I’m often asked how commodity futures trading got its start. For the U.S. futures markets, it all started in Chicago in 1849.
At the time, Chicago was a major commercial center for agricultural products. Farmers (sellers) and agricultural dealers (buyers) began creating ‘contracts’ between each other to set prices for ‘future’ delivery.
For example, a wheat farmer may enter into an agreement to sell 5,000 bushels of his wheat to a flourmill at a specified price in 3 months. By doing so, the farmer knew in advance what he will be paid for his wheat and the flourmill knew exactly what his cost will be in 3 months to purchase the wheat. Neither party had to wonder what wheat prices might be in the future.
As this practice of creating these contracts for ‘future delivery’ developed between producer and user, these ‘futures contracts’ began to be bought and sold by third parties, either for there own use or for speculation.
Another benefit that arose from the exchanging of futures contacts was the benefit of hedging to both the farmers and dealers. They both now had a way to ‘lock in’ or ‘hedge’ their price for a future delivery date.
Let’s look at a specific example. Let’s say in July, a corn farmer wants to hedge his crop for delivery in November. With spot (cash) corn prices currently at $4.00 per bushel and the December corn futures price at $4.25, the farmer will attempt to lock this price in by selling December corn futures with his commodity futures broker. If he expects to bring 10,000 or more bushels to market in November, he would sell 2 December corn futures contracts (1 corn futures contract represents 5,000 bushels of corn) at a price of $4.25 per bushel. Come November, the price of corn has fallen to a current spot (cash) price of corn is $3.77 per bushel and the December futures price is at $3.95. The farmer would then sell his 10,000 bushels of corn for $3.77 per bushel and liquidate or buy back his 2 short corn futures contracts at $3.95 as well. Although corn is now trading at $0.23 less per bushel from back in July, he gained $0.30 per bushel with his futures contracts thus giving him a net selling price of $4.07 per bushel.
As you can see, the farmer actually came out $0.07 per bushel better than he expected. For a dealer or purchaser of corn, a reverse hedge would be used. The dealer would have bought December corn futures contracts as opposed to selling them to hedge their future corn purchase price.
I hope you’ve found this post interesting. Please feel free to contact me with any questions you may have on hedging with commodity futures.
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