Silver producers can hedge against falling silver price by taking up a position in the silver futures market.
Silver producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of silver that is only ready for sale sometime in the future.
To implement the short hedge, silver producers sell (short) enough silver futures contracts in the futures market to cover the quantity of silver to be produced.
A silver mining firm has just entered into a contract to sell 3.00 million grams of silver, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of silver on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at JPY 30.00/gm, the silver mining firm can enter a short position in an appropriate number of TOCOM Silver futures contracts. With each TOCOM Silver futures contract covering 30,000 grams of silver, the silver mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the silver mining firm will be able to sell 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.
As per the sales contract, the silver mining firm will have to sell the silver at only JPY 27.21/gm, resulting in a net sales proceeds of JPY 81,621,000.
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 short futures position was entered at JPY 30.00/gm, it will have gained JPY 30.00 - JPY 27.21 = JPY 2.7930 per gram. With 100 contracts covering a total of 3000000 grams, the total gain from the short futures position is JPY 8,379,000
Together, the gain in the silver futures market and the amount realised from the sales contract will total JPY 8,379,000 + JPY 81,621,000 = JPY 90,000,000. This amount is equivalent to selling 3.00 million grams of silver at JPY 30.00/gm.
With the increase in silver price to JPY 33.25/gm, the silver producer will be able to sell the 3.00 million grams of silver for a higher net sales proceeds of JPY 99,759,000.
However, as the short futures position was entered at a lower price of JPY 30.00/gm, it will have lost 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 loss from the short futures position is JPY 9,759,000.
In the end, the higher sales proceeds is offset by the loss in the silver futures market, resulting in a net proceeds of JPY 99,759,000 - JPY 9,759,000 = JPY 90,000,000. Again, this is the same amount that would be received by selling 3.00 million grams of silver at JPY 30.00/gm.
As can be seen from the above examples, the downside of the short hedge is that the silver seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling silver prices while still be able to benefit from a rise in silver price is to buy silver put options.
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