Hedging Against Rising Cocoa Prices using Cocoa Futures

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Contents

Hedging Against Rising Cocoa Prices using Cocoa Futures

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

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

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

Cocoa Futures Long Hedge Example

A chocolate maker will need to procure 1,000 tonnes of cocoa in 3 months’ time. The prevailing spot price for cocoa is GBP 1,812/ton while the price of cocoa futures for delivery in 3 months’ time is GBP 1,800/ton. To hedge against a rise in cocoa price, the chocolate maker decided to lock in a future purchase price of GBP 1,800/ton by taking a long position in an appropriate number of Euronext Cocoa futures contracts. With each Euronext Cocoa futures contract covering 10 tonnes of cocoa, the chocolate maker 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 chocolate maker will be able to purchase the 1,000 tonnes of cocoa at GBP 1,800/ton for a total amount of GBP 1,800,000. Let’s see how this is achieved by looking at scenarios in which the price of cocoa makes a significant move either upwards or downwards by delivery date.

Scenario #1: Cocoa Spot Price Rose by 10% to GBP 1,993/ton on Delivery Date

With the increase in cocoa price to GBP 1,993/ton, the chocolate maker will now have to pay GBP 1,993,200 for the 1,000 tonnes of cocoa. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the cocoa futures price will have converged with the cocoa spot price and will be equal to GBP 1,993/ton. As the long futures position was entered at a lower price of GBP 1,800/ton, it will have gained GBP 1,993 – GBP 1,800 = GBP 193.20 per tonne. With 100 contracts covering a total of 1,000 tonnes of cocoa, the total gain from the long futures position is GBP 193,200.

In the end, the higher purchase price is offset by the gain in the cocoa futures market, resulting in a net payment amount of GBP 1,993,200 – GBP 193,200 = GBP 1,800,000. This amount is equivalent to the amount payable when buying the 1,000 tonnes of cocoa at GBP 1,800/ton.

Scenario #2: Cocoa Spot Price Fell by 10% to GBP 1,631/ton on Delivery Date

With the spot price having fallen to GBP 1,631/ton, the chocolate maker will only need to pay GBP 1,630,800 for the cocoa. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the cocoa futures price will have converged with the cocoa spot price and will be equal to GBP 1,631/ton. As the long futures position was entered at GBP 1,800/ton, it will have lost GBP 1,800 – GBP 1,631 = GBP 169.20 per tonne. With 100 contracts covering a total of 1,000 tonnes, the total loss from the long futures position is GBP 169,200

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Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the cocoa futures market and the net amount payable will be GBP 1,630,800 + GBP 169,200 = GBP 1,800,000. Once again, this amount is equivalent to buying 1,000 tonnes of cocoa at GBP 1,800/ton.

Risk/Reward Tradeoff

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

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

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Hedging Against Falling Cocoa Prices using Cocoa Futures

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

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

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

Cocoa Futures Short Hedge Example

A cocoa farmer has just entered into a contract to sell 1,000 tonnes of cocoa, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of cocoa on the day of delivery. At the time of signing the agreement, spot price for cocoa is GBP 1,812/ton while the price of cocoa futures for delivery in 3 months’ time is GBP 1,800/ton.

To lock in the selling price at GBP 1,800/ton, the cocoa farmer can enter a short position in an appropriate number of Euronext Cocoa futures contracts. With each Euronext Cocoa futures contract covering 10 tonnes of cocoa, the cocoa farmer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the cocoa farmer will be able to sell the 1,000 tonnes of cocoa at GBP 1,800/ton for a total amount of GBP 1,800,000. Let’s see how this is achieved by looking at scenarios in which the price of cocoa makes a significant move either upwards or downwards by delivery date.

Scenario #1: Cocoa Spot Price Fell by 10% to GBP 1,631/ton on Delivery Date

As per the sales contract, the cocoa farmer will have to sell the cocoa at only GBP 1,631/ton, resulting in a net sales proceeds of GBP 1,630,800.

By delivery date, the cocoa futures price will have converged with the cocoa spot price and will be equal to GBP 1,631/ton. As the short futures position was entered at GBP 1,800/ton, it will have gained GBP 1,800 – GBP 1,631 = GBP 169.20 per tonne. With 100 contracts covering a total of 1000 tonnes, the total gain from the short futures position is GBP 169,200

Together, the gain in the cocoa futures market and the amount realised from the sales contract will total GBP 169,200 + GBP 1,630,800 = GBP 1,800,000. This amount is equivalent to selling 1,000 tonnes of cocoa at GBP 1,800/ton.

Scenario #2: Cocoa Spot Price Rose by 10% to GBP 1,993/ton on Delivery Date

With the increase in cocoa price to GBP 1,993/ton, the cocoa producer will be able to sell the 1,000 tonnes of cocoa for a higher net sales proceeds of GBP 1,993,200.

However, as the short futures position was entered at a lower price of GBP 1,800/ton, it will have lost GBP 1,993 – GBP 1,800 = GBP 193.20 per tonne. With 100 contracts covering a total of 1,000 tonnes of cocoa, the total loss from the short futures position is GBP 193,200.

In the end, the higher sales proceeds is offset by the loss in the cocoa futures market, resulting in a net proceeds of GBP 1,993,200 – GBP 193,200 = GBP 1,800,000. Again, this is the same amount that would be received by selling 1,000 tonnes of cocoa at GBP 1,800/ton.

Risk/Reward Tradeoff

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

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

Learn More About Cocoa Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

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. ]

What are Binary Options and How to Trade Them?

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. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

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 Hedging Works in Commodities Markets

EmirMemedovski / Getty Images

The commodity markets are made up primarily of speculators and hedgers. It is easy to understand what speculators are all about; they are taking on risk in the markets to make money. Hedgers are there for pretty much the opposite reason: to reduce their risk of losing money.

A hedger is an individual or company that is involved in a business related to a particular commodity. They are usually either a producer of the commodity or a company that regularly needs to purchase the commodity.

An Example With Soybeans

A farmer is one example of a hedger. Farmers grow crops—soybeans, in this example—and carry the risk that the price of their soybeans will decline by the time they’re harvested. Farmers can hedge against that risk by selling soybean futures, which could lock in a price for their crops early in the growing season.

A soybean futures contract on the CME Group’s Chicago Board of Trade exchange consists of 5,000 bushels of soybeans. If a farmer expected to produce 500,000 bushels of soybeans, they would sell 100 soybean futures contracts.

Let’s assume the price of soybeans is currently $13 a bushel. If the farmer knows they can turn a profit at $10, it might be wise to lock in the $13 price by selling the futures contracts. In that way, the farmer could avoid the risk that the price of soybeans would fall below $10 when they’re ready to be sold.

There is always the possibility that soybeans could move much higher by harvest time. Soybeans could move to $16 a bushel, and the farmer would miss out on that higher price if they sold the $13-a-bushel futures contracts.

Failing to Hedge

Most airlines are now diligent about using hedges to protect against soaring prices of jet fuel. But in 2008, major airlines posted big losses—and some filed for bankruptcy protection—after the price of fuel spiked.

Farmers sometimes don’t hedge until the last minute. Grain prices often move higher in June and July on weather threats. During this time, some farmers watch prices move higher and higher and get greedy. They wait too long to lock in the high prices before they fall. In essence, these hedgers turn into speculators.

Original Purpose of Exchanges

Commodity futures exchanges were originally created to enable producers and buyers of commodities to hedge against their long or short cash positions in commodities. Even though traders and other speculators represent the bulk of trading volume on futures exchanges, hedgers are their true reason for being.

While futures exchanges require hedgers to pay margin—upfront money to cover potential losses—just like they do for speculators, the margin levels are often lower for hedgers. That’s because the exchanges view hedgers as less risky because they have a cash position in a commodity that offsets their futures position. A hedger must still apply for these special margin rates through the exchange and be approved after meeting certain criteria.

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