Businesses that need to buy significant quantities of tin can hedge against rising tin price by taking up a position in the tin futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of tin that they will require sometime in the future.
To implement the long hedge, enough tin futures are to be purchased to cover the quantity of tin required by the business operator.
A tin can manufacturer will need to procure 500 tonnes of tin in 3 months' time. The prevailing spot price for tin is USD 11,550/ton while the price of tin futures for delivery in 3 months' time is USD 12,000/ton. To hedge against a rise in tin price, the tin can manufacturer decided to lock in a future purchase price of USD 12,000/ton by taking a long position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin can manufacturer 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 tin can manufacturer will be able to purchase the 500 tonnes of tin at USD 12,000/ton for a total amount of USD 6,000,000. Let's see how this is achieved by looking at scenarios in which the price of tin makes a significant move either upwards or downwards by delivery date.
With the increase in tin price to USD 12,705/ton, the tin can manufacturer will now have to pay USD 6,352,500 for the 500 tonnes of tin. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 12,705/ton. As the long futures position was entered at a lower price of USD 12,000/ton, it will have gained USD 12,705 - USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total gain from the long futures position is USD 352,500.
In the end, the higher purchase price is offset by the gain in the tin futures market, resulting in a net payment amount of USD 6,352,500 - USD 352,500 = USD 6,000,000. This amount is equivalent to the amount payable when buying the 500 tonnes of tin at USD 12,000/ton.
With the spot price having fallen to USD 10,395/ton, the tin can manufacturer will only need to pay USD 5,197,500 for the tin. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 10,395/ton. As the long futures position was entered at USD 12,000/ton, it will have lost USD 12,000 - USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total loss from the long futures position is USD 802,500
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the tin futures market and the net amount payable will be USD 5,197,500 + USD 802,500 = USD 6,000,000. Once again, this amount is equivalent to buying 500 tonnes of tin at USD 12,000/ton.
As you can see from the above examples, the downside of the long hedge is that the tin buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising tin prices while still be able to benefit from a fall in tin price is to buy tin call options.
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