Long Hedge

The long hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or commodity to be purchased some time in the future. Hence, the long hedge is also known as input hedge.

The long hedge involves taking up a long futures position. Should the underlying commodity price rise, the gain in the value of the long futures position will be able to offset the increase in purchasing costs.

Long Hedge Example

In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in September. Let's assume that the total amount of wheat needed to produce the flour is 50000 bushels. Based on the agreed selling price for the flour, the flour maker calculated that he must purchase wheat at $7.00/bu or less in order to breakeven.

At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat futures are trading at $6.70 per bushel, and the flour maker wishes to lock in this purchase price. To do this, he enters a long hedge by buying some September Wheat futures.

With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures contracts to hedge his projected 50000 bushels requirement.

In August, the manufacturing process begins and the flour maker need to purchase his wheat supply from the local elevator. However, the price of wheat have since gone up and at the local elevator, the price has risen to $7.20 per bushel. Correspondingly, prices of September Wheat futures have also risen and are now trading at $7.27 per bushel.

Loss in Cash Market...

Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose $0.20/bu. At 50000 bushels, he will lose $10000 in the cash market.

So for all his efforts, the flour maker might have ended up with a loss of $10000.

... is Offset by Gain in Futures Market.

Fortunately, he had hedge his input with a long position in September Wheat futures which have since gained in value.

Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts = $335000

Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts = $363500

Net Gain in Futures Market = $363500 - $335000 = $28500

Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500

Hence, with the long hedge in place, the flour maker can still manage to make a profit of $18500 despite rising Wheat prices.

Basis Risk

The long hedge is not perfect. In the above example, while cash prices have risen by $0.60/bu, futures prices have only gone up by $0.57/bu and so the long futures position have only managed to offset 95% of the rise in price. This is due to the strengthening of the basis.

The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis once a hedge is in place. See basis.

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