Hedge Examples Assuming Zero Basis Risk
In the following worksheet we begin to illustrate basic hedging principles. As a first step, we assume that the futures contract price equals the cash price over the time in which the hedge strategy is in effect. That is, the basis is zero.
Basis: Defined as the difference between your local cash price and the futures price on a particular sale date.
In the first example we present a template for looking at the effect of a short hedge (e.g., you are long in the cash product in that you own the product). In the second example we present the template for a long hedge (e.g. you are short the cash product in that you need the actual product).
Given the assumption of zero basis, to show how one locks in a particular cash price all one has to do is enter the sell (purchase) and purchase (sell) futures price at the time of initiating the hedge strategy in the worksheet. It is important to note that we have also assumed zero commission costs. These will be discussed later.
Example of a Short Class III Hedge With Zero Basis Risk
Under a short hedge, you sell a futures contracts to cover your long position in the cash market. If you are a dairy farm operator selling milk to a cheese plant you are long in Class III milk.
- Use short hedge to lock in your unknown output price
- Given the above assumptions of zero basis, by entering the futures contract sell price you can effectively lock in this price for your cash product.
- With a short hedge you sell a futures contract which commits you to sell in the future at the specified price
- You are now long in the cash market (own the product now) and short in the futures market
- Unless you lift your hedge, any gain or loss in the cash market relative to the current price will hopefully be offset by a loss or gain in the futures markets
- At the end of the contract when you sell your milk in the cash market you will cash settle (e.g., buy back) the futures contract at the announced Class III settle price
In the example below all you have to enter is the initial Class III futures sale price and the settle price that you purchase back this futures contract which will be the announced Class III price if you do not lift the hedge prematurely.
With the above assumption of zero basis risk, the expected cash price equals the actual hedged price. In reality, there will be some basis risk resulting in a divergence between expected sale cash price and actual hedge price.
The Actual Hedged Selling Price of your product is the net price you receive for your cash product after taking into account the profits or losses earned in the futures market segment of your hedge.
Example of a Long Class III Hedge With Zero Basis Risk
Similar to the short hedge example, with zero basis risk
- Assume you are a cheese plant and want to protect your milk costs
- With a long hedge you buy a futures contract which commits you to purchase in the future at the specified price
- The plant is now short in the cash market (will need to purchase milk) and long in the futures market
- Undertaking a long hedge locks in the price you have to pay for your cash commodity input (e.g., cheese plant needing to protect their milk costs).
- Unless the plant lifts its hedge prematurly, any gain or loss in the cash market relative to the current price will offset any loss or gain in the futures market
- In the following example, all you have to enter is the initial purchase price to initiate the long hedge and the final Announced Class III price sale price that offsets you long position.
- In reality with basis risk there will be some difference between the expected cash purchase price and Actual Hedged Purchase Price where the Actual Hedged Purchase Price of your input is its net price you after taking into account the profits or losses earned in the futures market segment of your hedge.