Short Hedge

[AbhishekJha]

Hi,

In Chapter 8, definition of short hedge is given as - "A short forward or futures hedge is an agreement to sell in the future and is suitable for a hedger who owns (or will own) an asset that needs to be sold in the future. The classic example is a farmer who wants to lock in the sales price of a crop, for example, corn, so as to protect against its price decline. By owning the crop, the farmer effectively has a long position in corn". To offset the exposure or risk in this long position, the farmer enters into a corresponding short position, which is exactly what a short hedge accomplishes.


Question 1 : How does owning the crop or any commodity imply that Farmer has a Long Position by default? I understand in the example given with the definition, farmer will owm a Crop and hence he would like to hedge the Price in future which explains why he would like to get into a Short hedge however i want to understand how does simply owning a crop mean that someone has effectively a long position in that commodity?

In the same context there is an example provided - "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 this 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."

Question 2 : In the above example, since the coffee producer already has a contract to sell coffee for $3.00 to a key customer(his selling price is locked at $3.00). I donot understand why this coffee producer should take a long position in this instance to cover the Price increase in the spot rate for Future(in 1 year's time that is) .
His Price for selling the Coffee is already locked at $3.00 with his key customer.

So, why would he need to hedge this contract by getting a Long future? His Price at $3.00 is locked and he is a coffee producer himself so whether price increases or decreases in future , he does NOT have to buy it in the market to provide it to his customer. He needs to lock in his price in 1 years time which he has done at $3.00 so what is the need for a long position here.
If the Price increases say to 5.00 how does it help the farmer have a long position here? If he wants to sell at 5.00, he will have to pay the 5.00 to buy it first so what is he achieving by getting into a long position with futures in this instance?
Could you help explain this with a simple explanation and with some details Plz.

Note : For the 2nd question, there is some explanation already provided in another thread however I didnot quiet understand the explanation there. It was bit confusing after having read the entire thread. Hence I have added this question as a new Post . The Thread I am referring to is https://forum.bionicturtle.com/threads/short-hedge-long-hedge.22341/#post-75291


Thanks,
Abhishek

 

[Lu Shu Kai FRM]

Hi @AbhishekJha ,

Question 1 : How does owning the crop or any commodity imply that Farmer has a Long Position by default? I understand in the example given with the definition, farmer will owm a Crop and hence he would like to hedge the Price in future which explains why he would like to get into a Short hedge however i want to understand how does simply owning a crop mean that someone has effectively a long position in that commodity?
- The definition of a long position means to own the asset; I don't understand what is your confusion here.

Question 2 : In the above example, since the coffee producer already has a contract to sell coffee for $3.00 to a key customer(his selling price is locked at $3.00). I donot understand why this coffee producer should take a long position in this instance to cover the Price increase in the spot rate for Future(in 1 year's time that is) .
His Price for selling the Coffee is already locked at $3.00 with his key customer.
- This is a different situation. In here, the selling price is predetermined at $3 and you are afraid of the price increasing because you could have sold it for more (if you did not pre-agree on a price of $3). This is why you enter into a long hedge/position.

 

[David Harper CFA FRM]

Hi @AbhishekJha

I agree with @lushukai about Question 1: we can be long the future contract, but we can also be long the (commodity) and we can also say this "long the spot price" or "long the cash commodity" but they both refer to owning the commodity (versus being long the futures contract on the commodity which is not ownership) and is therefore to "be long" the spot price (e.g., spot price goes up and our asset value increases).

You question about Question 2 is good because the coffee producer does not need to hedge in this situation. We are just illustrating what the hedge would be, if he/she hedged. The hedge here is tricky because, as Lu Shu suggests, it's really just a (highly optional and probably not very desirable!) hedge against the opportunity cost of selling at a higher price. It depends on whether the producer's future costs (inputs, raw materials) are correlated to the future spot price. So You have a good point. Realistically, in this pure scenario, the producer probably does not hedge. But the implicit assumption is that the coffee producer's input costs are correlated: although he has a predetermined sale price of $3.00, if the price goes up to $5.00, then the use of hedge implies that his costs go up such that, in the future, selling at $3.00 might actually be unprofitable; conversely, the implicit assumption that a lower future spot price implies input costs/raw materials go down.

The Metallgesellschaft case is not a perfect analog ...

"Metallgesellschaft—How a Dynamic Hedging Strategy Can Go Wrong: MGRM was a U.S. subsidiary of Metallgesellschaft AG, an industrial conglomerate based in Frankfurt, Germany. In 1993, MGRM entered into long-term, fixed-price contracts to deliver oil products (primarily gasoline and heating oil) to end-user customers. Because MGRM could not change its prices after these contracts were signed, it was exposed to the risk of rising energy prices. Lacking a liquid market for appropriate long-term futures contracts would allow it to hedge its price risk, MGRM implemented a dynamic hedging strategy that used short-dated energy futures contracts. This strategy required that the hedging instruments (i.e., the futures contracts) be “rolled forward” each month as they expired. The derivative position was adjusted monthly to reflect the changing amount of outstanding contracts to be hedged in order to preserve a one-to-one hedge. “Such a strategy is neither inherently unprofitable nor fatally flawed, provided top management understands the pro-gram and the long-term funding commitments necessary to make it work,” according to Culp and Miller (1995)." -- May, Bill. 2020 Financial Risk Management Part I: Foundations of Risk Management, 10th Edition. Pearson Learning Solutions, 2019. VitalBook file.

... but notice how the underlying exposure is a long-term contract to sell oil at a fixed price such that the hedge was long positions short-term futures contracts. Thanks,