Long Hedge

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Long Hedge

What Is a Long Hedge?

A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year.

For this reason, a long hedge may also be referred to as an input hedge, a buyers hedge, a buy hedge, a purchasers hedge, or a purchasing hedge.

Understanding Long Hedges

A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.

Example of a Long Hedge

In a simplified example, we might assume that it is January, and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $2.50 per pound, but the May futures price is $2.40 per pound. In January the aluminum manufacturer would take a long position in a May futures contract on copper.

This futures contract can be sized to cover part or all of the expected order. Sizing the position sets the hedge ratio. For example, if the purchaser hedges half the purchase order size, then the hedge ratio is 50%. If the May spot price of copper is over $2.40 per pound, then the manufacturer has benefited from taking a long position. This is because the overall profit from the futures contract helps offset the higher purchasing cost paid for copper in May.

If the May spot price of copper is below $2.40 per pound, the manufacturer takes a small loss on the futures position while saving overall, thanks to a lower-than-anticipated purchasing price.

Long Hedges vs. Short Hedges

Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price.

Hedges, both long and short, can be thought of as a form of insurance. There is a cost to setting them up, but they can save a company a large amount in an adverse situation.

Long Hedge

The long hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or commodity to be purchased some time in the future. Hence, the long hedge is also known as input hedge.

The long hedge involves taking up a long futures position. Should the underlying commodity price rise, the gain in the value of the long futures position will be able to offset the increase in purchasing costs.

Long Hedge Example

In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in September. Let’s assume that the total amount of wheat needed to produce the flour is 50000 bushels. Based on the agreed selling price for the flour, the flour maker calculated that he must purchase wheat at $7.00/bu or less in order to breakeven.

At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat futures are trading at $6.70 per bushel, and the flour maker wishes to lock in this purchase price. To do this, he enters a long hedge by buying some September Wheat futures.

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With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures contracts to hedge his projected 50000 bushels requirement.

In August, the manufacturing process begins and the flour maker need to purchase his wheat supply from the local elevator. However, the price of wheat have since gone up and at the local elevator, the price has risen to $7.20 per bushel. Correspondingly, prices of September Wheat futures have also risen and are now trading at $7.27 per bushel.

Loss in Cash Market.

Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose $0.20/bu. At 50000 bushels, he will lose $10000 in the cash market.

So for all his efforts, the flour maker might have ended up with a loss of $10000.

. is Offset by Gain in Futures Market.

Fortunately, he had hedge his input with a long position in September Wheat futures which have since gained in value.

Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts = $335000

Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts = $363500

Net Gain in Futures Market = $363500 – $335000 = $28500

Overall profit = Gain in Futures Market – Loss in Cash Market = $28500 – $10000 = $18500

Hence, with the long hedge in place, the flour maker can still manage to make a profit of $18500 despite rising Wheat prices.

Basis Risk

The long hedge is not perfect. In the above example, while cash prices have risen by $0.60/bu, futures prices have only gone up by $0.57/bu and so the long futures position have only managed to offset 95% of the rise in price. This is due to the strengthening of the basis.

Cash September Futures Basis
May $6.60 $6.70 -$0.10
August $7.20 $7.27 -$0.07
Net -$0.60/bu +$0.57/bu +$0.03 (Stengthened by $0.03)

The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis once a hedge is in place. See basis.

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