Predetermined Future Price

[y2alk]

Hi all,

Excerpt from notes:
Consider two scenarios for a coffee producer that plans to sell 100 pounds of coffee on a
future date:
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
If the coffee producer wants to hedge with coffee futures, is the hedge the same for both?
No, they are different!
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 exposes 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.

Apart from the earlier pointed out typo, I have the below query

I have always been under the assumption that if the underlying exposure is short then the hedge instrument should be long but here i see you have made a distinction. I don't understand how you say producer is exposed to future spot price increase(in scenario 1) or decrease(in scenario 2)?

 

[jairamjana]

You must have noticed that key difference between first and second scenario is that price is fixed in scenario 1. So whether prices of coffee move up or down we are gonna sell at 3$ . As a seller you will be fearing an increase in coffee prices above 3$ , so the coffee producer might buy futures contracts. Then, if the price of coffee increases, the coffee futures price also will increase and produce a profit on the futures position. (Long hedge)
In scenario 2 coffee will be sold at the future spot price.. So really speaking whether the future spot price go up or down we will sell at this unknown price.. So obviously a decrease in future spot price compared to the current spot price will lead to a loss since we will be contractually bound to sell at the decreased future spot price .. So short Position in futures will be best. if the spot price decreases, the futures price also will decrease. Since the hedger is short the futures contract, the futures transaction produces a profit that at least partially offsets the loss on the spot position.(short hedge)..
The key point is that the direction of price that leads to a loss, the determines your hedge position.. Hope it's clear.

P.S .. I will try to put the ideas of hedging mathematically
∏ (short hedge profit) = (S(t) - S(0)) + (F(0) - F(t))
∏ (long hedge profit) = (S(0) - S(t)) + ((F(t) - F(0))

Scenario 1 we will use the 2nd formula and for convenience sake since we don't know price S(0) .. we will assume 0 and S(t) is 3$ so it becomes
∏ (long hedge) = - 3 + ((F(t) - F(0))
For a profit we would need F(t) > F(0) ( F(t) - F(0) > 3 in this case only since we assumed S(0) = 0.. If S(0) is > 0.. The difference should be less than 3..)

For Scenario 2
∏ (short hedge profit) = (S(t) - S(0)) + (F(0) - F(t))
Just see that if S(0) < S(t) future stock should decrease and check for yourself.

 

[y2alk]

Thanks @jairamjana.

I totally agree with you on scenario 1 but the reason I got confused with Scenario 2 is because at maturity the future price and spot price would converge and be the same so why hedge?

 

[jairamjana]

Not really if that were the cases basis risk would not exist..
Basis at expiration = S(T) - F(T)
Though hedging might not always bear fruit if it converges eventually.. But the risk always exists..

SHORT HEDGE BASIS SCENARIOS

Spot price rises more than futures price rises
or
Spot price falls less than futures price falls
or
Spot price rises and futures price falls​

 

[y2alk]

Thanks @jairamjana

I was just considering perfect hedge situation.

 

[jairamjana]

In a perfect hedge you lose nothing and you gain nothing.. Its rare though in real life.. Even though future and spot prices move together.. Basis risk might factor in and make the hedge nearly perfect..
Doing nothing according to your argument means you will lose definitely if price falls.. Perfect hedge and going naked are opposites..

 

[srini]

In the text( attached as image),

"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."

In the first scenario, the producer is exposed to a future spot price increase, so enters into long position for a price @ $3.00 per pound thereby if price increases, the long position offset.

"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"

"In the second scenario, the producer is exposes 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."

Isn't these two positions short position and hedge for those positions would be long position. Why is the text says the hedge for the second scenario is long position.

Could someone please clarify on this?

 

[Nicole Seaman]

In the text( attached as image),

"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."

In the first scenario, the producer is exposed to a future spot price increase, so enters into long position for a price @ $3.00 per pound thereby if price increases, the long position offset.

"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"

"In the second scenario, the producer is exposes 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."

Isn't these two positions short position and hedge for those positions would be long position. Why is the text says the hedge for the second scenario is long position.

Could someone please clarify on this?

View attachment 1016

Hello @ksrini,

Please note that I moved your post to this thread, where this question is already being discussed. There is a search box in the upper right corner of the forum, where you can search to find out if a question has already been answered

Thank you,

Nicole

 

[David Harper CFA FRM]

Hi @ksrini Both scenarios concern a commodity producer with plans to sell in the future, they have this is common. The key difference is whether the producer locks-in the future sales price. Our typical scenario is the producer (e.g., a corn farmer) in the second case above who will be selling at the prevailing market price in the future, which is currently unknown. This is a seller whose exposure is price risk but specifically who is exposed to a price drop because she/he will be receiving a lower price. The hedge here is short hedge; i.e., a futures contract that will compensate in the downside scenario of a price decline.

Contrast with the first scenario. This is a also a producer who will be selling in the future, but crucially, this seller has locked-in the future sale price. There is an implicit unstated assumption here: the producer has variable input costs and also opportunity costs: if the agreed-upon price to sell is $3.00, but imagine the spot price increases to $4.00; in such a future, the producer regrets locking in the lower price! The price risk here is actually an increase in the spot, such that the hedge is a long hedge; ie, a futures contract that profits if the price increases. I hope that clarifies, thanks!

 

[srini]

thank you

 

[[email protected]]

A key difference: is the future price predetermined?

Consider two scenarios for a coffee producer that plans to sell 100 pounds of coffee on a future date:
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

If the coffee producer wants to hedge with coffee futures, is the hedge the same for both?
No, they are different!

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 exposes 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.

I do not necessarily understand how the hedge is a long position or short position?
The idea in both the cases is to hedge against market price movements. Then how one is long and other is short hedge position?

 

[David Harper CFA FRM]

@[email protected] I moved your question to this recent thread. "Long hedge" and "short hedge" are (simply) names given to the hedge trade; e.g., if the hedge trade is a short futures contract, then it's called a "short hedge." I like to remind that we have two things: 1. an exposure (in this case price risk of the underlying contract with the customer); and 2. a hedge trade (position). You are correct that, in both scenarios, the market risk is a price movement. In scenario #1, the underlying risk (i.e., the bad thing that could happen), given that the future sale price is predtermined, is that the future spot price increases (because the coffee producer will be "stuck" selling at the lower, promised price). The hedge here is a long futures contract, so it's called a "long hedge." In scenario #2, the price risk is the opposite direction: if the price is not pre-promised, then a future spot price is a good thing for the coffee producer, and the future spot price decrease will be the bad thing (the risk). So the risk is in a different direction, and in scenario #2, the coffee producer wants a "short hedge" in case prices go down in the future. I hope that clarifies!