Zinc producers can hedge against falling zinc price by taking up a position in the zinc futures market.
Zinc producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of zinc that is only ready for sale sometime in the future.
To implement the short hedge, zinc producers sell (short) enough zinc futures contracts in the futures market to cover the quantity of zinc to be produced.
A zinc mining company has just entered into a contract to sell 2,500 tonnes of zinc, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of zinc on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 1,200/ton, the zinc mining company can enter a short position in an appropriate number of LME Zinc futures contracts. With each LME Zinc futures contract covering 25 tonnes of zinc, the zinc mining company will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the zinc mining company will be able to sell 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.
As per the sales contract, the zinc mining company will have to sell the zinc at only USD 1,091/ton, resulting in a net sales proceeds of USD 2,727,000.
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 short futures position was entered at USD 1,200/ton, it will have gained USD 1,200 - USD 1,091 = USD 109.20 per tonne. With 100 contracts covering a total of 2500 tonnes, the total gain from the short futures position is USD 273,000
Together, the gain in the zinc futures market and the amount realised from the sales contract will total USD 273,000 + USD 2,727,000 = USD 3,000,000. This amount is equivalent to selling 2,500 tonnes of zinc at USD 1,200/ton.
With the increase in zinc price to USD 1,333/ton, the zinc producer will be able to sell the 2,500 tonnes of zinc for a higher net sales proceeds of USD 3,333,000.
However, as the short futures position was entered at a lower price of USD 1,200/ton, it will have lost 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 loss from the short futures position is USD 333,000.
In the end, the higher sales proceeds is offset by the loss in the zinc futures market, resulting in a net proceeds of USD 3,333,000 - USD 333,000 = USD 3,000,000. Again, this is the same amount that would be received by selling 2,500 tonnes of zinc at USD 1,200/ton.
As can be seen from the above examples, the downside of the short hedge is that the zinc seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling zinc prices while still be able to benefit from a rise in zinc price is to buy zinc put options.
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