Businesses that need to buy significant quantities of sugar can hedge against rising sugar price by taking up a position in the sugar futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of sugar that they will require sometime in the future.
To implement the long hedge, enough sugar futures are to be purchased to cover the quantity of sugar required by the business operator.
A beverage company will need to procure 11.20 million pounds of sugar in 3 months' time. The prevailing spot price for sugar is USD 0.1111/lb while the price of sugar futures for delivery in 3 months' time is USD 0.1100/lb. To hedge against a rise in sugar price, the beverage company decided to lock in a future purchase price of USD 0.1100/lb by taking a long position in an appropriate number of Euronext Raw Sugar (No. 408) futures contracts. With each Euronext Raw Sugar (No. 408) futures contract covering 112000 pounds of sugar, the beverage 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 beverage company will be able to purchase the 11.20 million pounds of sugar at USD 0.1100/lb for a total amount of USD 1,232,000. Let's see how this is achieved by looking at scenarios in which the price of sugar makes a significant move either upwards or downwards by delivery date.
With the increase in sugar price to USD 0.1222/lb, the beverage company will now have to pay USD 1,368,752 for the 11.20 million pounds of sugar. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the sugar futures price will have converged with the sugar spot price and will be equal to USD 0.1222/lb. As the long futures position was entered at a lower price of USD 0.1100/lb, it will have gained USD 0.1222 - USD 0.1100 = USD 0.0122 per pound. With 100 contracts covering a total of 11.20 million pounds of sugar, the total gain from the long futures position is USD 136,752.
In the end, the higher purchase price is offset by the gain in the sugar futures market, resulting in a net payment amount of USD 1,368,752 - USD 136,752 = USD 1,232,000. This amount is equivalent to the amount payable when buying the 11.20 million pounds of sugar at USD 0.1100/lb.
With the spot price having fallen to USD 0.1000/lb, the beverage company will only need to pay USD 1,119,888 for the sugar. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the sugar futures price will have converged with the sugar spot price and will be equal to USD 0.1000/lb. As the long futures position was entered at USD 0.1100/lb, it will have lost USD 0.1100 - USD 0.1000 = USD 0.0100 per pound. With 100 contracts covering a total of 11.20 million pounds, the total loss from the long futures position is USD 112,112
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the sugar futures market and the net amount payable will be USD 1,119,888 + USD 112,112 = USD 1,232,000. Once again, this amount is equivalent to buying 11.20 million pounds of sugar at USD 0.1100/lb.
As you can see from the above examples, the downside of the long hedge is that the sugar buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising sugar prices while still be able to benefit from a fall in sugar price is to buy sugar call options.
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