Businesses that need to buy significant quantities of uranium can hedge against rising uranium price by taking up a position in the uranium futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of uranium that they will require sometime in the future.
To implement the long hedge, enough uranium futures are to be purchased to cover the quantity of uranium required by the business operator.
A nuclear power company will need to procure 25,000 pounds of uranium in 3 months' time. The prevailing spot price for uranium is USD 53.00/lb while the price of uranium futures for delivery in 3 months' time is USD 53.00/lb. To hedge against a rise in uranium price, the nuclear power company decided to lock in a future purchase price of USD 53.00/lb by taking a long position in an appropriate number of NYMEX Uranium futures contracts. With each NYMEX Uranium futures contract covering 250 pounds of uranium, the nuclear power 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 nuclear power company will be able to purchase the 25,000 pounds of uranium at USD 53.00/lb for a total amount of USD 1,325,000. Let's see how this is achieved by looking at scenarios in which the price of uranium makes a significant move either upwards or downwards by delivery date.
With the increase in uranium price to USD 58.30/lb, the nuclear power company will now have to pay USD 1,457,500 for the 25,000 pounds of uranium. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the uranium futures price will have converged with the uranium spot price and will be equal to USD 58.30/lb. As the long futures position was entered at a lower price of USD 53.00/lb, it will have gained USD 58.30 - USD 53.00 = USD 5.3000 per pound. With 100 contracts covering a total of 25,000 pounds of uranium, the total gain from the long futures position is USD 132,500.
In the end, the higher purchase price is offset by the gain in the uranium futures market, resulting in a net payment amount of USD 1,457,500 - USD 132,500 = USD 1,325,000. This amount is equivalent to the amount payable when buying the 25,000 pounds of uranium at USD 53.00/lb.
With the spot price having fallen to USD 47.70/lb, the nuclear power company will only need to pay USD 1,192,500 for the uranium. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the uranium futures price will have converged with the uranium spot price and will be equal to USD 47.70/lb. As the long futures position was entered at USD 53.00/lb, it will have lost USD 53.00 - USD 47.70 = USD 5.3000 per pound. With 100 contracts covering a total of 25,000 pounds, the total loss from the long futures position is USD 132,500
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the uranium futures market and the net amount payable will be USD 1,192,500 + USD 132,500 = USD 1,325,000. Once again, this amount is equivalent to buying 25,000 pounds of uranium at USD 53.00/lb.
As you can see from the above examples, the downside of the long hedge is that the uranium buyer would have been better off without the hedge if the price of the commodity fell.
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