Hedging Against Falling Corn Prices using Corn Futures

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Contents

Hedging Against Falling Corn Prices using Corn Futures

Corn producers can hedge against falling corn price by taking up a position in the corn futures market.

Corn producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of corn that is only ready for sale sometime in the future.

To implement the short hedge, corn producers sell (short) enough corn futures contracts in the futures market to cover the quantity of corn to be produced.

Corn Futures Short Hedge Example

A corn grower has just entered into a contract to sell 5,000 tonnes of corn, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of corn on the day of delivery. At the time of signing the agreement, spot price for corn is EUR 129.25/ton while the price of corn futures for delivery in 3 months’ time is EUR 130.00/ton.

To lock in the selling price at EUR 130.00/ton, the corn grower can enter a short position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the corn grower will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the corn grower will be able to sell the 5,000 tonnes of corn at EUR 130.00/ton for a total amount of EUR 650,000. Let’s see how this is achieved by looking at scenarios in which the price of corn makes a significant move either upwards or downwards by delivery date.

Scenario #1: Corn Spot Price Fell by 10% to EUR 116.33/ton on Delivery Date

As per the sales contract, the corn grower will have to sell the corn at only EUR 116.33/ton, resulting in a net sales proceeds of EUR 581,625.

By delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 116.33/ton. As the short futures position was entered at EUR 130.00/ton, it will have gained EUR 130.00 – EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5000 tonnes, the total gain from the short futures position is EUR 68,375

Together, the gain in the corn futures market and the amount realised from the sales contract will total EUR 68,375 + EUR 581,625 = EUR 650,000. This amount is equivalent to selling 5,000 tonnes of corn at EUR 130.00/ton.

Scenario #2: Corn Spot Price Rose by 10% to EUR 142.18/ton on Delivery Date

With the increase in corn price to EUR 142.18/ton, the corn producer will be able to sell the 5,000 tonnes of corn for a higher net sales proceeds of EUR 710,875.

However, as the short futures position was entered at a lower price of EUR 130.00/ton, it will have lost EUR 142.18 – EUR 130.00 = EUR 12.18 per tonne. With 100 contracts covering a total of 5,000 tonnes of corn, the total loss from the short futures position is EUR 60,875.

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In the end, the higher sales proceeds is offset by the loss in the corn futures market, resulting in a net proceeds of EUR 710,875 – EUR 60,875 = EUR 650,000. Again, this is the same amount that would be received by selling 5,000 tonnes of corn at EUR 130.00/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the corn seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling corn prices while still be able to benefit from a rise in corn price is to buy corn put options.

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Hedging Against Rising Corn Prices using Corn Futures

Businesses that need to buy significant quantities of corn can hedge against rising corn price by taking up a position in the corn futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of corn that they will require sometime in the future.

To implement the long hedge, enough corn futures are to be purchased to cover the quantity of corn required by the business operator.

Corn Futures Long Hedge Example

An ethanol producer will need to procure 5,000 tonnes of corn in 3 months’ time. The prevailing spot price for corn is EUR 129.25/ton while the price of corn futures for delivery in 3 months’ time is EUR 130.00/ton. To hedge against a rise in corn price, the ethanol producer decided to lock in a future purchase price of EUR 130.00/ton by taking a long position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the ethanol producer will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the ethanol producer will be able to purchase the 5,000 tonnes of corn at EUR 130.00/ton for a total amount of EUR 650,000. Let’s see how this is achieved by looking at scenarios in which the price of corn makes a significant move either upwards or downwards by delivery date.

Scenario #1: Corn Spot Price Rose by 10% to EUR 142.18/ton on Delivery Date

With the increase in corn price to EUR 142.18/ton, the ethanol producer will now have to pay EUR 710,875 for the 5,000 tonnes of corn. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 142.18/ton. As the long futures position was entered at a lower price of EUR 130.00/ton, it will have gained EUR 142.18 – EUR 130.00 = EUR 12.18 per tonne. With 100 contracts covering a total of 5,000 tonnes of corn, the total gain from the long futures position is EUR 60,875.

In the end, the higher purchase price is offset by the gain in the corn futures market, resulting in a net payment amount of EUR 710,875 – EUR 60,875 = EUR 650,000. This amount is equivalent to the amount payable when buying the 5,000 tonnes of corn at EUR 130.00/ton.

Scenario #2: Corn Spot Price Fell by 10% to EUR 116.33/ton on Delivery Date

With the spot price having fallen to EUR 116.33/ton, the ethanol producer will only need to pay EUR 581,625 for the corn. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 116.33/ton. As the long futures position was entered at EUR 130.00/ton, it will have lost EUR 130.00 – EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5,000 tonnes, the total loss from the long futures position is EUR 68,375

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the corn futures market and the net amount payable will be EUR 581,625 + EUR 68,375 = EUR 650,000. Once again, this amount is equivalent to buying 5,000 tonnes of corn at EUR 130.00/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the corn buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising corn prices while still be able to benefit from a fall in corn price is to buy corn call options.

Learn More About Corn Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

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Investing in Growth Stocks using LEAPS® options

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Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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How Are Futures Used to Hedge a Position?

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.

The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead. Here, we dig a little bit deeper into using futures to hedge.

Key Takeaways

  • Futures contracts allow producers, consumer, and investors to hedge certain market risks.
  • For instance, a farmer planting wheat today may sell a wheat futures contract now. He will then buy it back come harvest when he sells his wheat – effectively locking in today’s price and hedging away market fluctuations between planting and harvest.
  • Because futures contracts often require actual delivery of the underlying at expiration, hedgers must be sure to exit or roll over positions before expiry.

Using Futures Contracts to Hedge

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company’s risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

Sometimes, if a commodity to be hedged is not available as a futures contract, an investor will instead seek out a futures contract in something that closely follows the movements of that commodity, for example buying wheat futures to hedge the production of barley.

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