Suppose that you are a silver fabricator. You will acquire 2,000,000 troy ounces

Question

Suppose that you are a silver fabricator. You will acquire 2,000,000 troy ounces of silver at the prevailing market price on December, 2017, from your long-time business partner. But, you worry about the uncertainty in the market price of silver in the future. Hence, you decide to use Globex (“online”) silver future contracts to hedge risk. You will place an order of silver future contracts at the last day closing price of the date when you enter into the futures contracts at the last day closing price of the date when you enter into the future contracts. 1. Which type of hedge, between short and long, has to be used? 2. What is the contract size of the silver futures per one contract? How many contracts do you have to trade? 3. State the date you enter into the silver futures contract and future price (last closing price) that you determined. Attach the snapshot of the price listing. See an example. 4. Assume that both the spot and future prices in december $11 per ounce. Find out profits of the unhedged spot position, future position and hedged position (hedged position = unhedged spot position + future position) 5. Assume that both the spot and future prices in december are $16 per ounce. Find out profits of the unhedged spot position, future position and hedged position. 6. Discuss the effectiveness of your hedged. 7. Now, suppose that you don’t have to acquire 2,000,000 ounces of silver from your business partner at the spot market in july. You will directly use the silver future market to acquire silver and to hedge price risk. Determine the cost to acquire silver and to hedge price risk. Determine the cost to acquire silver of 2,000,000 ounces. Explain this hedge and compare with the hedged in (1) ~ (5). Please show step by step

Explanation / Answer

Since we will be acquiring (purchasing) 2,000,000 troy ounces of silver in the month of December we are prone to risk that the price of Silver will increase and thus we will end up paying more. To hedge our risk we need to buy silver futures contract. This is an example of long hedge where by buying the silver futures contract we are effectively locking in a price.

The contract size of one “Globex” silver futures contract is 1000 troy ounces. Thus we would need to buy (2,000,000/1000) = 2000 contracts.

On 11/17/2017 the price of the December Silver futures contract $ 17.12 per troy ounce.

In a long hedge trade we are short the physical commodity and long the futures contract. Thus, we are short silver in the spot market, and long silver in the futures market.

So the question says that price of Silver in December drops to $ 11. In that case:

Unhedged Spot Position: Since we are short silver in the spot market a price drop will be beneficial to us. Hence, our hypothetical profit will be:

                                                              (17.2-11)×2,000,000=$ 12,400,000.00

Futures Position: Since we are long in the silver futures a rise in silver prices will lead to loss. So our loss will be:

                                                     (11-17.2)×2000 (contracts)×1000 (contract size)=- $ 12,400,000.00

Hedge Position: Unhedged Spot Position+ Futures Position

                                           =$ 12,400,000.00+- $ 12,400,000.00=0

In a hedged position there is no profit or loss as we have locked in a price of Silver at $ 17.2.

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