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:

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.

Answer 1

Given,

Main raw material used in production is crude palm oil(CPO)

Quantity Required in March 2021 = 25,000MT

Current spot price of CPO =RM 2,200/MT

Being afraid of raise in CPO, company wants to hedge the risk by using best alternative from the following available hedging alternatives.

(a) Forward cover:

Forward price of CPO = RT 3,600/MT

Therefore Net purchase price under forward cover = 25,000×3,600 = RT 900lacs

(b) Futures contract:

As the company is afraid of CPO prices going up, it will take long position on CPO futures

Contract size = 25 MT, Exposure = 25,000MT

No. of future contracts = Exposure÷Contract size

No. of contracts = 25,000÷25 = 1,000 contracts

Current trading price in Futures = RT 2,280/MT

If CPO closing price on March 2021 is RT 3,500/MT,

As the price of CPO in futures has been increased as expected, it results in gain on contract

Gain on futures

= (3,500-2,280)×25×1,000 = RT 305lacs

and if on March 2021, Spot price of CPO remains the same as futures price of RT 3,500

Purchase price to be settled in spot market

= 25,000×3,500 = RT 875lacs

Gain on futures = RT 305lacs

Therefore Net purchase price of CPO under Futures contract

= 875lacs-305lacs = RT 570lacs

The futures contract covers the total exposure and no. of contracts results to be exact 1,000 contracts, hence there is a perfect Hedge.

(c) Option cover:

As the company is afraid of raise in CPO prices, it will enter into call option i.e., right to buy

Strike price or Exercise price = RT 3,300/MT

Call premium = RT 200/MT

Total cost per MT = 3,300+200 = RT 3,500/MT

Net purchase price of CPO under Option cover

= 25,000×3,500 = RT 875lacs

(d) If remains unhedged:

Spot price of CPO on March 2021

= RT 3,400/MT

then, Net purchase price of CPO if remains unhedged = 25,000×3,400 = RT 850lacs

Summary:

Hedge Alternative	Net purchase price of CPO
Forward cover	RT 900lacs
Futures contract	RT 570lacs
European options	RT 875lacs
If remains unhedged	RT 850lacs

CONCLUSION: It is beneficial to hedge the exposure and better to enter into Futures contract as Net purchase price of CPO is lower under this alternative.