----------------------------------------------------------------------------
HEDGING
to protect a gain on a favorable purchase of actual sugar
--------------+-----------------------------------------+----------+--------
Initial | |
Transactions | Subsequent Transactions | Result
--------------+--------+----------+---------+-----------+----------+--------
| Hedge |Condition |Price you| Result of | Figure | In
| |of market | pay for | hedge and | actual | each
| | when you | futures | covering | sugar | case
| | "cover" | to cover| operation | cost | the
| |your hedge| hedge | | this way | same
--------------+--------+----------+---------+-----------+----------+---------
You buy actual| | | | |Price paid|
sugar at 6.00,| | | | |for actual|
but before you| |It has | | |sugar less|Your
have received | |declined | | |hedging |sugar
it (or before | |to | |A profit |profit |cost
you sell it) | |6.00 | 6.00 |of 2.00 |6-2=4.00 |is
the price | | | | | |2.00
advances to | | | | | |under
8.00 | | | | |Price paid|the
| | | | |for actual|market
You now have |You sell|It has | | |sugar plus|
your sugar at |futures |advanced | | |hedging |
2.00 under the|at |to | |A loss |loss |
market |8.00 |10.00 | 10.00 |of 2.00 |6+2=8.00 |
| | | | | |
You feel that | |It stands | |No profit, | |
the market may| |at 8.00 | 8.00 |no loss | 6.00 |
recede and | | | | | |
eliminate | | | | | |
this gain, | | | | | |
so-- | | | | | |
--------------+--------+----------+---------+-----------+----------+--------
In both of these cases, the operation is relative. If a man has a
profit, let us say 2c a pound, and he hedges, he maintains his profit
of 2c a pound as compared with the market at the time of delivery, or
at the time when he expects to sell this sugar, regardless of whether
the market is higher or lower.
In the same way, conversely, if he has a loss on his sugar of 2c a
pound, by hedging he can limit that loss to 2c a pound, even though the
market goes still lower. In other words, his sugar cost at the time of
delivery, or at the time when he expects to sell the sugar, will be
about 2c above the market price, whether the market is higher or lower.
We shall assume that you have bought from a refiner through your broker
a supply of actual sugar at 6.00. While your sugar is in transit or
before it has been shipped by refiners, the market advances to 8.00, at
which point it apparently is steady. You now have a _theoretical_ gain
of 2.00--that is, if you were to sell your sugar at once, you would
have an _actual_ profit of 2.00; but you do not sell because your
sugar is in transit or you need it for your trade. However, you do want
to preserve and protect this favorable position of having your sugar
2.00 below the market at the time you want to sell it. So you sell the
same quantity of futures on the Exchange at 8.00.
Three things may occur--the market may decline, or it may continue to
advance, or it may remain steady. You have accomplished your purpose in
any case (see Chart 2).
By the time you sell your sugar (or at the time of its delivery) it
becomes necessary for you to cover your hedge and if the market has
declined from 8.00 (at which point you hedged) and stands at 6.00
again, your hedging operations considered alone would net you an actual
profit of 2.00. Your original sugar cost was 6.00. Your profit on your
hedge was 2.00, so that you would figure your actual sugar cost at
4.00. You would have accomplished your purpose of getting your sugar
2.00 under the market at the time of selling it (or at the time of its
delivery). That is, your delay in selling your sugar has cost you
practically nothing, even though the market has declined.
If the market has advanced to 10.00, when it becomes necessary for you
to cover your hedge (at the time of selling your sugar or when it is
delivered) your hedging operations considered alone would net you a
_loss_ of 2.00. You would buy in futures at 10.00, which you sold at
8.00. Your original sugar cost was 6.00, your loss on your hedge was
2.00, so that you would figure your actual sugar cost at 8.00. But the
market at that time was 10.00, so that you have accomplished your
purpose of getting your sugar 2.00 under the market at the time of
selling it (or at the time of delivery). In other words, you would make
the same profit as though you had re-sold your sugar to second-hands
originally, instead of hedging, but had you followed this course, you
might not have had sugar in stock for your regular trade.
On the other hand, when it becomes necessary for you to cover your
hedge, if the market has remained steady and is again at 8.00, the two
futures transactions cancel themselves without profit or loss. Your
original cost of 6.00, therefore, stands as your actual sugar cost at
the time of selling (or at the time of delivery). This is 2.00 under
the market and you have accomplished your purpose.
HEDGING _to establish and limit a loss on an unfavorable purchase_.
This operation is identical in its working with the previous example,
except that you have a different end in view.