Hedging Against Rising Coffee Prices using Coffee Futures

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Contents

Hedging Against Rising Coffee Prices using Coffee Futures

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

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

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

Coffee Futures Long Hedge Example

A coffeehouse chain will need to procure 1,000 tonnes of coffee in 3 months’ time. The prevailing spot price for coffee is USD 1,648/ton while the price of coffee futures for delivery in 3 months’ time is USD 1,600/ton. To hedge against a rise in coffee price, the coffeehouse chain decided to lock in a future purchase price of USD 1,600/ton by taking a long position in an appropriate number of Euronext Robusta Coffee (No. 409) futures contracts. With each Euronext Robusta Coffee (No. 409) futures contract covering 10 tonnes of coffee, the coffeehouse chain 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 coffeehouse chain will be able to purchase the 1,000 tonnes of coffee at USD 1,600/ton for a total amount of USD 1,600,000. Let’s see how this is achieved by looking at scenarios in which the price of coffee makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coffee Spot Price Rose by 10% to USD 1,813/ton on Delivery Date

With the increase in coffee price to USD 1,813/ton, the coffeehouse chain will now have to pay USD 1,812,800 for the 1,000 tonnes of coffee. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,813/ton. As the long futures position was entered at a lower price of USD 1,600/ton, it will have gained USD 1,813 – USD 1,600 = USD 212.80 per tonne. With 100 contracts covering a total of 1,000 tonnes of coffee, the total gain from the long futures position is USD 212,800.

In the end, the higher purchase price is offset by the gain in the coffee futures market, resulting in a net payment amount of USD 1,812,800 – USD 212,800 = USD 1,600,000. This amount is equivalent to the amount payable when buying the 1,000 tonnes of coffee at USD 1,600/ton.

Scenario #2: Coffee Spot Price Fell by 10% to USD 1,483/ton on Delivery Date

With the spot price having fallen to USD 1,483/ton, the coffeehouse chain will only need to pay USD 1,483,200 for the coffee. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,483/ton. As the long futures position was entered at USD 1,600/ton, it will have lost USD 1,600 – USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1,000 tonnes, the total loss from the long futures position is USD 116,800

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coffee futures market and the net amount payable will be USD 1,483,200 + USD 116,800 = USD 1,600,000. Once again, this amount is equivalent to buying 1,000 tonnes of coffee at USD 1,600/ton.

Risk/Reward Tradeoff

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

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

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Hedging Against Falling Coffee Prices using Coffee Futures

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

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

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

Coffee Futures Short Hedge Example

A coffee producer has just entered into a contract to sell 1,000 tonnes of coffee, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of coffee on the day of delivery. At the time of signing the agreement, spot price for coffee is USD 1,648/ton while the price of coffee futures for delivery in 3 months’ time is USD 1,600/ton.

To lock in the selling price at USD 1,600/ton, the coffee producer can enter a short position in an appropriate number of Euronext Robusta Coffee (No. 409) futures contracts. With each Euronext Robusta Coffee (No. 409) futures contract covering 10 tonnes of coffee, the coffee producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the coffee producer will be able to sell the 1,000 tonnes of coffee at USD 1,600/ton for a total amount of USD 1,600,000. Let’s see how this is achieved by looking at scenarios in which the price of coffee makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coffee Spot Price Fell by 10% to USD 1,483/ton on Delivery Date

As per the sales contract, the coffee producer will have to sell the coffee at only USD 1,483/ton, resulting in a net sales proceeds of USD 1,483,200.

By delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,483/ton. As the short futures position was entered at USD 1,600/ton, it will have gained USD 1,600 – USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1000 tonnes, the total gain from the short futures position is USD 116,800

Together, the gain in the coffee futures market and the amount realised from the sales contract will total USD 116,800 + USD 1,483,200 = USD 1,600,000. This amount is equivalent to selling 1,000 tonnes of coffee at USD 1,600/ton.

Scenario #2: Coffee Spot Price Rose by 10% to USD 1,813/ton on Delivery Date

With the increase in coffee price to USD 1,813/ton, the coffee producer will be able to sell the 1,000 tonnes of coffee for a higher net sales proceeds of USD 1,812,800.

However, as the short futures position was entered at a lower price of USD 1,600/ton, it will have lost USD 1,813 – USD 1,600 = USD 212.80 per tonne. With 100 contracts covering a total of 1,000 tonnes of coffee, the total loss from the short futures position is USD 212,800.

In the end, the higher sales proceeds is offset by the loss in the coffee futures market, resulting in a net proceeds of USD 1,812,800 – USD 212,800 = USD 1,600,000. Again, this is the same amount that would be received by selling 1,000 tonnes of coffee at USD 1,600/ton.

Risk/Reward Tradeoff

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

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

Learn More About Coffee Futures & Options Trading

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Continue Reading.

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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. ]

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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

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

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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

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. ]

How Are Futures Used to Hedge a Position?

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.

The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead. Here, we dig a little bit deeper into using futures to hedge.

Key Takeaways

  • Futures contracts allow producers, consumer, and investors to hedge certain market risks.
  • For instance, a farmer planting wheat today may sell a wheat futures contract now. He will then buy it back come harvest when he sells his wheat – effectively locking in today’s price and hedging away market fluctuations between planting and harvest.
  • Because futures contracts often require actual delivery of the underlying at expiration, hedgers must be sure to exit or roll over positions before expiry.

Using Futures Contracts to Hedge

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company’s risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

Sometimes, if a commodity to be hedged is not available as a futures contract, an investor will instead seek out a futures contract in something that closely follows the movements of that commodity, for example buying wheat futures to hedge the production of barley.

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