Hedging Against Falling Tin Prices using Tin Futures

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Contents

Hedging Against Rising Tin Prices using Tin Futures

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

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

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

Tin Futures Long Hedge Example

A tin can manufacturer will need to procure 500 tonnes of tin in 3 months’ time. The prevailing spot price for tin is USD 11,550/ton while the price of tin futures for delivery in 3 months’ time is USD 12,000/ton. To hedge against a rise in tin price, the tin can manufacturer decided to lock in a future purchase price of USD 12,000/ton by taking a long position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin can 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 tin can manufacturer will be able to purchase the 500 tonnes of tin at USD 12,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of tin makes a significant move either upwards or downwards by delivery date.

Scenario #1: Tin Spot Price Rose by 10% to USD 12,705/ton on Delivery Date

With the increase in tin price to USD 12,705/ton, the tin can manufacturer will now have to pay USD 6,352,500 for the 500 tonnes of tin. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 12,705/ton. As the long futures position was entered at a lower price of USD 12,000/ton, it will have gained USD 12,705 – USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total gain from the long futures position is USD 352,500.

In the end, the higher purchase price is offset by the gain in the tin futures market, resulting in a net payment amount of USD 6,352,500 – USD 352,500 = USD 6,000,000. This amount is equivalent to the amount payable when buying the 500 tonnes of tin at USD 12,000/ton.

Scenario #2: Tin Spot Price Fell by 10% to USD 10,395/ton on Delivery Date

With the spot price having fallen to USD 10,395/ton, the tin can manufacturer will only need to pay USD 5,197,500 for the tin. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 10,395/ton. As the long futures position was entered at USD 12,000/ton, it will have lost USD 12,000 – USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total loss from the long futures position is USD 802,500

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the tin futures market and the net amount payable will be USD 5,197,500 + USD 802,500 = USD 6,000,000. Once again, this amount is equivalent to buying 500 tonnes of tin at USD 12,000/ton.

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Risk/Reward Tradeoff

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

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

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Hedging Against Falling Tin Prices using Tin Futures

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

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

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

Tin Futures Short Hedge Example

A tin mining company has just entered into a contract to sell 500 tonnes of tin, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of tin on the day of delivery. At the time of signing the agreement, spot price for tin is USD 11,550/ton while the price of tin futures for delivery in 3 months’ time is USD 12,000/ton.

To lock in the selling price at USD 12,000/ton, the tin mining company can enter a short position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin mining company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the tin mining company will be able to sell the 500 tonnes of tin at USD 12,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of tin makes a significant move either upwards or downwards by delivery date.

Scenario #1: Tin Spot Price Fell by 10% to USD 10,395/ton on Delivery Date

As per the sales contract, the tin mining company will have to sell the tin at only USD 10,395/ton, resulting in a net sales proceeds of USD 5,197,500.

By delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 10,395/ton. As the short futures position was entered at USD 12,000/ton, it will have gained USD 12,000 – USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total gain from the short futures position is USD 802,500

Together, the gain in the tin futures market and the amount realised from the sales contract will total USD 802,500 + USD 5,197,500 = USD 6,000,000. This amount is equivalent to selling 500 tonnes of tin at USD 12,000/ton.

Scenario #2: Tin Spot Price Rose by 10% to USD 12,705/ton on Delivery Date

With the increase in tin price to USD 12,705/ton, the tin producer will be able to sell the 500 tonnes of tin for a higher net sales proceeds of USD 6,352,500.

However, as the short futures position was entered at a lower price of USD 12,000/ton, it will have lost USD 12,705 – USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total loss from the short futures position is USD 352,500.

In the end, the higher sales proceeds is offset by the loss in the tin futures market, resulting in a net proceeds of USD 6,352,500 – USD 352,500 = USD 6,000,000. Again, this is the same amount that would be received by selling 500 tonnes of tin at USD 12,000/ton.

Risk/Reward Tradeoff

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

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

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Hedging

The LME offers those at all stages of the metals supply chain the opportunity to hedge their price risk and gain protection from adverse price movements.

Hedging is the process of offsetting the risk of price movements in the physical market by locking in a price for the same commodity in the futures market.
There are two main motivations for a company to hedge:

  • To lock in a future price which is attractive, relative to an organisation’s costs
  • To secure a price fixed against an external contract

When hedging, an organisation starts with price risk exposure from its physical operations, and will buy or sell a futures contract to offset that price exposure in the futures market. An organisation can decide on the amount of risk it is prepared to accept. It may wish to eliminate price risk entirely.

To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the LME Official Settlement Price in order to achieve the most effective hedge and to meet the international accounting standards.

Speculation

Hedging is the opposite of speculation as its primary purpose is to offset risk. Speculators, however, come to the futures market with no initial risk. They assume risk by taking on futures positions, which in turn provides market liquidity. Hedgers reduce or eliminate the chance of future losses or profits, while speculators risk losses in order to make profits.

Hedging programme

To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the LME Official Settlement Price in order to achieve the most effective hedge and to meet the international accounting standards.

The programme can be as simple or as complex as a company wants to make it, but it will depend on that company’s appetite for risk, internal practices, pricing policies and hedging motives. Not only must a hedging programme be well devised, but it must also be managed according to the changing circumstances of a company’s physical operations.

Hedging example

The below example provides an overview of a typical offset hedge strategy conducted on the LME.

An offset hedge is designed to remove the basis price risk of the physical operation by offsetting it with an equal and opposite sale or purchase of a futures contract on the Exchange. Any risk of price volatility that arises from the physical transaction is thereby eliminated.

An offset hedge is a financial operation in which the hedger (the company hedging) maintains a ‘balanced book’ with each physical transaction being offset by an LME transaction. In this example both the buyer and the seller choose to hedge their price risk. However, it is not necessary for both parties to the physical transaction to hedge; this will depend entirely on their organisation’s internal practices and approach to risk management.

There are three main stages to the process:

1. Physical Transaction

A producer agrees to sell a specific quantity of physical material to a consumer for a delivery date in the future. For hedging to be successful for either party, the contract must be agreed basis the current LME Official Settlement Price.

Both the producer and the consumer are likely to be exposed to a change in price over the life span of the physical contract because the delivery date is in the future. Each company has the ability to hedge this exposure on the LME.

2. Financial Transaction

Once the physical transaction has been agreed the hedger will instruct their broker to open a futures contract on the LME. This will be made up of an equal and opposite position for the same delivery date as their physical transaction. This allows the hedger to lock in the future price and delivery date to match the physical contract already agreed.

Once an LME contract, or trade, has been entered and matched by the broker, a process known as ‘novation’ takes place. This is when the clearing house, LME Clear, becomes the counterparty to both sides of the trade. The brokers are now no longer exposed to the credit worthiness of each other and the financial risk of default is taken on by the clearing house.

When entering into a futures contract a hedger is required to make margin payments to their broker. This includes an initial margin at the outset and variation margin throughout the life of the contract. Variation margins are a form of collateral which provide daily security against any adverse price movements of a futures position. Margins are a regulatory requirement and are calculated by LME Clear, not the broker.

3. Settlement

Two days before the delivery date, the hedger will instruct their broker to financially settle the LME position by buying or selling back the original futures contract at the current LME Official Settlement Price.

In parallel to the financial transaction, the producer makes the physical sale of material to the consumer as agreed at the outset. Provided that this is agreed basis the current LME Official Settlement Price, the price risk of the base product over the period is eliminated for both parties, as the profits from one transaction offsets the losses from the other, and vice versa.

Producer benefits

LME contracts offer a number of benefits for producers, including the ability to:

  1. Offer a long-term fixed sales price and lock in a profit margin
  2. Use inventory financing and trade financing
  3. Access lower financing cost (banks view companies that hedge as lower risk)
  4. Protect the value of unsold inventory in a falling market
  5. Hedge physical purchases in times of strong demand.

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Merchant benefits

LME contracts offer a number of benefits for merchants, including the ability to:

  1. Hedge physical sales and purchases
  2. Offer a long-term fixed sales price
  3. Swap physical material on a location and grade/producer basis
  4. Gain a competitive advantage by offering a fixed sales price
  5. Protect the value of physical stock against a fall in price
  6. Bring over-the-counter (OTC) transactions on Exchange.

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Consumer benefits

LME contracts offer a number of benefits for consumers including the ability to:

  1. Lock-in a forward purchase price
  2. Accurate budgeting for raw material requirement costs
  3. Increased ability to commit to future sales prices

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Scrap dealer benefits

LME contracts offer a number of benefits for a scrap recycler, including the ability to:

  1. Protect against price movements
  2. Offer long-term fixed sales price and lock in a profit margin
  3. Hedge the timing difference between scrap purchase and sale

The entire supply chain benefits from a transparent and accurate pricing mechanism.

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