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Does hedging require the use of Forward and Future Contracts at the same time?


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Does hedging require the use of Forward and Future Contracts at the same time?

  #1 (permalink)
 FrazMann 
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Hi,

I'm having some issues with understanding hedging and i was wondering if someone could help.

Example:
Net Result of Short Hedges
First, we'll look at the short hedge as prices decrease. It is May and an ethanol producer wants to hedge approximately 1.5 million gallons of his July production to guard against the possibility of falling prices. So he short hedges by selling 52 July ethanol futures contracts (a contract is for a railcar of 29,000 gallons on the CBOT) at $1.28/gallon. Both cash and futures prices have subsequently fallen. On July 1, when the producer sells physical ethanol to the local terminal, the price he receives is $1.15/gal. The producer simultaneously offsets his hedge, by purchasing July ethanol futures at $1.20. The transaction looks like this:

imgur/a/P8uC7

(Could someone please edit this as i dont have enough posts to include links atm.)


As a result, the hedger sold ethanol for cash on the forward market at $1.15 (the July Cash Market box), gained 8 cents on the futures position (sold the future for $1.28 and bought it back for $1.20), so it was as if he sold the commodity for $1.23.

investopedia /exam-guide/series-3/studyguide/hedging/hedging-calculations.asp#ixzz4WhEdA6hp

(Could someone please edit this as i dont have enough posts to include links atm.)

Question:
I thought a "Forward" contract was similar to a Futures contract except it wasn't standardised and was over the counter not through an exchange. Why is the example using both a Forward and Future Contract?

My understanding of a short hedge was(If you don't already own the goods):
May) Buy goods on Spot, Sell Future
Sept) Sell goods on Spot, Buy back Future


or in the case of a Forward contract:
May) Buy Forward contract.
Sept) Deliver goods.
Sept - Cash Settlement) Pay supplier (Forward Price - Spot).
#Where a negative value means supplier pays buyer.

I would really appreciate some help on this, thanks for your time.

FrazMann

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  #3 (permalink)
 
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 SMCJB 
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FrazMann View Post
(Could someone please edit this as i dont have enough posts to include links atm.)

Can't edit other image links and the URL you gave seems to be broken.

FrazMann View Post
Question:
I thought a "Forward" contract was similar to a Futures contract except it wasn't standardized and was over the counter not through an exchange.

It is. Of course that means their is a lot more performance and credit risk, but the forward can be tailored more. The other major difference is that most forwards eventually are physically delivered, while most futures are eventually closed out.

FrazMann View Post
Why is the example using both a Forward and Future Contract?

Maybe something was lost in your broken links, but it seems to me that your example includes a Cash Sale and a Futures trade.

FrazMann View Post
My understanding of a short hedge was(If you don't already own the goods):
May) Buy goods on Spot, Sell Future
Sept) Sell goods on Spot, Buy back Future

Yes I would call that using futures to a hedge a spot physical position.

FrazMann View Post
or in the case of a Forward contract:
May) Buy Forward contract.
Sept) Deliver goods.
Sept - Cash Settlement) Pay supplier (Forward Price - Spot).
#Where a negative value means supplier pays buyer.

Sorry but I don't understand the example.
In May what Forward contract are you buying? September? At a fixed Price? If so then you have price exposure until you sell the product. Of course you could hedge that exposure by selling futures against it. In this case the difference between these and the previous example would be that you are hedging a forward contract instead of a physical cash position, but the logic is the same.

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  #4 (permalink)
 FrazMann 
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Hi SMCJD,

Thanks for taking the time to reply to my post. I think the following question should clarify where my misunderstanding is?? (i hope)

Example:
Say i'm a farmer and i will harvest my field in 2 months time. If i Sell a Forward contract with delivery in 2 months to you for say $5, i thought this was classed as hedging?

Based on your reply, assuming i have understood you correctly, i also need to buy a futures contract?


OR

is the futures contract only required if i didnt produce the goods and was only planning on buying them and shipping them straight to the buyer of the Forward contract?

Thanks again for your time.

Fraz

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  #5 (permalink)
 
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 SMCJB 
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FrazMann View Post
Example:
Say i'm a farmer and i will harvest my field in 2 months time. If i Sell a Forward contract with delivery in 2 months to you for say $5, i thought this was classed as hedging?

It is. You have hedged your physical production with a forward sale.

FrazMann View Post
Based on your reply, assuming i have understood you correctly, i also need to buy a futures contract?

Nope. Hedging is reducing price exposure. Production or Physical Postion = Long, hence you need to sell something against it. In your example you use a Forward, you could also have used a future.

FrazMann View Post
OR

is the futures contract only required if i didnt produce the goods and was only planning on buying them and shipping them straight to the buyer of the Forward contract?

Sort of.

Just like a farmer or ethanol plant can forward sell their production, somebody who needs to buy something in the future can also forward buy that commodity. Imagine I'm a commercial baker and a grocery store agrees to buy bread from me for the next 6 months. In this case I have a physical forward sale, and need to buy something to hedge it. My major ingredient is flour, so I could go out and buy say Grain futures, to hedge the price of the flour, and hence hopefully hedge my bread sales.

Note: All of these discussions assume that all transactions have fixed prices (ie $1.17) and not index prices (ie Platts Ethanol Chicago +$0.01)

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  #6 (permalink)
 FrazMann 
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That makes sense.

One last question if i may? For a long hedge, do you always have to short the "physical"??

Thank you very much for your help 😃

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 SMCJB 
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FrazMann View Post
One last question if i may? For a long hedge, do you always have to short the "physical"??

Well to be long a hedge, you have to be short something that your hedging, but it doesn't have to be physical. Imagine a refiner, he's looking at to the summer and sees that the Gasoline-Crude "Crack Spread" is very wide and if it stays that wide he can make a lot of money. So he enters into a trade where he sells Gasoline Futures, and buys Crude Futures. When he actually buys his physical crude he will sell his crude futures. And when he sells his physical gasoline he will buy back his gasoline futures. In this case you can think of owning a refinery as being "long the spread" and hence to hedge you have to "sell the spread" but it as an example where a long futures hedge is offset with a short futures hedge and not a physical.

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  #8 (permalink)
 FrazMann 
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Thanks very much 😃

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