Hi
This is the easiest version that I have compiled which guarantees 100% easy understanding of Commodity Futures mechanism.
Let us assume you are a farmer who grows wheat and you expect to harvest 10,000 bushels of wheat in six months. You want to hedge against the risk of a decline in the wheat price by the time you sell your crop. You can use wheat futures contracts to lock in a price today and avoid any losses due to price fluctuations.
A wheat futures contract is an agreement to buy or sell 5,000 bushels of wheat at a specified price and date in the future. Suppose the current spot price of wheat is $5 per bushel and the six-month futures price is $5.10 per bushel. You can sell two wheat futures contracts (10,000 bushels) at $5.10 per bushel and receive $51,000 in six months, regardless of the spot price at that time. This is called a short hedge.
Now let us assume you are a speculator who believes that the wheat price will increase in six months. You want to profit from this price movement by buying wheat futures contracts today and selling them later at a higher price. You can use wheat futures contracts to take a long position in the market and benefit from any gains due to price fluctuations.
Suppose the current spot price of wheat is $5 per bushel and the six-month futures price is $5.10 per bushel. You can buy two wheat futures contracts (10,000 bushels) at $5.10 per bushel and pay $51,000 in six months, regardless of the spot price at that time. This is called a long hedge.
Let us compare the outcomes of the two strategies under different scenarios:
Scenario 1: The spot price of wheat in six months is $4.90 per bushel.
- The farmer who hedged with futures contracts will receive $51,000 from selling the futures contracts and $49,000 from selling the wheat crop in the spot market, for a total of $100,000. The farmer will have a net gain of $10,000 from hedging, as the futures price was higher than the spot price.
- The speculator who traded with futures contracts will pay $51,000 for buying the futures contracts and receive $49,000 from selling the wheat crop in the spot market, for a total of $98,000. The speculator will have a net loss of $2,000 from trading, as the futures price was lower than the spot price.
Scenario 2: The spot price of wheat in six months is $5.30 per bushel.
- The farmer who hedged with futures contracts will receive $51,000 from selling the futures contracts and $53,000 from selling the wheat crop in the spot market, for a total of $104,000. The farmer will have a net loss of $4,000 from hedging, as the futures price was lower than the spot price.
- The speculator who traded with futures contracts will pay $51,000 for buying the futures contracts and receive $53,000 from selling the wheat crop in the spot market, for a total of $106,000. The speculator will have a net gain of $6,000 from trading, as the futures price was higher than the spot price.
As you can see, hedging with futures contracts reduces the risk of price fluctuations, but also limits the potential profits. Trading with futures contracts increases the risk of price fluctuations, but also enhances the potential profits. Therefore, hedging and trading are two different strategies that involve different trade-offs and objectives.
Regards
CAclubindia
