9.1.5-HEDGING AND OTHER OPERATIONS-THE BUYING HEDGE - AN EXAMPLE
The buying hedge - an example
Roasters may have customers who want to purchase a certain percentage of their requirements at a fixed price for monthly deliveries up to a year ahead. But it would be both economically and physically impractical to purchase spot green coffee and finance and warehouse it for that period of time, so the roaster's alternative is to buy futures positions for as far forward as necessary to cover the sale of the roasted coffee.
Thus, in covering their needs for green coffee in a general way by purchasing the various forward months on the exchange, the roaster is in a position to buy a specific growth and quantity of physical coffee as and when needed for roasting, to fulfil their spread sale of roasted coffee. Upon purchasing the actual coffee they require, they then either sell out their position on the exchange or tender it as an 'AA' (against actuals) through the exchange with the agreement of the dealer from whom they are purchasing the physicals.
The dealer or importer who has sold forward a spread of up to 12 monthly deliveries to a roaster can purchase the various trading months of the futures contract to protect their sale until they are able to buy the physical coffee to be delivered against the forward sale. Once physical coffee is purchased, they sell back that part of their long position in futures on the exchange. As in the selling hedge, both parties have protected their price risk, regardless of market fluctuations up or down.
demonstrates how the buying hedge should work.
On 2 January, a roaster sells roasted coffee equivalent to 500 bags arabica coffee per month, February through to January at the (fixed) price of US$ 0.93/lb (GBE - green bean equivalent). They now protect their price by simultaneously buying the monthly positions of the 'C' contract as follows:
5 lots (1,250 bags) of March @ US$ 0.88/lb
5 lots (1,250 bags) of May @ US$ 0.90/lb
5 lots (1,250 bags) of July @ US$ 0.92/lb
5 lots (1,250 bags) of September @ US$ 0.94/lb
4 lots (1,000 bags) of December @ US$ 0.96/lb
i.e. 24 lots (6,000 bags) at an average of 91.83 cts/lb or 1.17 cts/lb below the selling price.
With this activity the roaster has immediately hedged most of the price risk involved. They can now deal with the purchase of the physical coffee at their convenience by periodically buying physicals to roast and ship to their customer, while simultaneously selling the corresponding amount of futures.
For example, on 1 February, they buy 1,250 bags of spot milds at US$ 0.90/lb, and simultaneously sell the five lots of March 'C' at US$ 0.90/lb. They apply their profit of 2 cents from the sale of the 'C' to lower the cost of their physical purchase to US$ 0.88/lb. On 1 April, they buy 1,250 bags of spot milds at US$ 0.89/lb and sell the five lots of May 'C' at US$ 0.89/lb. They apply the 1-cent loss from the 'C' sale to the cost of their physical purchase, resulting in a price of US$ 0.90/lb. And so on.
The roaster continues to buy in the approved physicals of their choice as needed, whether 250 bags at a time or 1,250 bags at once, and sells out the equivalent futures. Their hedging objective is to maintain their average differential of 1.17 cts/lb or better on the purchase of their physical coffee compared to their position on the futures market.
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