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Hedging strategy to protect against falling prices

Price fluctuations in commodities can have significant consequences for companies, especially if the fluctuation involves a prime raw material for a company. Different companies will adopt different strategies to manage the risk in price fluctuations, including adjusting the timing of their commodity purchases, maintaining a safety stock of their raw materials, and hedging.

Consider the case of Red Pencil Office Supplies, a large copper-producing company:

The company’s cost of producing copper is about $3.85 per pound. The current market price for copper is $4.62 per pound. The six-month futures price for copper is $4.81 per pound. At this selling price, the company can maintain its earnings growth. The company expects to produce 500,000 pounds of copper in this six months. (Note: Copper futures are traded at a standard size of 250,000 pounds.)

If the company does not hedge the copper it produces, it can expect to earn a total revenue of __________ at the end of six months.

If Red Pencil places a hedge on its copper production in the futures market, it would ___________ contracts for delivery in six months at a delivery price of $4.81 per pound to generate profits that maintain its desired earnings growth.

When the contract comes due in six months, the spot price of copper is $3.27 per pound in the cash markets. Prices on the new six-month futures contracts in copper are $4.09 per pound. Calculate the expected revenue in the following markets:

Futures Market

Net gain or loss in the futures market:

A. –$2,405,000

B. $770,000

C. -$290,000

D. $2,045,000

Cash Market

Net gain or loss in the cash market:

A. –$2,045,000

B. -$290,000

C. $190,000

D. $360,000

The cost of production of copper is $1,925,000. Thus, Red Pencil will _______ in the futures market and _______ in the cash market.

This gain and loss offset each other, and the company benefits from placing the hedge. This hedging strategy would be referred to as a _______ hedge, and it helps protect the producer to sell a commodity against falling prices.

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