Long Hedge

Long Hedge: What it is and how it works

A long hedge is a risk-management strategy in which a buyer takes a long position in futures contracts to lock in a future purchase price for a commodity or raw material. It protects buyers against rising prices by offsetting higher physical costs with gains on futures contracts. Long hedges are commonly used by manufacturers, food processors, airlines, and other businesses with predictable future input needs.

How a long hedge works

• A company that expects to purchase a commodity later buys futures contracts for that commodity.
• If the commodity’s market price rises, the futures position increases in value and offsets the higher cost of the physical purchase.
• If the market price falls, the futures position loses value, but the company benefits from the lower spot price when buying the physical commodity.
• The net economic outcome typically approximates the futures price locked in when the hedge was entered.

Think of a long hedge like insurance: it reduces price volatility and helps stabilize costs, but it can result in paying more than the spot market if prices fall.

Example

A cookie manufacturer needs 10,000 pounds of sugar in six months.
– Current spot price: $0.50 per pound
– Futures delivery price (for July): $0.55 per pound
– Manufacturer buys futures covering 10,000 pounds at $0.55

Scenario A — Prices rise:
– July spot price = $0.65 per pound
– Physical cost = $0.65 × 10,000 = $6,500
– Futures gain = ($0.65 − $0.55) × 10,000 = $1,000
– Net cash outflow = $6,500 − $1,000 = $5,500 → effective price = $0.55 per pound

Scenario B — Prices fall:
– July spot price = $0.45 per pound
– Physical cost = $0.45 × 10,000 = $4,500
– Futures loss = ($0.55 − $0.45) × 10,000 = $1,000
– Net cash outflow = $4,500 + $1,000 = $5,500 → effective price = $0.55 per pound

In both scenarios the effective price equals the futures price ($0.55), illustrating how the hedge stabilizes cost.

Hedge ratio

The hedge ratio is the proportion of the expected purchase quantity that is hedged (e.g., 80% hedged). Factors that influence the chosen hedge ratio include:
– Market volatility (higher volatility often leads to higher hedge ratios)
– Storage and carrying costs
– Budget and liquidity constraints (cost of maintaining futures positions and margin requirements)
– Corporate risk tolerance and policies

There is no single “perfect” hedge ratio—companies balance protection against flexibility and cost.

Pricing long hedges: cost of carry

Futures prices reflect the spot price plus or minus costs and benefits of holding the commodity until delivery, often summarized as the “cost of carry.” Key components:
– Financing costs (interest)
– Storage and insurance expenses
– Income from holding the asset (if any, e.g., convenience yield or dividends)

For assets with significant storage costs or seasonality (agricultural products, oil), these factors heavily influence futures pricing.

Futures contracts vs. marketing (forward) contracts

• Marketing (forward) contracts: Customized bilateral agreements between producer and buyer specifying price, quantity, and delivery terms. Common among smaller producers who prefer simplicity and avoidance of exchange margin calls.
• Futures contracts: Standardized exchange-traded contracts (e.g., CME) with set sizes and delivery months. They offer liquidity and price discovery but require margin management and are less customizable.

Both tools manage price risk but serve different operational and scale needs.

Short hedge vs. long hedge

• Long hedge: Used by buyers who want to protect against price increases (e.g., manufacturers hedging raw material purchases).
• Short hedge: Used by sellers or producers who want to protect against price declines by taking a short position in futures (e.g., farmers, oil producers).

Both hedge types aim to stabilize the economics of future transactions; the difference is whether the hedger is locking in a purchase cost (long) or a sales price (short).

Who uses long hedges?

Typical users include:
– Manufacturers that regularly buy commodities (metals, chemicals, grains)
– Food processors and ingredient-dependent producers
– Airlines hedging jet fuel
– Any business with predictable future input needs that seeks to stabilize costs

Key takeaways

• A long hedge uses futures to lock in a future purchase price and reduce exposure to rising commodity prices.
• The hedge transfers price risk from the buyer to the market, creating price certainty at the cost of foregoing potential benefits if prices fall.
• Effective hedging requires choosing an appropriate hedge ratio, understanding cost-of-carry influences on futures pricing, and selecting the right contract type (futures vs. marketing/forward).

Tip: Align hedges with actual business needs and review them regularly—over-hedging can be costly, while under-hedging leaves exposure to volatile markets.