Businesses that need to buy significant quantities of zinc can hedge against rising zinc price by taking up a position in the zinc futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of zinc that they will require sometime in the future.
To implement the long hedge, enough zinc futures are to be purchased to cover the quantity of zinc required by the business operator.
A battery manufacturer will need to procure 2,500 tonnes of zinc in 3 months' time. The prevailing spot price for zinc is USD 1,212/ton while the price of zinc futures for delivery in 3 months' time is USD 1,200/ton. To hedge against a rise in zinc price, the battery manufacturer decided to lock in a future purchase price of USD 1,200/ton by taking a long position in an appropriate number of LME Zinc futures contracts. With each LME Zinc futures contract covering 25 tonnes of zinc, the battery 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 battery manufacturer will be able to purchase the 2,500 tonnes of zinc at USD 1,200/ton for a total amount of USD 3,000,000. Let's see how this is achieved by looking at scenarios in which the price of zinc makes a significant move either upwards or downwards by delivery date.
With the increase in zinc price to USD 1,333/ton, the battery manufacturer will now have to pay USD 3,333,000 for the 2,500 tonnes of zinc. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the zinc futures price will have converged with the zinc spot price and will be equal to USD 1,333/ton. As the long futures position was entered at a lower price of USD 1,200/ton, it will have gained USD 1,333 - USD 1,200 = USD 133.20 per tonne. With 100 contracts covering a total of 2,500 tonnes of zinc, the total gain from the long futures position is USD 333,000.
In the end, the higher purchase price is offset by the gain in the zinc futures market, resulting in a net payment amount of USD 3,333,000 - USD 333,000 = USD 3,000,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of zinc at USD 1,200/ton.
With the spot price having fallen to USD 1,091/ton, the battery manufacturer will only need to pay USD 2,727,000 for the zinc. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the zinc futures price will have converged with the zinc spot price and will be equal to USD 1,091/ton. As the long futures position was entered at USD 1,200/ton, it will have lost USD 1,200 - USD 1,091 = USD 109.20 per tonne. With 100 contracts covering a total of 2,500 tonnes, the total loss from the long futures position is USD 273,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the zinc futures market and the net amount payable will be USD 2,727,000 + USD 273,000 = USD 3,000,000. Once again, this amount is equivalent to buying 2,500 tonnes of zinc at USD 1,200/ton.
As you can see from the above examples, the downside of the long hedge is that the zinc buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising zinc prices while still be able to benefit from a fall in zinc price is to buy zinc call options.
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