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:

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

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

c) 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?

d) 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

	Quantity required(Q)	25000	MT
	Spot Price(S)	2200
a)	No Hedge
	Expected price(P)	3400
	Purchase amount(Q*P)	85,000,000
b)	Hedging using forward contract
	Forward rate(F)	3600
	Purchase amount(Q*F)	90,000,000
c)	Hedging using futures contract
	Future price	2280
	Contract size	25
	No. of contracts(25000/25)	1000
	Rate in March 2021	3500
	Purchase amount	=25*1000*2280	57,000,000
	Yes, this is a case of perfect hedge using futures contract as the number of contract is not in decimals but is a complete number of 1000 contracts. Also, the future contract is of March 2021 and not prior or after the period when the company has to purchase raw material. These explain that futures contract is a perfect hedge thereby reducing risks to the lowest.
d)	Hedging using options contract
	Expected price(P)	3400
	Assumption- each alternation of strike price below is indifferent to each other and investor can choose both call and put option
	Strike price(K)	Call option	Put option	Hedging choice	Payout	Net premium payment	Net payout	Total payout amount	=(Net Payout-3400)*25000
	3300	200	120	Call option(P<K)	100	-80	20	(84,500,000)
	3400	190	140	No option(P=K)	0	-50	-50	(86,250,000)
	3500	180	150	Put option(P>K)	100	-30	70	(83,250,000)
	3700	140	200	Put option(P>K)	300	60	360	(76,000,000)
	Thus, best hedging option is K=3700
	Analysing all the hedging choices, the best choice is using futures contract for hedging