Hedging Against Rising Lean Hogs Prices using Lean Hogs Futures

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Contents

Hedging Against Rising Lean Hogs Prices using Lean Hogs Futures

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

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

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

Lean Hogs Futures Long Hedge Example

A meat distributor will need to procure 4.00 million pounds of lean hogs in 3 months’ time. The prevailing spot price for lean hogs is USD 0.6015/lb while the price of lean hogs futures for delivery in 3 months’ time is USD 0.6000/lb. To hedge against a rise in lean hogs price, the meat distributor decided to lock in a future purchase price of USD 0.6000/lb by taking a long position in an appropriate number of CME Lean Hogs futures contracts. With each CME Lean Hogs futures contract covering 40000 pounds of lean hogs, the meat distributor 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 meat distributor will be able to purchase the 4.00 million pounds of lean hogs at USD 0.6000/lb for a total amount of USD 2,400,000. Let’s see how this is achieved by looking at scenarios in which the price of lean hogs makes a significant move either upwards or downwards by delivery date.

Scenario #1: Lean Hogs Spot Price Rose by 10% to USD 0.6617/lb on Delivery Date

With the increase in lean hogs price to USD 0.6617/lb, the meat distributor will now have to pay USD 2,646,600 for the 4.00 million pounds of lean hogs. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.6617/lb. As the long futures position was entered at a lower price of USD 0.6000/lb, it will have gained USD 0.6617 – USD 0.6000 = USD 0.0617 per pound. With 100 contracts covering a total of 4.00 million pounds of lean hogs, the total gain from the long futures position is USD 246,600.

In the end, the higher purchase price is offset by the gain in the lean hogs futures market, resulting in a net payment amount of USD 2,646,600 – USD 246,600 = USD 2,400,000. This amount is equivalent to the amount payable when buying the 4.00 million pounds of lean hogs at USD 0.6000/lb.

Scenario #2: Lean Hogs Spot Price Fell by 10% to USD 0.5414/lb on Delivery Date

With the spot price having fallen to USD 0.5414/lb, the meat distributor will only need to pay USD 2,165,400 for the lean hogs. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.5414/lb. As the long futures position was entered at USD 0.6000/lb, it will have lost USD 0.6000 – USD 0.5414 = USD 0.0587 per pound. With 100 contracts covering a total of 4.00 million pounds, the total loss from the long futures position is USD 234,600

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Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the lean hogs futures market and the net amount payable will be USD 2,165,400 + USD 234,600 = USD 2,400,000. Once again, this amount is equivalent to buying 4.00 million pounds of lean hogs at USD 0.6000/lb.

Risk/Reward Tradeoff

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

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

Learn More About Lean Hogs Futures & Options Trading

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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. ]

Hedging Against Rising Lean Hogs Prices using Lean Hogs Futures

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. Support for this pricing relationship is based upon the argument that arbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored.

To begin understanding how the put-call parity is established, let’s first take a look at two portfolios, A and B. Portfolio A consists of a european call option and cash equal to the number of shares covered by the call option multiplied by the call’s striking price. Portfolio B consist of a european put option and the underlying asset. Note that equity options are used in this example.

Portfolio A = Call + Cash, where Cash = Call Strike Price

Portfolio B = Put + Underlying Asset

It can be observed from the diagrams above that the expiration values of the two portfolios are the same.

Call + Cash = Put + Underlying Asset

Eg. JUL 25 Call + $2500 = JUL 25 Put + 100 XYZ Stock

If the two portfolios have the same expiration value, then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a riskfree profit on expiration day. Hence, taking into account the need to calculate the present value of the cash component using a suitable risk-free interest rate, we have the following price equality:

Put-Call Parity and American Options

Since American style options allow early exercise, put-call parity will not hold for American options unless they are held to expiration. Early exercise will result in a departure in the present values of the two portfolios.

Validating Option Pricing Models

The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

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Bull Call Spread: An Alternative to the Covered Call

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Valuing Common Stock using Discounted Cash Flow Analysis

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Using Futures to Hedge Against Shifts in Commodity Prices

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Producers and consumers of commodities use futures markets to protect against adverse price moves that could result in large financial losses. A producer of a commodity is at risk of prices moving lower while a consumer of a commodity is at risk of prices moving higher.

Hedging is an important tool when it comes to running a business from either of those perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price. A hedge will guaranty a producer a known price for their commodity output.

Advantages of Futures

Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers alike a mechanism with which to hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that closely reflect their risks. Additionally, futures contracts are liquid instruments, meaning there’s a lot of trading activity in them and they’re generally easy to buy and sell.

Aside from producers and consumers, speculators, traders, investors, and other market participants utilize these markets. The exchange requires those who hold long and short positions to post margin, which is a performance bond to cover potential losses.

Producers and consumers often receive special treatment on commodity exchanges. As hedgers, their margin rates are often lower than other market participants, who are trying to make money on trading, not protect against losses.

Reducing Risks

To hedge, it is necessary to take a futures position of approximately the same size—but opposite in price direction—from one’s own position. Therefore, a producer who is naturally long a commodity hedges by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer, who is acting as a short hedger.

A consumer who is naturally short a commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer, who is acting as a long hedger.

While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk. Producers and consumers who use futures markets to hedge transfer their price risk.

If someone holds the physical commodity, they assume the price risk for it as well as the costs associated with holding that commodity, including insurance and storage costs. The price of a commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures is higher than nearby futures prices.

When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity, they exchange price risk for basis risk, which is the risk that the difference in the cash price of the commodity and the futures price will diverge against them.

Futures exchanges have associations that act as clearing houses, which means they become the transaction partner of a trade. They match up buyer and seller, check their creditworthiness, and ensure each one is paid what they’re owed. Therefore the clearing houses help remove credit risk from the system.

A Drawback of Hedging With Futures

Hedging in the futures market isn’t perfect. For one thing, futures markets depend upon standardization. Commodity futures contracts require certain quantities to be delivered on set dates. For example, a futures contract for corn might entail a delivery of 5,000 bushels in December 2020. And sometimes quality—for example, the purity of precious metals—comes into play.

Hedgers sometimes produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures.

Alternatives to Futures Markets

Futures markets are not the only choice for hedgers. They can also use forwards and swaps to hedge. These markets entail principal-to-principal transactions—meaning no exchange is involved—with each party assuming the risks of the other. However, these tailor-made transactions may meet the specific needs of commodity consumers or producers better than standardized futures contracts can.

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