware company will be able to purchase the 3.00 million grams of silver at JPY 30.00/gm for a total amount of JPY 90,000,000. Let's see how this is achieved by looking at scenarios in which the price of silver makes a significant move either upwards or downwards by delivery date.
With the increase in silver price to JPY 33.25/gm, the silverware company will now have to pay JPY 99,759,000 for the 3.00 million grams of silver. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 33.25/gm. As the long futures position was entered at a lower price of JPY 30.00/gm, it will have gained JPY 33.25 - JPY 30.00 = JPY 3.2530 per gram. With 100 contracts covering a total of 3.00 million grams of silver, the total gain from the long futures position is JPY 9,759,000.
In the end, the higher purchase price is offset by the gain in the silver futures market, resulting in a net payment amount of JPY 99,759,000 - JPY 9,759,000 = JPY 90,000,000. This amount is equivalent to the amount payable when buying the 3.00 million grams of silver at JPY 30.00/gm.
With the spot price having fallen to JPY 27.21/gm, the silverware company will only need to pay JPY 81,621,000 for the silver. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 27.21/gm. As the long futures position was entered at JPY 30.00/gm, it will have lost JPY 30.00 - JPY 27.21 = JPY 2.7930 per gram. With 100 contracts covering a total of 3.00 million grams, the total loss from the long futures position is JPY 8,379,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the silver futures market and the net amount payable will be JPY 81,621,000 + JPY 8,379,000 = JPY 90,000,000. Once again, this amount is equivalent to buying 3.00 million grams of silver at JPY 30.00/gm.
As you can see from the above examples, the downside of the long hedge is that the silver buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising silver prices while still be able to benefit from a fall in silver price is to buy silver call options.
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