2 scenarios: futures contract with predetermined price or future spot price

[ziminli1228]

Hi

This is a bit of fundamental but this part has always got me confused. Please correct me if I am not thinking in the right direction:

Consider a coffee producer who plans to sell 100 pounds of coffee on a future date under

two different scenarios:

1. To a key customer, the coffee producer promises to sell 100 pounds, on a date one year in the future, at $3.00 per pound.
   
2. To a key customer, the coffee producer promises to sell 100 pounds, on a date one year in the future, at the future spot price (which is obviously unknown today

1. In the first scenario, the producer is exposed to a future spot price increase, such that the appropriate hedge is a long position in coffee futures contracts. Because the sales price of $3.00 is predetermined, the underlying exposure is effectively a short position, such that the hedge instrument is a long position to offset.
   
2. In the second scenario, the producer is exposed to a future spot price decrease, such that the appropriate hedge is a short position in coffee futures contracts. In this case as the future sale price is not predetermined, the underlying exposure is effectively a short position such that the hedge instrument is a long position.
   

the 1st one, producer is exposed to increase in pricing as he will lose the chance to sell at higher price so the appropriate hedge is long position in futures contract? Using the gains from long futures to cover losses from selling underlying at less favorable price? So at the delivery date, what will happen is producer will sell underlying at 3 and buy underlying at 3 whereas the spot price is already 5? This way technically he is not delivering but the value of his underlying is lifted?

the 2nd one, he is exposed to decrease in price how is the producer short the underlying and enter into a short hedge at the same time? is it a typo? Assuming the hedge is long position in futures contract, what will happen is he will sell the underlying at future spot price at say 2 and long the underlying at 2 which offsets the decrease in price?


The numerical example could be wrong but if you can also walk me through numbers that would be easier for me to understand.

 

[David Harper CFA FRM]

Hi @ziminli1228 Yes, thank you, despite previous clarifications, unfortunately the text persists in containing a typo(s). I think it should be as I have copied below. To use numbers:

1. When the producer promises to sell forward at $3.00 (which is effectively a long-term short forward contract), just as you suggest, the exposure (risk) here is the opportunity cost of a higher future spot price. For example, if the future spot price is $4.50, the producer forfeits $1.50 = $4.50 (could have received in spot market) - $3.00 (actually received). But the long hedge, which is to say the long futures position at delivery price = $3.00, earns a profit of $1.50 due to the increase so the producer's net receipt is $3.00 + $1.50. Or put another way, if the producer needs to buy in order to sell, like you say: then the producer needs to buy at 4.50 and sell at 3.00, but the $1.50 keeps the producer's net profit to zero. Whether you assume she/he needs to buy the future spot in order to sell it, or not, in either case here, the producer's underlying position (the short forward) is a "bet against" an increase in future spot price and a "bet in favor of" a future stop price decrease, which is to say "expresses a short view" by locking in the sale price. So here the exposure (risk) is to spot price increase (aka, underlying position is effectively short) and the appropriate hedge is a long position and so is a long hedge.
2. When the producer promises to sell without a price guarantee, this is the classical situation. The producer is exposed to price decreases; i.e., the underlying position is effectively a long position. The hedge is a short futures contract and so the hedge is a short hedge.

To summarize:

• Producer will sell in future at predetermined price ($3.00): underlying position is effectively short, such that the appropriate hedge is a long hedge
• Producer will sell in future at prevailing price: underlying position is effectively long, such that the appropriate hedge is a short hedge.

.. I can see that an issue is the potential ambiguity of "underlying exposure" which can be read two different ways. This is why I am changing this to "underlying position is effectively ... ". Sorry for the confusion, I hope this makes sense!

A key difference: is the future price predetermined?

Consider a coffee producer who plans to sell 100 pounds of coffee on a future date under two different scenarios:

1. To a key customer, the coffee producer promises to sell 100 pounds, on a date one year in the future, at $3.00 per pound.
2. To a key customer, the coffee producer promises to sell 100 pounds, on a date one year in the future, at the future spot price (which is obviously unknown today)

If the coffee producer wants to hedge with coffee futures, the hedge differs depending on the scenario:
1. In the first scenario, the producer is exposed to a future spot price increase, such that the appropriate hedge is a long position in coffee futures contracts. Because the sales price of $3.00 is predetermined, the underlying position is effectively a short position, such that the hedge instrument is a long position to offset.
2. In the second scenario, the producer is exposed to a future spot price decrease, such that the appropriate hedge is a short position in coffee futures contracts. In this case as the future sale price is not predetermined, the underlying position is effectively a long position such that the hedge instrument is a short position.

 

[ziminli1228]

Hi @ziminli1228 Yes, thank you, despite previous clarifications, unfortunately the text persists in containing a typo(s). I think it should be as I have copied below. To use numbers:

1. When the producer promises to sell forward at $3.00 (which is effectively a long-term short forward contract), just as you suggest, the exposure (risk) here is the opportunity cost of a higher future spot price. For example, if the future spot price is $4.50, the producer forfeits $1.50 = $4.50 (could have received in spot market) - $3.00 (actually received). But the long hedge, which is to say the long futures position at delivery price = $3.00, earns a profit of $1.50 due to the increase so the producer's net receipt is $3.00 + $1.50. Or put another way, if the producer needs to buy in order to sell, like you say: then the producer needs to buy at 4.50 and sell at 3.00, but the $1.50 keeps the producer's net profit to zero. Whether you assume she/he needs to buy the future spot in order to sell it, or not, in either case here, the producer's underlying position (the short forward) is a "bet against" an increase in future spot price and a "bet in favor of" a future stop price decrease, which is to say "expresses a short view" by locking in the sale price. So here the exposure (risk) is to spot price increase (aka, underlying position is effectively short) and the appropriate hedge is a long position and so is a long hedge.
2. When the producer promises to sell without a price guarantee, this is the classical situation. The producer is exposed to price decreases; i.e., the underlying position is effectively a long position. The hedge is a short futures contract and so the hedge is a short hedge.

To summarize:

• Producer will sell in future at predetermined price ($3.00): underlying position is effectively short, such that the appropriate hedge is a long hedge
• Producer will sell in future at prevailing price: underlying position is effectively long, such that the appropriate hedge is a short hedge.

.. I can see that an issue is the potential ambiguity of "underlying exposure" which can be read two different ways. This is why I am changing this to "underlying position is effectively ... ". Sorry for the confusion, I hope this makes sense!

• Are you differentiating the underling position by "expressing view"? I am just trying to find another way to help myself understand better. This part has always been hard for me. If seller sells in future at predetermined price, he is betting against price increase which is a short view whereas if he sells at future spot price, he is betting in favor of price increase which is a long view? Is this how should read it?

• Then, the first scenario, long hedge of futures position at delivery price of 3 will earns a profit of 1.5, but that profit has not been realized, am i not on the right track?

• For the 2nd scenario, why is it when seller is selling and underlying position is long and effective hedge is short?

Some of the questions maybe very conceptual and fundamental, just trying to clarify if I am understanding it correctly.

 

[David Harper CFA FRM]

HI @ziminli1228

• Yes, exactly. Imagine you are the producer. If you are very confident the future spot price will be high, you do not want to guarantee the future sale at only $3.00. If you are confident the future spot price will be low (e.g., $1.50), you do want to guarantee the future sale at $3.00. So by guaranteeing, you are expressing a pessimistic opinion of the future spot price. In regard to this "underlying exposure," to guarantee the future sale price is to effectively enter a short forward contract with the customer. The analogy here perhaps is the Metallgesellschaft case study (topic 1) https://en.wikipedia.org/wiki/Metallgesellschaft. The company guaranteed long-term forward (not exchanged-traded) contracts (i.e., promised to sell oil at a predetermined price) with customers. And hedged this exposure with short-term, futures (exchanged-traded) contracts that were "rolled."
• The futures contract can be closed out for a profit. At the time of delivery to the customer, per the short forward contract (e.g., promise to sell at $3.00 in the future) the producer will collect $3.00. Then separately she/he can close out the long futures contract for a gain of S(t) - $3.00, assuming delivery, K = $3.00. Let's assume the producer will need to purchase the commodity for delivery, so it will cost -S(t). The net profit to producer is then -S(t) + [S(t) - $3.00] + $3.00 = zero profit. The producer does not need to hedge here; the point is to identify the critical difference between a "planned future sale at future market price" versus a short forward exposure (arrangement to sell at predetermined price). If the producer is pessimistic about the future spot price, it is better to simply leave the short forward arrangement alone; i.e., guarantee the collection of $3.00 and "risk" forgoing a higher spot price. But if the producer does this, then the net profit = -S(t) + $3.00 which could be negative. You can argue that the scenario is not even a natural candidate for the futures contract.
• If the producer is confident the future spot price will increase, she would prefer to avoid the $3.00 guarantee and instead wants to sell at the future spot price which she expects to be higher; she does not prefer this arrangement if she is pessimistic about the future spot price. In this sense, the arrangement reflects a positive view about the underlying. The hedge is a short hedge because the risk here is that the future spot price declines, and so the short futures contract produces a gain to offset. While the former scenario is more natural, I think, if the producer expects to purchase the commodity as inventory in the future, this scenario may be more natural if the producer is currently producing the commodity and "carrying" to delivery. It's very situational. The more critical idea is this latter idea: that producers with plans to sell in the future at the then-prevailing (not predetermined) spot price are natural candidates for short hedges; and buyers will plans to buy in the future at the future spot price are more natural candidates for long hedges, where long/short hedge simply means long/short futures contract that does the hedging. I hope that's helpful. Thanks!