Question

conditions for a perfect futures contract hedge. To illustrate the hedge, use an abattoir (consumer) who is required to purchase 20,000 kg of live cattle in December 2020.

Futures contract on live cattle:

Contract size: 10,000 Kg

Contract maturity: Dec. 2020

Answer 1

For a perfect hedge, we match the holding period & the futures expiration date of the live cattle to be hedged with the live cattle underlying the futures contract- thereby avoiding any risk of change in price of the live cattle underlying the futures contract.

Illustration:

Quantity of live cattle to be hedged = 20,000 kg

Contract Size = 10,000 kg

Therefore number of future contracts to be entered into = 20,000 / 10,000 = 2 Contracts/Lots

Contract maturity given for the future contract = December 2020

Consumer's requirement (for live cattle) is also for December 2020.

Hence the given contract is perfect for the consumer's need.

He can hedge the risk of change in prices of live cattle using the given future contract.

Future contracts are settled in cash, the consumer can hedge his risk as explained below:

Let's assume that 1kg live cattle costs $1 today.

Hence 20,000kg live cattle will cost $20,000 today.

Now the price of live cattle may go up or go down till december. This change will be taken care of by entering into future contract.

Buy 2 lots of future contract today (10,000kg per lot) = ($20,000)

Assume price falls to $0.8 per kg in december = $16,000

Hence loss in future contract ($16,000 - $20,000) = ($4,000)

Purchase actual live cattle in december @0.8 per kg = ($16,000)

Therefore total outflow of funds ($4,000 + $16000) = ($20,000)

Similarly, we will still be able to hedge the change in price even when the price increases:

Buy 2 lots of future contract today (10,000kg per lot) = ($20,000)

Assume price rises to $1.4 per kg in december    = $28,000

Hence profit in future contract ($28,000 - $20,000) = $8,000

Purchase actual live cattle in december @0.8 per kg = ($28,000)

Therefore total outflow of funds ($28,000 - $8000) = ($20,000)

Hence, by entering into 2 lots of future contract today, maturing in december, we are able to perfectly hedge the risk of change in price of live cattle.