In the 57th blog of Hedging with Jorge, we delve into a practical scenario that illustrates the complexities of aluminium trading, particularly focusing on premium arbitrage and the strategic use of futures hedging.
Scenario overview:
A trading company purchases 5,000 tonnes of aluminium at a fixed price of $2,500 per tonne, with an additional premium of $450, totaling $2,950 per tonne. The company seeks a buyer who is willing to pay a premium of $490 per tonne. This presents a $40 per tonne gain on the premium differential.
However, the buyer stipulates that the base price will be determined by the LME cash settlement price on August 20. This introduces price risk, as the future LME price is uncertain.
Implementing a hedge:
To mitigate this risk, the company decides to hedge by selling 200 lots (each representing 25 tonnes, totaling 5,000 tonnes) of aluminium futures contracts through a broker. These contracts are set to expire on August 22, two days after the buyer’s pricing date, to align with the settlement process.
At the time of hedging, the futures price is $2,509 per tonne, slightly higher than the initial purchase price due to market conditions.
Market movement and outcome:
On August 20, the LME cash settlement price drops to $2,400 per tonne. Consequently:
- Physical market: The company sells the aluminium at $2,400 per tonne, incurring a loss of $100 per tonne compared to the purchase price.
- Premium differential: The company gains $40 per tonne from the premium difference ($490 – $450).
- Futures market: The company closes the futures position by buying back at $2,400 per tonne, realizing a profit of $109 per tonne ($2,509 – $2,400).
Net result:
Loss on physical sale: -$100 per tonne
Gain on premium: +$40 per tonne
Gain on futures: +$109 per tonne
Total net profit: $49 per tonne
This example underscores the importance of strategic hedging in commodity trading. By using futures contracts, the company effectively mitigates price risk associated with market fluctuations, turning a potential loss into a profit.
Conclusion:
Understanding and implementing hedging strategies are crucial for trading companies dealing with commodities like aluminium. Futures contracts serve as valuable tools to manage price volatility and secure profitability, even when market conditions are unfavourable.