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Hedging Commodity Price Risk: A Comparison of Strategies

ChAI
Published by ChAI
Jun 19 2024
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Hedging Commodity Price Risk: A Comparison of Strategies

With options such as Bull Call Spreads, Commodity Derivatives and OTC Swaps for hedging your commodity price risk, it can be challenging to identify the appropriate  strategy for you. In this article, we provide a side-by-side comparison of two common strategies available today to manufacturing organisations who purchase raw materials and want to protect against the price rising.

We will compare in this case the following hedging strategies commonly available to manufacturing organisations for commodity price risk management.

  1. Commodity Forward Contracts: Contracts to buy a commodity at a predetermined price and time in the future, available primarily via banks. These are very similar to securing a fixed price contract with a supplier.
  2. Bull Call Spreads: An options trading strategy involving the purchase of a pair of call options, where going short one option while buying another limits the upside protection but results in an overall lower price. These are typically available via brokers, as they require the purchase of options.

Assumptions and Parameters

If you buy a material that is trading at a current price of $100 per unit (for example $100 per tonne), and are concerned about the potential cost of this material increasing in 1 year, you could seek to lock in your prices for 1 year in the future with a Forward Contract or a price fixing arrangement with a supplier. Typically, this involves you agreeing to pay a fixed premium on top of the current spot price to fix the price in the future, say to $110. Your counterparty would charge you a premium to set up this hedge, say $10. This would ensure that no matter what the prevailing price in 1 year is, the effective price you pay is $120.

Alternatively, you could consider a Bull Call Spread. In this case you would want to lock in the price at which your cover starts (say $110) by buying a Call Option at that price, and selling a Call Option at the price at which your cover stops (say $150), and would be charged an up-front premium for this (say $5). This would mean that if the prevailing price in 1 year is anywhere between $110 and $150, your hedge would payout as the difference between the prevailing price and $110, meaning you effectively pay $115 for your material. If the prevailing price were above $150, your hedge would always pay out $40, reducing your effective price by $35 in all cases (as you pay the premium up front).

With those assumptions, we can see that a bull call spread is a better strategy than a Forward contract for all settlement prices up to $155, as represented by the shaded portion on the above chart.

A commodity Forward Contract would only be useful if you are able to secure a premium that is lower than the sum of the start price and the premium for an equivalent Bull Call Spread. This is unlikely as the structure of a Bull Call Spread is designed to lower its cost in comparison to an equivalent Forward contract.

Furthermore, while a Forward Contract obliges its buyers to buy the agreed volume of materials at the forward price, a Bull Call Spread strategy would only act as a financial hedge. The main benefit of this is that the buyer of a Bull Call Spread can benefit from full downside participation in the market, in other words you can take advantage of the price being lower at settlement (instead of having locked in a high price).

A Bull Call Spread is typically more effective than an equivalent Forward Contract as this strategy caps the upside benefit of the strategy to lower the cost of the hedge. For manufacturing organisations that are looking for cost effective ways to achieve certainty on their Effective Price of raw materials, and therefore their cost of goods sold, Bull Call spreads can be the perfect way to manage their risk efficiently. Forwards, while allowing for full upside protection, can be considerably more expensive, and should be considered in cases where you have strong conviction that the market will move significantly higher than prevailing prices.

ChAI Protect

At ChAI we offer a product that mimics all of the characteristics of a Bull Call Spread, but is embodied as an insurance product. We offer this in markets where there is no exchange traded product (for example in packaging materials) and directly replicate the risk our clients have in terms of the price indices they have exposure to. This means that the above analysis can be used to compare the effectiveness of ChAI Protect versus a price fixing or forward contract strategy.

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