Businesses that need to buy significant quantities of soybeans can hedge against rising soybeans price by taking up a position in the soybeans futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of soybeans that they will require sometime in the future.
To implement the long hedge, enough soybeans futures are to be purchased to cover the quantity of soybeans required by the business operator.
A soybean processing company will need to procure 500,000 bushels of soybeans in 3 months' time. The prevailing spot price for soybeans is USD 9.6900/bu while the price of soybeans futures for delivery in 3 months' time is USD 9.7000/bu. To hedge against a rise in soybeans price, the soybean processing company decided to lock in a future purchase price of USD 9.7000/bu by taking a long position in an appropriate number of CBOT Soybeans futures contracts. With each CBOT Soybeans futures contract covering 5000 bushels of soybeans, the soybean processing 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 soybean processing company will be able to purchase the 500,000 bushels of soybeans at USD 9.7000/bu for a total amount of USD 4,850,000. Let's see how this is achieved by looking at scenarios in which the price of soybeans makes a significant move either upwards or downwards by delivery date.
With the increase in soybeans price to USD 10.66/bu, the soybean processing company will now have to pay USD 5,329,500 for the 500,000 bushels of soybeans. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the soybeans futures price will have converged with the soybeans spot price and will be equal to USD 10.66/bu. As the long futures position was entered at a lower price of USD 9.7000/bu, it will have gained USD 10.66 - USD 9.7000 = USD 0.9590 per bushel. With 100 contracts covering a total of 500,000 bushels of soybeans, the total gain from the long futures position is USD 479,500.
In the end, the higher purchase price is offset by the gain in the soybeans futures market, resulting in a net payment amount of USD 5,329,500 - USD 479,500 = USD 4,850,000. This amount is equivalent to the amount payable when buying the 500,000 bushels of soybeans at USD 9.7000/bu.
With the spot price having fallen to USD 8.7210/bu, the soybean processing company will only need to pay USD 4,360,500 for the soybeans. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the soybeans futures price will have converged with the soybeans spot price and will be equal to USD 8.7210/bu. As the long futures position was entered at USD 9.7000/bu, it will have lost USD 9.7000 - USD 8.7210 = USD 0.9790 per bushel. With 100 contracts covering a total of 500,000 bushels, the total loss from the long futures position is USD 489,500
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the soybeans futures market and the net amount payable will be USD 4,360,500 + USD 489,500 = USD 4,850,000. Once again, this amount is equivalent to buying 500,000 bushels of soybeans at USD 9.7000/bu.
As you can see from the above examples, the downside of the long hedge is that the soybeans buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising soybeans prices while still be able to benefit from a fall in soybeans price is to buy soybeans call options.
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