Hedging Against Falling Rubber Prices using Rubber Futures

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Contents

Hedging Against Falling Rubber Prices using Rubber Futures

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

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

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

Rubber Futures Short Hedge Example

A rubber producer has just entered into a contract to sell 500,000 kilograms of rubber, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of rubber on the day of delivery. At the time of signing the agreement, spot price for rubber is JPY 133.00/kg while the price of rubber futures for delivery in 3 months’ time is JPY 130.00/kg.

To lock in the selling price at JPY 130.00/kg, the rubber producer can enter a short position in an appropriate number of TOCOM Rubber futures contracts. With each TOCOM Rubber futures contract covering 5,000 kilograms of rubber, the rubber producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the rubber producer will be able to sell the 500,000 kilograms of rubber at JPY 130.00/kg for a total amount of JPY 65,000,000. Let’s see how this is achieved by looking at scenarios in which the price of rubber makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rubber Spot Price Fell by 10% to JPY 119.70/kg on Delivery Date

As per the sales contract, the rubber producer will have to sell the rubber at only JPY 119.70/kg, resulting in a net sales proceeds of JPY 59,850,000.

By delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 119.70/kg. As the short futures position was entered at JPY 130.00/kg, it will have gained JPY 130.00 – JPY 119.70 = JPY 10.30 per kilogram. With 100 contracts covering a total of 500000 kilograms, the total gain from the short futures position is JPY 5,150,000

Together, the gain in the rubber futures market and the amount realised from the sales contract will total JPY 5,150,000 + JPY 59,850,000 = JPY 65,000,000. This amount is equivalent to selling 500,000 kilograms of rubber at JPY 130.00/kg.

Scenario #2: Rubber Spot Price Rose by 10% to JPY 146.30/kg on Delivery Date

With the increase in rubber price to JPY 146.30/kg, the rubber producer will be able to sell the 500,000 kilograms of rubber for a higher net sales proceeds of JPY 73,150,000.

However, as the short futures position was entered at a lower price of JPY 130.00/kg, it will have lost JPY 146.30 – JPY 130.00 = JPY 16.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms of rubber, the total loss from the short futures position is JPY 8,150,000.

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In the end, the higher sales proceeds is offset by the loss in the rubber futures market, resulting in a net proceeds of JPY 73,150,000 – JPY 8,150,000 = JPY 65,000,000. Again, this is the same amount that would be received by selling 500,000 kilograms of rubber at JPY 130.00/kg.

Risk/Reward Tradeoff

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

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Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Rubber Prices using Rubber Futures

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

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

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

Rubber Futures Long Hedge Example

A tire manufacturer will need to procure 500,000 kilograms of rubber in 3 months’ time. The prevailing spot price for rubber is JPY 133.00/kg while the price of rubber futures for delivery in 3 months’ time is JPY 130.00/kg. To hedge against a rise in rubber price, the tire manufacturer decided to lock in a future purchase price of JPY 130.00/kg by taking a long position in an appropriate number of TOCOM Rubber futures contracts. With each TOCOM Rubber futures contract covering 5000 kilograms of rubber, the tire manufacturer 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 tire manufacturer will be able to purchase the 500,000 kilograms of rubber at JPY 130.00/kg for a total amount of JPY 65,000,000. Let’s see how this is achieved by looking at scenarios in which the price of rubber makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rubber Spot Price Rose by 10% to JPY 146.30/kg on Delivery Date

With the increase in rubber price to JPY 146.30/kg, the tire manufacturer will now have to pay JPY 73,150,000 for the 500,000 kilograms of rubber. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 146.30/kg. As the long futures position was entered at a lower price of JPY 130.00/kg, it will have gained JPY 146.30 – JPY 130.00 = JPY 16.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms of rubber, the total gain from the long futures position is JPY 8,150,000.

In the end, the higher purchase price is offset by the gain in the rubber futures market, resulting in a net payment amount of JPY 73,150,000 – JPY 8,150,000 = JPY 65,000,000. This amount is equivalent to the amount payable when buying the 500,000 kilograms of rubber at JPY 130.00/kg.

Scenario #2: Rubber Spot Price Fell by 10% to JPY 119.70/kg on Delivery Date

With the spot price having fallen to JPY 119.70/kg, the tire manufacturer will only need to pay JPY 59,850,000 for the rubber. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the rubber futures price will have converged with the rubber spot price and will be equal to JPY 119.70/kg. As the long futures position was entered at JPY 130.00/kg, it will have lost JPY 130.00 – JPY 119.70 = JPY 10.30 per kilogram. With 100 contracts covering a total of 500,000 kilograms, the total loss from the long futures position is JPY 5,150,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rubber futures market and the net amount payable will be JPY 59,850,000 + JPY 5,150,000 = JPY 65,000,000. Once again, this amount is equivalent to buying 500,000 kilograms of rubber at JPY 130.00/kg.

Risk/Reward Tradeoff

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

Learn More About Rubber 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?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

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Effect of Dividends on Option Pricing

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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Using Futures to Hedge Against Shifts in Commodity Prices

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Producers and consumers of commodities use futures markets to protect against adverse price moves that could result in large financial losses. A producer of a commodity is at risk of prices moving lower while a consumer of a commodity is at risk of prices moving higher.

Hedging is an important tool when it comes to running a business from either of those perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price. A hedge will guaranty a producer a known price for their commodity output.

Advantages of Futures

Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers alike a mechanism with which to hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that closely reflect their risks. Additionally, futures contracts are liquid instruments, meaning there’s a lot of trading activity in them and they’re generally easy to buy and sell.

Aside from producers and consumers, speculators, traders, investors, and other market participants utilize these markets. The exchange requires those who hold long and short positions to post margin, which is a performance bond to cover potential losses.

Producers and consumers often receive special treatment on commodity exchanges. As hedgers, their margin rates are often lower than other market participants, who are trying to make money on trading, not protect against losses.

Reducing Risks

To hedge, it is necessary to take a futures position of approximately the same size—but opposite in price direction—from one’s own position. Therefore, a producer who is naturally long a commodity hedges by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer, who is acting as a short hedger.

A consumer who is naturally short a commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer, who is acting as a long hedger.

While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk. Producers and consumers who use futures markets to hedge transfer their price risk.

If someone holds the physical commodity, they assume the price risk for it as well as the costs associated with holding that commodity, including insurance and storage costs. The price of a commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures is higher than nearby futures prices.

When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity, they exchange price risk for basis risk, which is the risk that the difference in the cash price of the commodity and the futures price will diverge against them.

Futures exchanges have associations that act as clearing houses, which means they become the transaction partner of a trade. They match up buyer and seller, check their creditworthiness, and ensure each one is paid what they’re owed. Therefore the clearing houses help remove credit risk from the system.

A Drawback of Hedging With Futures

Hedging in the futures market isn’t perfect. For one thing, futures markets depend upon standardization. Commodity futures contracts require certain quantities to be delivered on set dates. For example, a futures contract for corn might entail a delivery of 5,000 bushels in December 2020. And sometimes quality—for example, the purity of precious metals—comes into play.

Hedgers sometimes produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures.

Alternatives to Futures Markets

Futures markets are not the only choice for hedgers. They can also use forwards and swaps to hedge. These markets entail principal-to-principal transactions—meaning no exchange is involved—with each party assuming the risks of the other. However, these tailor-made transactions may meet the specific needs of commodity consumers or producers better than standardized futures contracts can.

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