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!

 

[DMira8572]

Hi

so to summarise, Future Long and future short is hedging tool, Forward shot is agreed contract to just lock the price. When you have forward short position you do not have to hedge as it is a mechanism used only to lock the price. but as precautionary measure you have taken necessary step if the prices go up to buy Long Future and if the prices go down short future. this eliminates pricing risk Am I correct in my understanding?

 

[Clay Carter]

Hi

so to summarise, Future Long and future short is hedging tool, Forward shot is agreed contract to just lock the price. When you have forward short position you do not have to hedge as it is a mechanism used only to lock the price. but as precautionary measure you have taken necessary step if the prices go up to buy Long Future and if the prices go down short future. this eliminates pricing risk Am I correct in my understanding?

@DMira8572 Let me break this down:

1. "Forward short is an agreed contract to just lock the price" - Correct
2. "When you have a forward short position you do not have to hedge" - Correct if your goal is simply price uncertainty
3. "But as precautionary measure you have taken necessary step if the prices go up to buy Long Future and if the prices go down short future" - Not exactly

-If you’re already short a forward, you’ve locked in the price. You don’t hedge that unless you're trying to undo or balance the price lock.
-If you’re not yet contracted, and you're worried about price falling, you short futures to hedge.
-If you’re worried about price rising (as a buyer), you go long futures to hedge.

 

[DMira8572]

Thank you @Clay Carter

got confused

so if seller is in the market to sell the coffee bean, he locks the price by getting into forward contract

but he also buys long future thinking the prices could go up and he can make profit of it.

so the transaction is net off between forward and futures? so this creates transaction buy, sell and profit/loss? is this hedged? did I get this wrong?

 

[Clay Carter]

@DMira8572 Think about it this way,

If the coffee producer sells forward at a predetermined price, like $3.00, they’ve already locked in the sale price, so no hedge is strictly needed to manage price risk, the forward contract itself eliminates uncertainty. However, if the producer wants to protect against the opportunity cost of rising prices (say they regret locking in $3.00 if the spot price jumps to $5.00), they might enter a long futures position. That long futures trade isn’t really a "hedge" in the pure risk management sense; it’s more like speculating to offset potential regret. In fact, if you’re long a forward contract to sell (short the underlying exposure) and you go long a futures contract at the same price, the gains and losses can cancel each other out at maturity, so you’ve effectively neutralized your exposure, but that’s not traditional hedging, it’s more like unwinding the short exposure you created with the forward.

In summary:

• Forward contract = locks in the price (you don’t need to hedge if you’re happy with the lock-in).
• Futures contracts = hedging tools, but using them on top of a forward contract changes your exposure, possibly turning it into speculation or an attempt to "reverse" part of your forward position. So, yes—buying futures after locking in a forward price creates additional trades (buy/sell and profit/loss), but it’s not necessary for hedging if you’re already fully contracted through the forward. It’s all about what risk or opportunity you want to manage!

 

[DMira8572]

That make sense, thank you @Clay Carter

so I can go long futures considering that in future the spot price will be $5 and I do not want to regret that I sold the physical asset at $3. so I bet $5

So the entry will be sale of physical asset $3 through forward contract and second entry $5 buying of the future. so Profit entry $2. is that correct?

 

[Clay Carter]

@DMira8572 If the coffee producer locks in a sale at $3.00 with a forward contract, they've guaranteed that price, so they no longer face price risk on the sale itself. However, if they believe the spot price might go to $5.00, they could enter a long futures position to capture the upside. In that case, the futures position will generate a gain of $2.00 per pound because the futures would have been bought at $3.00 and settled at $5.00. So yes, the futures profit is $2.00, and when combined with the forward sale at $3.00, the producer effectively realizes $5.00 total

The key here is that once the initial forward is a hedge because it eliminates price risk. However, the long futures position is not a hedge because it adds risk to the producer.

Here is what the cash flows look like:

• Forward sale: Receive $3.00 from customer (this is a price locked position)
• Futures gain: Receive $2.00 from the futures market (this was pretty much a bet)
• Total receipts: $5.00

I also want to throw in here that since they are a producer they probably make the whole $3 (minus the cost of production because they are not buying on the open market like a trader would) when they engage in the forward contract.

 

[DMira8572]

@DMira8572 If the coffee producer locks in a sale at $3.00 with a forward contract, they've guaranteed that price, so they no longer face price risk on the sale itself. However, if they believe the spot price might go to $5.00, they could enter a long futures position to capture the upside. In that case, the futures position will generate a gain of $2.00 per pound because the futures would have been bought at $3.00 and settled at $5.00. So yes, the futures profit is $2.00, and when combined with the forward sale at $3.00, the producer effectively realizes $5.00 total

The key here is that once the initial forward is a hedge because it eliminates price risk. However, the long futures position is not a hedge because it adds risk to the producer.

Here is what the cash flows look like:

• Forward sale: Receive $3.00 from customer (this is a price locked position)
• Futures gain: Receive $2.00 from the futures market (this was pretty much a bet)
• Total receipts: $5.00

I also want to throw in here that since they are a producer they probably make the whole $3 (minus the cost of production because they are not buying on the open market like a trader would) when they engage in the forward contract.

Thank you for your help. between trading and hedging it can get confusing. do you have any suggestions to avoid the confusion

 

[Clay Carter]

Thank you for your help. between trading and hedging it can get confusing. do you have any suggestions to avoid the confusion

@DMira8572 The best advice is to just take a minute and review what position is taking risk off the table and what position is putting more risk on the table!

 

[DMira8572]

sure, thank you @Clay Carter