The long hedge

Buyers of agricultural products by definition need protection against rising prices.

For example, suppose a feed producer plans to buy feed wheat in December. The cash market price now for feed wheat delivered in December is 187 euros per ton.

However, the producer is afraid that the price will rise and wants to hedge (hedge) this risk. He does this by buying futures at a rate of 187 euros per tonne in December.

If the price does indeed rise to 195 euros per ton, the feed producer will be compensated by the result on the futures market:

In this example, the higher cost of wheat was offset by a profit on the futures market.

 

Cash Market

Futures Market

May

Feed Wheat is 187/t

Buy Dec Futures at 187/t

December

Buy Feed wheat at 195/t

Sell Dec Futures at 195/t

Change

8 /t loss

8/t gain

 

Buy  cash wheat at

195/t

 

Gain on Future position -

8/t

 

Net Purchase price

187/t

 

Conversely, if wheat prices were to fall by EUR 7 per ton, the lower cost of wheat on the spot market would have been offset by a loss on the futures market. The net purchase price would still be 187 euros per ton:

 

Cash Market

Futures Market

May

Feed Wheat is 187/t

Buy Dec Futures at 187/t

December

Buy Feed wheat at 180/t

Sell Dec Futures at 180/t

Change

7 /t gain

7/t loss

 

Buy  cash wheat at

180/t

 

Loss on Future position +

7/t

 

Net purchase price

187/t

 

The producer could also have chosen to actually buy the raw material in advance from his suppliers. This is called an (OTC) Forward contract. The effect of this is approximately the same as a Future contract, namely that you have set prices in advance. The difference is that you can make all kinds of different agreements in an OTC forward contract regarding delivery, quality, etc. On the other hand, you always have to find a counterparty for those types of contracts. Something that costs little effort in standard markets due to standardization.

Covering price risk on the purchasing side enables the feed producer to make price agreements for the longer term without running the risk of the market turning against him and losing money on it. That makes long-term pricing in the chain less risky.

Want to know more about risk management? Or the use of forward contracts and forward contracts, perhaps to make chain agreements? Then call 06 46 26 58 74 or mail to R.vantRiet@DCA.nl.