Question

Unioil produces vegetable-based cooking oil and butter spreads. Unioil uses large quantities of crude palm oil (CPO)in its production process as a main raw material. It is September 2020 now and Unioil estimates a need of 25,000 metric tons (MTs)of CPO in March 2021. Current spot price of CPO is RM2200 per MT. You as the procurement manager of Unioil, have the following alternatives to hedge the possible increase in the CPO price by March 2021:

[EACH OPTION (a, b, c, d) IS MUTUALLY EXCLUSIVE]—Do not link them

1. The commodities analysist predicts that the CPO will be trading at RM3400 per MT in March 2021.

2. Forward contracts on CPO for March 2021 delivery is available at RM3600 per MT.

3. March 2021 Futures contract on CPO (FCPO) is available and currently trading at RM2280 per MT. (FCPO has a contract specification of 25 metric tons per contract). What would be your net purchase price in March 2021 if the CPO closing price in March 2021 is RM3500 per MT? Justify whether this is a perfect hedge?

4. European Options on March 2021 CPO is available at the following prices:

March 2021 Strike RM/MT	European Call March 2021	European Put March 2021
3300	200	120
3400	190	140
3500	180	150
3600	160	180
3700	140	200

You are required to evaluate each hedge alternative carefully and suggest the best hedge strategy or would you decide to remain unhedged. Your answer should include a careful cost and benefit analysis for each hedge alternative and justify your selection in terms of its certainty and effectiveness.

[EACH OPTION (a, b, c, d) IS MUTUALLY EXCLUSIVE]—Do not link them

Answer 1

In March,2021 Unioil needs 25,000 Metric Tons (MT) of CPO

Current Spot Price of CPO = RM 2200 per MT

Purchase Amount = 25000 * 2200 = RM 55,000,000

Hedging is a strategy of minimise losses in investment by taking an opposite position in that particular asset.

  Hedging = Change in existing position + Profit / loss in Hedging instrument = 0

a ) Commodities analyst predicts

expected price = RM 3,400 per MT

i.e., Purchase amount of CPO at expected price = 25000 * 3400 = RM 85,000,000

b ) Forwrd Contract price = RM 3600 per MT

Purchase price of CPO at forward contract price = 25000 * 3600 = RM 90,000,000

c ) Future Contract price = RM 2280 per MT

Contract size = 25 MT

Number of Contracts = 25000 / 25 = 1000 contract

March 2021 CPO closing price = RM 3500 per MT

Purchase amount (with future contract) = 1000 * 25 * 2280 = RM 57,000,000

Purchase amount (without future contract) = 25000 * 3500 = RM 87,500,000

At the end of March,2021 CPO price = RM 3500 per MT which is greater than future contract price RM 2280 per MT.

Benefit if we purchase future contract = RM 87,500,000 - RM 57,000,000

= RM 30,500,000

Yes, this is a perfect case of hedging. In this case number of contracts are not in decimals also the future contract price of March,2021 not after or prior of the period when company has procure raw material. At the end of March,2021 CPO price = RM 3500 per MT which is greater than future contract price RM 2280 per MT. As future contract price less than the current price in March which reduces the risk at the lowest.

d )

Expected price of CPO in March,2021 = RM 3400

Unioil has short position in CPO, that means needs palm oil in future.

Call option gives the right to buy underlying asset on agrred price and date.

So here call option is used not put option.

Strike price	Call option Premium	Cost = Strike price + Premium	Benefit = Expected Price - Cost
3300	200	3300 + 200 = 3500	3400 - 3500 = -100
3400	190	3400 + 190 = 3590	3400 - 3590= -190
3500	180	3500 + 180 = 3690	3400 - 3690 = -200
3600	160	3600 + 160 = 3760	3400 - 3760 = -360
3700	140	3700 + 140 = 3840	3400 - 3840 = -440

No option hedging as it not gives any benefit.

We choose future contract option for hedging, that is the best option.