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HEDGING
to establish and limit a loss on an unfavorable purchase
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Initial | |
Transactions| Subsequent Transactions | Result
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| Hedge | Condition of | Price | Result | Figure | In
| | market when | you | of | actual | each
| | you "cover" | pay | hedge | sugar | case
| | your hedge | for | and | cost | the
| | |futures| covering | this | same
| | | to | operation| way |
| | | cover | | |
| | | hedge | | |
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You buy | | | | |Price paid|
actual sugar| | | | |for actual|
at 6.00 but | | | | |sugar less|
before you | | | | |hedging |
have | |It has declined| | A profit |profit |
received it | |to 4.00 | 4.00 | of 1.00 |6-1=5.00 |
(or before | | | | | |
you sell it)| | | | | |
the price | | | | | |
declines to | | | | | |
5.00 | | | | | |
| | | | | |
You now have| | | | |Price paid|Your
your sugar | | | | |for actual|sugar
at 1.00 | | | | |sugar plus|cost is
above the |You sell| | | |hedging |1.00
market |futures |It has advanced| |A loss of |loss |above
|at 5.00 |to 6.00 | 6.00 |1.00 |6+1=7.00 |the
| | | | | |market
You feel | |It stands at | |No profit,| |
that the | |5.00 | 5.00 |no loss | 6.00 |
market may | | | | | |
decline | | | | | |
still | | | | | |
further and | | | | | |
increase | | | | | |
this loss, | | | | | |
so-- | | | | | |
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Let us say that you purchase actual sugar at 6.00. If the market
declines to 5.00 after your original purchase at 6.00, you have a
_loss_ of 1.00, in the value of your sugar. Facing the possibility of a
further decline and desiring to _limit_ this loss to 1.00, you hedge by
selling futures. In this case you should limit your _loss_ to 1.00 just
as effectively as in the previous example you preserved your _gain_ of
2.00, and by the same course of procedure. (See Chart 3.)
By the time it is necessary for you to cover your hedge by buying an
equivalent amount of futures, the market may have declined still
further, say to 4.00. You sold at 5.00, you bought at 4.00, profit on
that operation, 1.00. Subtract this profit from your original cost
(6.00) and figure your sugar cost at 5.00. In other words, although the
market went still lower, you succeeded in limiting your loss to 1.00,
as compared with the market price at the time of the delivery of your
sugar (or at the time you sell it). Had you omitted the hedge, your
actual sugar cost would have been 6.00, which was 2.00 above the
market.
After your original purchase at 6.00, and market decline to 5.00 (at
which point you hedged), the market might advance again to 6.00, or
remain steady at 5.00, but the operation is no different from that
previously described, and you in each case attain the same result.