Businesses that need to buy significant quantities of wheat can hedge against rising wheat price by taking up a position in the wheat futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of wheat that they will require sometime in the future.
To implement the long hedge, enough wheat futures are to be purchased to cover the quantity of wheat required by the business operator.
A bread maker will need to procure 500,000 bushels of wheat in 3 months' time. The prevailing spot price for wheat is USD 5.7000/bu while the price of wheat futures for delivery in 3 months' time is USD 5.7000/bu. To hedge against a rise in wheat price, the bread maker decided to lock in a future purchase price of USD 5.7000/bu by taking a long position in an appropriate number of CBOT Wheat futures contracts. With each CBOT Wheat futures contract covering 5000 bushels of wheat, the bread maker 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 bread maker will be able to purchase the 500,000 bushels of wheat at USD 5.7000/bu for a total amount of USD 2,850,000. Let's see how this is achieved by looking at scenarios in which the price of wheat makes a significant move either upwards or downwards by delivery date.
With the increase in wheat price to USD 6.2700/bu, the bread maker will now have to pay USD 3,135,000 for the 500,000 bushels of wheat. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the wheat futures price will have converged with the wheat spot price and will be equal to USD 6.2700/bu. As the long futures position was entered at a lower price of USD 5.7000/bu, it will have gained USD 6.2700 - USD 5.7000 = USD 0.5700 per bushel. With 100 contracts covering a total of 500,000 bushels of wheat, the total gain from the long futures position is USD 285,000.
In the end, the higher purchase price is offset by the gain in the wheat futures market, resulting in a net payment amount of USD 3,135,000 - USD 285,000 = USD 2,850,000. This amount is equivalent to the amount payable when buying the 500,000 bushels of wheat at USD 5.7000/bu.
With the spot price having fallen to USD 5.1300/bu, the bread maker will only need to pay USD 2,565,000 for the wheat. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the wheat futures price will have converged with the wheat spot price and will be equal to USD 5.1300/bu. As the long futures position was entered at USD 5.7000/bu, it will have lost USD 5.7000 - USD 5.1300 = USD 0.5700 per bushel. With 100 contracts covering a total of 500,000 bushels, the total loss from the long futures position is USD 285,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the wheat futures market and the net amount payable will be USD 2,565,000 + USD 285,000 = USD 2,850,000. Once again, this amount is equivalent to buying 500,000 bushels of wheat at USD 5.7000/bu.
As you can see from the above examples, the downside of the long hedge is that the wheat buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising wheat prices while still be able to benefit from a fall in wheat price is to buy wheat call options.
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