Commodity Futures:
Definition
Commodity Futures: Standardized contracts to buy or sell a specific commodity at a
predetermined price on a future date.
Traded on exchanges like the Chicago Mercantile Exchange (CME) or Intercontinental Exchange
(ICE).
Commodities include agricultural products (e.g., wheat, corn), energy (e.g., crude oil, natural
gas), and metals (e.g., gold, silver).
Key Features:
Standardization: Contracts specify quantity, quality, delivery time, and location.
Leverage: Traders post a margin (small percentage of contract value), amplifying potential
gains/losses.
Settlement:
Physical Delivery: Actual commodity delivered (rare for speculators).
Cash Settlement: Difference between contract and market price paid in cash.
Expiration: Contracts have set expiration dates (e.g., monthly or quarterly).
Participants:
Hedgers: Producers (e.g., farmers) or consumers (e.g., manufacturers) locking in prices to manage
risk.
Speculators: Traders betting on price movements for profit, providing liquidity.
Arbitrageurs: Exploit price discrepancies across markets.
Pricing Factors:
Spot Price: Current market price of the commodity.
Supply and Demand: Weather, geopolitical events, and economic conditions impact prices.
Storage Costs: Costs to store commodities (e.g., grain silos, oil tanks).
Contango: Futures price higher than spot price (normal for non-perishable commodities).
Backwardation: Futures price lower than spot price (often due to short-term shortages).
Benefits:
Price Discovery: Futures markets reflect expectations of future prices.
Risk Management: Hedgers mitigate price volatility.
Liquidity: High trading volumes ensure ease of entry/exit.
Risks:
Leverage Risk: Magnified losses if prices move adversely.
Market Risk: Unpredictable price swings due to external factors.
Margin Calls: Additional funds required if margin falls below maintenance level.
Example:
A farmer sells corn futures at $5/bushel for delivery in 6 months to lock in the price.
If market price drops to $4/bushel, the farmer benefits from the higher futures price.
A speculator buying the same contract profits if the price rises above $5.
Regulation:
Overseen by bodies like the Commodity Futures Trading Commission (CFTC) in the U.S.
Ensures transparency, prevents manipulation, and monitors position limits.
Common Contracts:
Agricultural: Corn, soybeans, wheat, coffee, sugar.
Energy: Crude oil (WTI, Brent), natural gas.
Metals: Gold, silver, copper.
Trading Considerations
Margin Requirements: Vary by commodity and exchange (e.g., 5-10% of contract value).
Contract Size: Standardized (e.g., 5,000 bushels for corn, 1,000 barrels for oil).
Tick Size: Minimum price movement (e.g., $0.25/ton for soybeans).
Volatility: Energy and metals often more volatile than agricultural commodities.
Hedging with Commodity Futures “
Introduction to Hedging with Commodity Futures
Hedging with commodity futures involves using futures contracts to reduce or manage the risk of
adverse price movements in the underlying commodity. It is primarily used by producers (e.g.,
farmers, miners) and consumers (e.g., manufacturers, refiners) to lock in prices and stabilize cash
flows. Below, we explore the concept, strategies, formulas, detailed examples, problems, and
solutions.
Key Concepts:
Hedging: Taking a position in the futures market opposite to a position in the physical commodity
market to offset price risk.
Futures Contract: A standardized agreement to buy or sell a commodity at a set price on a future
date, traded on exchanges like the CME or ICE.
Types of Hedges:
Short Hedge: Selling futures to protect against falling prices (used by producers).
Long Hedge: Buying futures to protect against rising prices (used by consumers).
Basis: Difference between the spot price (S) and futures price (F): Basis = S - F.
A hedge is effective if the basis remains stable or predictable.
Hedge Ratio: The proportion of the physical position hedged via futures, often adjusted for risk or
contract size.
Objectives of Hedging
Price Stability: Lock in prices to ensure predictable revenue or costs.
Risk Reduction: Mitigate losses from volatile commodity prices.
Planning: Enable better financial forecasting for businesses.
Hedging Mechanism
Identify Exposure: Determine the quantity and timing of the commodity at risk (e.g., a farmer’s
expected harvest).
Choose Futures Contract: Select a contract matching the commodity, quantity, and delivery date.
Take Opposite Position:
Producers sell futures (short hedge) to offset potential declines in spot prices.
Consumers buy futures (long hedge) to offset potential increases in spot prices.
Monitor Basis: Track changes in the basis to assess hedge effectiveness.
Close Position: Offset the futures position at or before expiration, typically via cash settlement or
opposite trade.
Key Formulas:
Futures Price (Theoretical):
F = S × e^(r + c - y) × t
Where:
S: Spot price
r: Risk-free interest rate
c: Storage cost
y: Convenience yield
t: Time to maturity
e: Base of natural logarithm (~2.718)
Basis:
Basis = S - F
A negative basis (S < F) indicates contango; a positive basis (S > F) indicates backwardation.
Hedge Ratio (HR):
HR = (Quantity to Hedge) / (Futures Contract Size)
Adjust for risk or correlation if needed (e.g., using beta or covariance).
Gain/Loss on Futures:
Gain/Loss = (Initial Futures Price - Final Ascertainable Price (Final Futures Price)) × Contract Size
Hedging Strategies
1. Short Hedge (Producers)
Purpose: Protect against falling commodity prices.
Example: A farmer expects to harvest 10,000 bushels of corn in 6 months and fears a price drop.
Steps:
a) Sell corn futures contracts to lock in a price.
b) If the spot price falls, the futures gain offsets the loss in the physical market.
c) If the spot price rises, the futures loss is offset by higher physical market revenue.
2. Long Hedge (Consumers)
Purpose: Protect against rising commodity prices.
Example: A food manufacturer needs 5,000 barrels of soybean oil in 3 months and fears a price
increase.
Steps:
Buy soybean oil futures to lock in a price.
If the spot price rises, the futures gain offsets the higher cost in the physical market.
If the spot price falls, the futures loss is offset by lower physical market costs.
Detailed : Problems and Solutions
Problem 1: Short Hedge (Farmer Hedging Corn)
Scenario: A farmer expects to harvest 15,000 bushels of corn in 6 months. The current spot price
is $5.50/bushel, and the 6-month futures price is $5.60/bushel (contango). Each corn futures
contract covers 5,000 bushels. The farmer wants to hedge 100% of the crop. Calculate the
effective selling price if, at harvest, the spot price is $5.20/bushel and the futures price is
$5.30/bushel.
Solution:
Determine Number of Contracts:
Quantity to Hedge = 15,000 bushels
Contract Size = 5,000 bushels
Number of Contracts = 15,000 / 5,000 = 3 contracts
Hedge Setup (Today):
Sell 3 corn futures contracts at $5.60/bushel.
Total value locked in: 3 × 5,000 × $5.60 = $84,000.
At Harvest (6 Months Later):
Spot price = $5.20/bushel.
Futures price = $5.30/bushel.
Sell physical corn: 15,000 × $5.20 = $78,000.
Buy back futures to close position: Gain/Loss = (Initial Price - Final Price) × Contract Size ×
Number of Contracts
Gain = ($5.60 - $5.30) × 5,000 × 3 = $0.30 × 15,000 = $4,500.
Effective Selling Price:
Total Revenue = Physical Sale + Futures Gain
= $78,000 + $4,500 = $82,500
Effective Price per Bushel = $82,500 / 15,000 = $5.50/bushel
Basis Analysis:
Initial Basis = S - F = $5.50 - $5.60 = -$0.10 (contango).
Final Basis = $5.20 - $5.30 = -$0.10.
The basis remained constant, ensuring a perfect hedge.
Answer: The farmer locks in an effective selling price of $5.50/bushel, protecting against the
$0.30/bushel price drop.
Problem 2: Long Hedge (Manufacturer Hedging Soybean Oil):
Scenario: A food manufacturer needs 10,000 barrels of soybean oil in 4 months. The current spot
price is $50/barrel, and the 4-month futures price is $51/barrel. Each soybean oil futures contract
covers 1,000 barrels. The manufacturer hedges 100% of the need. Calculate the effective
purchase price if, in 4 months, the spot price is $53/barrel and the futures price is $54/barrel.
Solution:
Determine Number of Contracts:
Quantity to Hedge = 10,000 barrels
Contract Size = 1,000 barrels
Number of Contracts = 10,000 / 1,000 = 10 contracts
Hedge Setup (Today):
Buy 10 soybean oil futures contracts at $51/barrel.
Total cost locked in: 10 × 1,000 × $51 = $510,000.
At Delivery (4 Months Later):
Spot price = $53/barrel.
Futures price = $54/barrel.
Buy physical soybean oil: 10,000 × $53 = $530,000.
Sell futures to close position: Gain/Loss = (Final Price - Initial Price) × Contract Size × Number of
Contracts
Gain = ($54 - $51) × 1,000 × 10 = $3 × 10,000 = $30,000.
Effective Purchase Price:
Total Cost = Physical Purchase - Futures Gain
= $530,000 - $30,000 = $500,000
Effective Price per Barrel = $500,000 / 10,000 = $50/barrel
Basis Analysis:
Initial Basis = $50 - $51 = -$1.
Final Basis = $53 - $54 = -$1.
The basis remained constant, ensuring a perfect hedge.
Answer: The manufacturer locks in an effective purchase price of $50/barrel, avoiding a $3/barrel
price increase.
Problem 3: Imperfect Hedge (Basis Risk)
Scenario: A wheat farmer expects to sell 20,000 bushels in 3 months. The spot price is
$7.00/bushel, and the 3-month futures price is $7.10/bushel. Each wheat futures contract covers
5,000 bushels. The farmer sells 4 futures contracts. At harvest, the spot price is $6.80/bushel, and
the futures price is $7.05/bushel. Calculate the effective selling price and explain the impact of
basis risk.
Solution:
Hedge Setup (Today):
Sell 4 contracts at $7.10/bushel.
Total value locked in: 4 × 5,000 × $7.10 = $142,000.
Hedged quantity: 4 × 5,000 = 20,000 bushels (100% hedge).
At Harvest (3 Months Later):
Spot price = $6.80/bushel.
Futures price = $7.05/bushel.
Sell physical wheat: 20,000 × $6.80 = $136,000.
Buy back futures: Gain = ($7.10 - $7.05) × 5,000 × 4 = $0.05 × 20,000 = $1,000.
Effective Selling Price:
Total Revenue = $136,000 + $1,000 = $137,000
Effective Price per Bushel = $137,000 / 20,000 = $6.85/bushel
Basis Analysis:
Initial Basis = $7.00 - $7.10 = -$0.10.
Final Basis = $6.80 - $7.05 = -$0.25.
Basis widened by $0.15 ($0.10 - $0.25), reducing the effective price below the initial spot price
($7.00).
Answer: The effective selling price is $6.85/bushel, $0.15 below the initial spot price due to basis
risk (unfavorable basis change).
Common Problems in Hedging
Basis Risk: Changes in the basis can reduce hedge effectiveness.
Solution: Choose futures contracts closely aligned with the commodity and delivery location.
Monitor historical basis trends.
Quantity Mismatch: Physical exposure may not match contract sizes.
Solution: Adjust the hedge ratio or use mini-contracts if available.
Liquidity Risk: Illiquid futures markets may have wide bid-ask spreads.
Solution: Trade high-volume contracts (e.g., corn, crude oil).
Margin Calls: Adverse price movements may require additional funds.
Solution: Maintain adequate cash reserves or use options for limited-risk hedging.
Over- or Under-Hedging: Hedging too much or too little exposure.
Solution: Accurately forecast production or consumption needs.
Additional Notes
Perfect vs. Imperfect Hedge: A perfect hedge eliminates all price risk (constant basis); imperfect
hedges face basis risk.
Cross-Hedging: Using a related commodity’s futures (e.g., hedging jet fuel with crude oil futures)
when direct futures are unavailable, increasing basis risk.
Alternatives to Futures: Options, swaps, or forward contracts can also hedge but differ in cost and
flexibility.
Regulation: Hedging activities are monitored by the CFTC to prevent market manipulation.
Practical Example: Airlines hedge jet fuel costs by buying crude oil or heating oil futures, as jet
fuel futures are less common.
Benefits of Hedging
Risk Management: Protects against adverse price movements.
Financial Stability: Ensures predictable cash flows for budgeting.
Market Confidence: Encourages investment by reducing uncertainty.
Risks of Hedging:
Basis Risk: Unexpected basis changes reduce effectiveness.
Opportunity Cost: Locking in prices may forgo gains if prices move favorably.
Costs: Margin requirements and transaction fees reduce net returns.
