4. Hedging strategy to protect against falling prices Price fluctuations in comm

Question

4. Hedging strategy to protect against falling prices Price fluctuations in commodities can have significant consequences for companies, especially if the fluctuation involves a prime raw material for a company. Different companies will adopt different strategies to manage the risk in price fluctuations, including adjusting the timing of their commodity purchases, maintaining a safety stock of their raw materials, and hedging Consider the case of Green Catepillar Garden Supplies Inc., a large copper-producing company: The company's cost of producing copper is about $3.25 per pound. The current market price for copper is $3.90 per pound. The six-month futures price for copper is $4.06 per pound. At this selling price, the company can maintain its earnings growth. The company expects to produce 750,000 pounds of copper in this six months. (Note: Copper futures are traded at a standard size of 250,000 pounds.) at the If the company does not hedge the copper it produces, it can expect to earn a total revenue of end of six months. If Green Catepillar places a hedge on its copper production in the futures market, it would delivery in six months at a delivery price of $4.06 per pound to generate profits that maintain its desired earnings growth contracts for When the contract comes due in six months, the spot price of copper is $2.76 per pound in the cash markets. Prices on the new six-month futures contracts in copper are $3.45 per pound. Calculate the expected revenue in the following markets

Explanation / Answer

1. If the company does not hedge the copper it produces, it can expect to earn 487500 $ [(3.90-3.25)*750000] at the end of six month with current market condition.

2. If Green Catepillar places a hedge on its copper procution in the future market , it would sell 3 Contracts [750000/250000] for delivery in six months at a delivery price $ 4.06 per pound to generate profit that maintain its desired earning growth.

3.After 6 months in Cash Market =

It will sell at $ 2.76 but its production cost is 3.25 $ per pound of copper so its loss will be -367500 $ for 750000 pounds of copper.

But in Future market it will sell at contracted price $ 4.06 square up his position against spot $ 2.76 and in this process it will be able to generate gain for 4.06-2.76 = 1.3*3*250000= $ 975000

The cost of production of copper is $ 2,437,500. Thus Green Catepillar will Gain in the future market and Lost in the cash market.

This gain and loss offset each other, and the company benefit from placing the hedge. This hedging strategy would be referred to as Perfect hedge, and it helps protect the producer to sell a commodity against falling prices.

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