Tin producers can hedge against falling tin price by taking up a position in the tin futures market.
Tin producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of tin that is only ready for sale sometime in the future.
To implement the short hedge, tin producers sell (short) enough tin futures contracts in the futures market to cover the quantity of tin to be produced.
A tin mining company has just entered into a contract to sell 500 tonnes of tin, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of tin on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 12,000/ton, the tin mining company can enter a short position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin mining company will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the tin mining company will be able to sell 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.
As per the sales contract, the tin mining company will have to sell the tin at only USD 10,395/ton, resulting in a net sales proceeds of USD 5,197,500.
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 short futures position was entered at USD 12,000/ton, it will have gained USD 12,000 - USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total gain from the short futures position is USD 802,500
Together, the gain in the tin futures market and the amount realised from the sales contract will total USD 802,500 + USD 5,197,500 = USD 6,000,000. This amount is equivalent to selling 500 tonnes of tin at USD 12,000/ton.
With the increase in tin price to USD 12,705/ton, the tin producer will be able to sell the 500 tonnes of tin for a higher net sales proceeds of USD 6,352,500.
However, as the short futures position was entered at a lower price of USD 12,000/ton, it will have lost USD 12,705 - USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total loss from the short futures position is USD 352,500.
In the end, the higher sales proceeds is offset by the loss in the tin futures market, resulting in a net proceeds of USD 6,352,500 - USD 352,500 = USD 6,000,000. Again, this is the same amount that would be received by selling 500 tonnes of tin at USD 12,000/ton.
As can be seen from the above examples, the downside of the short hedge is that the tin seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling tin prices while still be able to benefit from a rise in tin price is to buy tin put options.
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