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  • The selling hedge - an example

     
     

    A party holding unsold stocks of a commodity - a producer, exporter, processor or importer/dealer - is interested in safeguarding against the risk that the price may fall. This risk is offset by a forward sale of a corresponding tonnage on the futures market: the short or selling hedge. If prices decline, long holders would lose on the physical coffee they own. However, they would be compensated by profits made at the exchange because the futures contract would have been bought back at a lower price as well. This relies on the assumption, usually accurate, that futures prices also decline when physical prices fall.

    A straightforward example (see below) would be that of an exporter in Guatemala who on 15 September buys 1,000 bags of prime washed arabica coffee ready for shipment in October. As there may be no buyers on that day willing to pay their asking price (FOB), the exporter sells four lots of the New York 'C' December position instead. They do this because the price obtainable is equivalent to their asking price for the physical coffee. If the market for the physical coffee goes down, they will protect themselves from the lower price they may eventually have to sell at, by simultaneously buying in their short sale of New York 'C' December. Should the market go up, they will make up their loss on the December futures by the higher price they will receive when they sell the 1,000 bags of physical coffee - assuming that the prices for futures and the physical coffee move in tandem.
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    EXAMPLE

    The market goes down

    Physical transaction:

    15 September: Exporter buys 1,000 bags of 152 lb each from grower @ US$ 0.82/lb
    30 October: Exporter sells 1,000 bags @ US$ 0.81/lb

    Loss of $0.01/lb on 152,000 lb = (US$ 1,520)

    Futures transaction:


    15 September: Exporter sells 4 lots December 'C' (150,000 lb) @ US$ 0.92/lb
    30 October: Exporter buys 4 lots December 'C' (150,000 lb) @ US$ 0.90/lb

    Profit of 200 points x 4 lots or $0.02/lb = US$ 3,000

    Gross profit before commissions = US$ 1,480
     

    The market goes up

    Physical transaction:

    September 15: Exporter buys 1,000 bags of 152 lb each from grower @ US$ 0.82/lb
    30 October: Exporter sells 1,000 bags @ US$ 0.85/lb

    Profit of $0.03/lb on 152,000 lb = US$ 4,560

    Futures transaction:

    15 September: Exporter sells 4 lots December 'C' (150,000 lb) @ US$ 0.92/lb
    30 October: Exporter buys 4 lots December 'C' (150,000 lb) @ US$ 0.94/lb

    Loss of 200 points x 4 lots or $0.02/lb = (US$ 3,000)

    Gross profit before commissions = US$ 1,560
    ......................................................................

    NB: Most countries in Latin America use bags of 69 kg although bags of 46 kg and 75 kg are also seen. Brazil and most Asian and African countries use 60 kg bags. All ICO statistics are expressed in 60 kg bags equivalent though.

    Differentials usually tend to be lower when futures prices are high, and higher when futures are low. A differential of 'plus 10' on arabica when the 'C' contract is at 60 cts/lb may change to 'even money' in the producing country when the 'C' for example goes to 120 cts/lb. This is favourable for exporters who need to buy physicals against a PTBF sale because when they fix the purchase the physicals will only cost 'even money'. A differential of 'minus 50' on robusta when LIFFE is at 700 US$/ton may perhaps change to 'even money' in the producing country when London goes to 500 US$/ton.

    This is unfavourable for exporters who need to buy physicals against a PTBF sale because when they fix the purchase the physicals will cost 'even money' against an open sale of 'minus 50'. For more on PTBF, see 09.02.

    But differentials in producing countries may also buck the general market trend, for example because of drought or other production problems.

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