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  • Hedging with futures contracts

    Chapter 4 - Cotton trading - Hedging and market systems 

     
     

    Cotton is traded both fixed price and unfixed price (on call price). Fixed price is just that. The price is determined at the time of the transacted contract. On-call contracts are transactions in which all of the contract specifications are set except for the price. In the case of a textile mill buying from a merchant, the mill buyer can fix the price within the time limit allowed by the merchant, i.e. buyer’s call.

    If a merchant sells fixed price cotton to a textile mill, the merchant will immediately go into the futures market and buy a similar amount of futures contracts. The merchant will hold these futures contracts until the cash cotton can be had, at which time the futures contracts will be liquidated. If a merchant sells cotton to a textile mill on call, the merchant will buy no futures contracts until the textile mill fixes the price. The merchant will then go into the futures market and buy futures contacts representing the amount of cotton fixed by the textile mill.

    Similarly, the buying of cotton by a merchant from a grower can be transacted both fixed price and on call. If the purchase is on call, the grower has the privilege of fixing the price within the time limit allowed by the merchant. When the price is fixed the merchant will go into the futures market and sell a like amount of futures contracts. The merchant holds the contracts as a hedge until the cotton is sold fixed price, at which time the futures contracts will be liquidated.

    If the hedger maintains the practice of completely hedging its cotton position the market position is said to be even, in other words not long or short. All open futures positions must be marked to market and margined on a daily basis. For this reason, the hedger should be adequately financed: some transactions may require open future positions to be in place for many weeks or even months.

    Before a cotton merchant buys cotton from a grower or ginner, and before the merchant sells cotton to a textile mill or another merchant, he or she must have some idea of both the buying and selling basis: the difference between the cash price and the future price.

    The merchant must calculate the buying basis on which he or she pays the grower or ginner. To do this he or she must calculate the cost of moving the cotton from where it sits, including warehousing, loading, transportation, commissions, etc. To this the merchant’s profit is usually added, and this becomes the selling basis. Much of the cotton traded in the global market is contracted for forward delivery. A merchant cannot buy the cotton when the contract is made for forward delivery, because the cost of carrying the cotton, storage, interest and insurance, would wipe out the merchant’s profit. Instead of buying the physical cotton, the merchant will buy futures contracts and hold them until he or she buys the physical cotton; at that time he or she would sell the futures contracts.

    If the buying basis does not change the merchant will realize all of the profit calculated. However, if the buying basis strengthens he or she will lose part or all of the profit. If the buying basis weakens and the merchant buys the physical cotton at a wider basis then his or her profit will increase. Merchants arrive at the buying basis by calculating the costs of buying the cotton at origin and moving it to an approved location in order to tender it as settlement of a New York futures contract. Assume the buying basis is calculated to be 4.00 cents per pound off, or less than, the futures contract. If the cotton can be bought at 5.00 cents per pound, the basis is considered to have weakened. On the other hand, if the merchant must pay 3.00 cents per pound at the time he or she buys the cotton, the basis is said to have strengthened. A weaker basis at the time the cotton is bought benefits the merchant.

    Examples of hedging

    In June a global merchant wishes to sell a certain textile mill 1,000 tons (4,400 United States-size bales) of a particular quality of raw cotton for delivery in December of the same year. The merchant cannot buy the cotton in June and carry it until the time to deliver it because the carrying charges would be prohibitive. The merchant calculates that the buying basis will be around the traditional basis of 4.00 cents per pound off New York December futures, which are trading at around 60.00 cents per pound. The merchant calculates that it will cost 7.50 cents per pound to deliver the cotton from the point of origin to the textile mill. The merchant wishes to gain a net profit of 2.00 cents per pound on the transaction, so offers the cotton to the textile mill at 5.50 cents per pound on December New York, which sets the fixed price at 65.50 cents per pound to the textile mill.

     

    4.00 c/lb off New York futures at 60.00 c/lb equals 
    56.00 c/lb 
    Costs to deliver the cotton to the textile mill 
    7.50 c/lb 
      
    --------------- 
      
    63.50 c/lb 
    Profit 
    2.00 c/lb 
      
    --------------- 
    Fixed price to the textile mill 
    65.50 c/lb 

     

    The textile mill agrees to pay the merchant 5.50 cents per pound on December New York futures and the price is fixed at 65.50 cents per pound for the cotton delivered to the mill in December. The merchant wishes to hedge the transaction, so immediately buys 44 December New York future contracts (of 100 bales each) at 60.00 cents per pound.

    Suppose that in November, when the merchant buys the cotton to deliver to the textile mill, December New York futures have risen to 65.00 cents per pound. The merchant is able to buy the cotton at the traditional basis of 4.00 cents per pound off December New York futures, and sell the 44 December future contracts at 65.00 cents per pound, resulting in a cash purchase price of 61.00 cents per pound. As predetermined, it will cost themerchant 7.50 cents per pound to deliver the cotton to the buyer, resulting in a total cost of 68.50 cents per pound. The cotton is invoiced to the textile mill at 65.50 cents per pound, resulting in a cash loss to the merchant of 3.00 cents per pound. However, the merchant had bought 44 December future contracts at 60.00 cents per pound which were sold at 65.00 cents per pound when the merchant bought the cash cotton, resulting in a profit of 5.00 cents per pound on the futures contracts. After deducting the 3.00 cents per pound loss on the cash transaction from the 5.00 cents per pound profit on the futures transaction, the merchant realizes a new profit of 2.00 cents per pound – just as expected.

    Suppose that December futures prices have gone down to 55.00 cents per pound between the date when the merchant transacted the sale and when he or she bought the cotton to deliver. The merchant is able to buy the cash cotton at a basis of 4.00 cents per pound off December futures, resulting in a cash purchase of 51.00 cents per pound. Adding the cost of 7.50 cents per pound to deliver the cotton to the mill results in a total cost to the merchant of 58.50 cents per pound. However, the merchant invoices the cotton to the buyer at 65.50 cents per pound and realizes a cash profit of 7.00 cents per pound. Again, when the merchant bought the cash cotton the December futures that he or she had paid 60.00 cents per pound for were sold for 55.00 cents per pound, leading to a loss on the futures transaction of 5.00 cents per pound. The 7.00 cents per pound gain on the cash transaction is partially offset by the 5.00 cents per pound loss on the futures transaction, leaving a net profit to the merchant of 2.00 cents per pound – just as expected.

    If the merchant buys cash cotton before making a cash sale, the proper hedge is to sell futures in the amount of the volume of the cash cotton. This hedge works the opposite way to the previous examples. When the merchant buys the cotton, December futures are trading at 60.00 cents per pound. The cash basis is 4.00 cents per pound off December futures, resulting in a cash purchase of the cotton at 56.00 cents per pound. The merchant sells a like amount of future contracts at 60.00 cents per pound in order to hedge the cash transaction.

    Imagine that by the time the merchant can sell the cotton to a textile mill December futures prices have risen to 65.00 cents per pound. The merchant calculates that the cost of carrying the cotton totals 7.50 cents per pound and wishes to make a profit of 2.00 cents per pound. Therefore the merchant sells the cotton to a textile mill at a basis price of 5.50 cents per pound on December futures, thereby setting the fixed price at 70.50 cents per pound. At the same time, the merchant buys back the 44 short December futures contracts that were sold when the cash cotton was bought. The results are shown below.

     

    Bought cash cotton 
    56.00 c/lb 
    Sold cash cotton 
    70.50 c/lb 
    Profit on cash 
    14.50 c/lb 
    Sold futures 
    60.00 c/lb 
    Bought futures 
    65.00 c/lb 
    Loss on futures 
    5.00 c/lb 
    Profit on cash less loss on futures 
    9.50 c/lb 
    Carry and delivery costs 
    7.50 c/lb 
    Profit on transaction 
    2.00 c/lb 

     

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