Hedging for Sales Support
Organizations often need to enter into long-term sales contracts with fixed prices, even when some of their costs depend on market fluctuations.
For example, construction and development companies sign long-term pre-sale agreements while being unable to control building material prices. The profitability of the aviation industry is significantly affected by oil price volatility, and aluminum composite panel production is influenced by changes in aluminum futures prices, and so on.
To mitigate such market risks, organizations frequently use “futures” transactions. For instance, if copper constitutes a significant portion of your product’s cost structure and you have signed a long-term contract with a buyer, you need to lock in the purchase price of copper to secure your profitability. In this case, you can buy a copper futures contract on the London Metal Exchange (LME), which grants you the right (and obligation) to purchase copper at a predetermined price in the future.
Futures and Spot Price Statistics
But how much should you buy? At first glance, you might think you need to buy exactly as much copper as you will need in the future. However, it’s not that simple. The volatility of futures prices does not perfectly match the volatility of spot prices. This means that when you need to sell your futures contract and buy physical copper, the gains and losses will not offset each other exactly.
For example, suppose you have signed a contract to buy 1,000 tons of copper in three months at a fixed price. Two months later, you need to purchase physical copper, but its market price has risen by 5% compared to your planned cost. Without a futures contract, you would incur a 5% loss. Since you have the right to buy at a lower price through your futures contract, it should ideally compensate for your loss. However, this is not always exact, especially because there is still time left until the futures contract expires.
To calculate the optimal number of contracts for hedging purposes, the following formula is used:
This formula considers the historical correlation between futures and spot prices and the risk range of each. For example, based on copper futures and spot price data over the past 49 days, a futures contract expiring in May 2025 requires a hedge ratio of 1.18. This means that to hedge the price of 1,000 tons of copper, you should enter into a futures contract for 1,180 tons of copper.
Considerations and Adjustments
It is important to note that copper prices may also decline, in which case your futures hedging decision could result in a loss. However, hedging is not about maximizing profits but rather about protecting the expected level of profitability.
Sometimes investors anticipate future price changes, and such expectations can influence the optimal hedge ratio. In these cases, the formula can be adjusted to account for price expectations, modifying the standard hedge ratio accordingly.
Excel File OHR