Hedging Against Rising Rubber Prices using Rubber Futures

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Contents

Hedging Against Rising Rubber Prices using Rubber Futures

Businesses that need to buy significant quantities of rubber can hedge against rising rubber price by taking up a position in the rubber futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of rubber that they will require sometime in the future.

To implement the long hedge, enough rubber futures are to be purchased to cover the quantity of rubber required by the business operator.

Rubber Futures Long Hedge Example

A tire manufacturer will need to procure 500,000 kilograms of rubber in 3 months’ time. The prevailing spot price for rubber is JPY 133.00/kg while the price of rubber futures for delivery in 3 months’ time is JPY 130.00/kg. To hedge against a rise in rubber price, the tire manufacturer decided to lock in a future purchase price of JPY 130.00/kg by taking a long position in an appropriate number of TOCOM Rubber futures contracts. With each TOCOM Rubber futures contract covering 5000 kilograms of rubber, the tire 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 tire manufacturer will be able to purchase the 500,000 kilograms of rubber at JPY 130.00/kg for a total amount of JPY 65,000,000. Let’s see how this is achieved by looking at scenarios in which the price of rubber makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rubber Spot Price Rose by 10% to JPY 146.30/kg on Delivery Date

With the increase in rubber price to JPY 146.30/kg, the tire manufacturer will now have to pay JPY 73,150,000 for the 500,000 kilograms of rubber. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 146.30/kg. As the long futures position was entered at a lower price of JPY 130.00/kg, it will have gained JPY 146.30 – JPY 130.00 = JPY 16.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms of rubber, the total gain from the long futures position is JPY 8,150,000.

In the end, the higher purchase price is offset by the gain in the rubber futures market, resulting in a net payment amount of JPY 73,150,000 – JPY 8,150,000 = JPY 65,000,000. This amount is equivalent to the amount payable when buying the 500,000 kilograms of rubber at JPY 130.00/kg.

Scenario #2: Rubber Spot Price Fell by 10% to JPY 119.70/kg on Delivery Date

With the spot price having fallen to JPY 119.70/kg, the tire manufacturer will only need to pay JPY 59,850,000 for the rubber. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 119.70/kg. As the long futures position was entered at JPY 130.00/kg, it will have lost JPY 130.00 – JPY 119.70 = JPY 10.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms, the total loss from the long futures position is JPY 5,150,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rubber futures market and the net amount payable will be JPY 59,850,000 + JPY 5,150,000 = JPY 65,000,000. Once again, this amount is equivalent to buying 500,000 kilograms of rubber at JPY 130.00/kg.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the rubber buyer would have been better off without the hedge if the price of the commodity fell.

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Hedging Against Falling Rubber Prices using Rubber Futures

Rubber producers can hedge against falling rubber price by taking up a position in the rubber futures market.

Rubber producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of rubber that is only ready for sale sometime in the future.

To implement the short hedge, rubber producers sell (short) enough rubber futures contracts in the futures market to cover the quantity of rubber to be produced.

Rubber Futures Short Hedge Example

A rubber producer has just entered into a contract to sell 500,000 kilograms of rubber, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of rubber on the day of delivery. At the time of signing the agreement, spot price for rubber is JPY 133.00/kg while the price of rubber futures for delivery in 3 months’ time is JPY 130.00/kg.

To lock in the selling price at JPY 130.00/kg, the rubber producer can enter a short position in an appropriate number of TOCOM Rubber futures contracts. With each TOCOM Rubber futures contract covering 5,000 kilograms of rubber, the rubber producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the rubber producer will be able to sell the 500,000 kilograms of rubber at JPY 130.00/kg for a total amount of JPY 65,000,000. Let’s see how this is achieved by looking at scenarios in which the price of rubber makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rubber Spot Price Fell by 10% to JPY 119.70/kg on Delivery Date

As per the sales contract, the rubber producer will have to sell the rubber at only JPY 119.70/kg, resulting in a net sales proceeds of JPY 59,850,000.

By delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 119.70/kg. As the short futures position was entered at JPY 130.00/kg, it will have gained JPY 130.00 – JPY 119.70 = JPY 10.30 per kilogram. With 100 contracts covering a total of 500000 kilograms, the total gain from the short futures position is JPY 5,150,000

Together, the gain in the rubber futures market and the amount realised from the sales contract will total JPY 5,150,000 + JPY 59,850,000 = JPY 65,000,000. This amount is equivalent to selling 500,000 kilograms of rubber at JPY 130.00/kg.

Scenario #2: Rubber Spot Price Rose by 10% to JPY 146.30/kg on Delivery Date

With the increase in rubber price to JPY 146.30/kg, the rubber producer will be able to sell the 500,000 kilograms of rubber for a higher net sales proceeds of JPY 73,150,000.

However, as the short futures position was entered at a lower price of JPY 130.00/kg, it will have lost JPY 146.30 – JPY 130.00 = JPY 16.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms of rubber, the total loss from the short futures position is JPY 8,150,000.

In the end, the higher sales proceeds is offset by the loss in the rubber futures market, resulting in a net proceeds of JPY 73,150,000 – JPY 8,150,000 = JPY 65,000,000. Again, this is the same amount that would be received by selling 500,000 kilograms of rubber at JPY 130.00/kg.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the rubber seller would have been better off without the hedge if the price of the commodity went up.

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Hedging Against Rising Coffee Prices using Coffee Futures

Businesses that need to buy significant quantities of coffee can hedge against rising coffee price by taking up a position in the coffee futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of coffee that they will require sometime in the future.

To implement the long hedge, enough coffee futures are to be purchased to cover the quantity of coffee required by the business operator.

Coffee Futures Long Hedge Example

A coffeehouse chain will need to procure 1,000 tonnes of coffee in 3 months’ time. The prevailing spot price for coffee is USD 1,648/ton while the price of coffee futures for delivery in 3 months’ time is USD 1,600/ton. To hedge against a rise in coffee price, the coffeehouse chain decided to lock in a future purchase price of USD 1,600/ton by taking a long position in an appropriate number of Euronext Robusta Coffee (No. 409) futures contracts. With each Euronext Robusta Coffee (No. 409) futures contract covering 10 tonnes of coffee, the coffeehouse chain 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 coffeehouse chain will be able to purchase the 1,000 tonnes of coffee at USD 1,600/ton for a total amount of USD 1,600,000. Let’s see how this is achieved by looking at scenarios in which the price of coffee makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coffee Spot Price Rose by 10% to USD 1,813/ton on Delivery Date

With the increase in coffee price to USD 1,813/ton, the coffeehouse chain will now have to pay USD 1,812,800 for the 1,000 tonnes of coffee. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,813/ton. As the long futures position was entered at a lower price of USD 1,600/ton, it will have gained USD 1,813 – USD 1,600 = USD 212.80 per tonne. With 100 contracts covering a total of 1,000 tonnes of coffee, the total gain from the long futures position is USD 212,800.

In the end, the higher purchase price is offset by the gain in the coffee futures market, resulting in a net payment amount of USD 1,812,800 – USD 212,800 = USD 1,600,000. This amount is equivalent to the amount payable when buying the 1,000 tonnes of coffee at USD 1,600/ton.

Scenario #2: Coffee Spot Price Fell by 10% to USD 1,483/ton on Delivery Date

With the spot price having fallen to USD 1,483/ton, the coffeehouse chain will only need to pay USD 1,483,200 for the coffee. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,483/ton. As the long futures position was entered at USD 1,600/ton, it will have lost USD 1,600 – USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1,000 tonnes, the total loss from the long futures position is USD 116,800

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coffee futures market and the net amount payable will be USD 1,483,200 + USD 116,800 = USD 1,600,000. Once again, this amount is equivalent to buying 1,000 tonnes of coffee at USD 1,600/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the coffee buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising coffee prices while still be able to benefit from a fall in coffee price is to buy coffee call options.

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Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

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Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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