Sugar producers can hedge against falling sugar price by taking up a position in the sugar futures market.
Sugar producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of sugar that is only ready for sale sometime in the future.
To implement the short hedge, sugar producers sell (short) enough sugar futures contracts in the futures market to cover the quantity of sugar to be produced.
A sugar refinery has just entered into a contract to sell 11.20 million pounds of sugar, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of sugar on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 0.1100/lb, the sugar refinery can enter a short position in an appropriate number of Euronext Raw Sugar (No. 408) futures contracts. With each Euronext Raw Sugar (No. 408) futures contract covering 112,000 pounds of sugar, the sugar refinery will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the sugar refinery will be able to sell 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.
As per the sales contract, the sugar refinery will have to sell the sugar at only USD 0.1000/lb, resulting in a net sales proceeds of USD 1,119,888.
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 short futures position was entered at USD 0.1100/lb, it will have gained USD 0.1100 - USD 0.1000 = USD 0.0100 per pound. With 100 contracts covering a total of 11200000 pounds, the total gain from the short futures position is USD 112,112
Together, the gain in the sugar futures market and the amount realised from the sales contract will total USD 112,112 + USD 1,119,888 = USD 1,232,000. This amount is equivalent to selling 11.20 million pounds of sugar at USD 0.1100/lb.
With the increase in sugar price to USD 0.1222/lb, the sugar producer will be able to sell the 11.20 million pounds of sugar for a higher net sales proceeds of USD 1,368,752.
However, as the short futures position was entered at a lower price of USD 0.1100/lb, it will have lost 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 loss from the short futures position is USD 136,752.
In the end, the higher sales proceeds is offset by the loss in the sugar futures market, resulting in a net proceeds of USD 1,368,752 - USD 136,752 = USD 1,232,000. Again, this is the same amount that would be received by selling 11.20 million pounds of sugar at USD 0.1100/lb.
As can be seen from the above examples, the downside of the short hedge is that the sugar seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling sugar prices while still be able to benefit from a rise in sugar price is to buy sugar put options.
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