Business, Legal & Accounting Glossary
Buying futures to hedge against the sale of a cash commodity. also called buying hedge.
A long hedge is a futures position taken for the purpose of maintaining price stability on a purchase. Long hedges are frequently employed by manufacturers and processors to eliminate price fluctuation in the purchase of necessary inputs. These input-dependent businesses anticipate the need for materials multiple times a year, therefore they enter futures positions to keep the purchase price stable throughout the year.
As a result, a long hedge is also known as an input hedge, a buyers hedge, a purchase hedge, a purchasers hedge, or a purchasing hedge.
A long hedge is a cost-cutting approach for a corporation that knows it will need to buy a commodity in the future and wants to lock in the price. The hedge is straightforward: the buyer of a commodity simply takes a long futures position. A long position suggests the commodities buyer is betting on the price of the commodity rising in the future. If the price of the good rises, the profit from the futures trade helps to cover the higher cost.
In a simple scenario, suppose it’s January and an aluminium factory requires 25,000 pounds of copper to create aluminium and meet a contract in May. The spot price is currently $2.50 per pound, but the May futures price is $2.40 per pound. In January, the aluminium maker announced a long position in a May copper futures contract.
This futures contract can be sized to cover a portion or the entire anticipated order. The hedge ratio is determined by the size of the stake. For example, if the purchaser hedges half the quantity of the purchase order, the hedge ratio is 50%. If the May spot price of copper exceeds $2.40 per pound, the manufacturer will have profited from its long position. This is due to the overall benefit from the futures contract helping to offset the higher purchasing cost of copper in May.
If the May spot price of copper is less than $2.40 per pound, the producer incurs a tiny loss on the futures position while saving overall due to a lower-than-expected purchase price.
It is difficult to offset all pricing risk due to basis risk, but a high hedge ratio on a long hedge will remove a lot of it. A short hedge, which protects the seller of a commodity or asset by locking in the sale price, is the inverse of a long hedge.
Long and short hedges can be looked of as a type of insurance. There is a cost to put them up, but they can save a corporation a lot of money in an emergency.
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This glossary post was last updated: 7th January, 2022 | 0 Views.