Hedging strategy to protect against falling prices Price fluctuations in commodities can have significant consequences for companies, especially if the fluctuation involves a prime raw material for a company. Different companies will adopt different strategies to manage the risk in price fluctuations, including adjusting the timing of their commodity purchases, maintaining a safety stock of their raw materials, and hedging. Consider the case of Green Catepillar Garden Supplies Inc., a large copper-producing company: The companys cost of producing copper is about $3.60 per pound. The current market price for copper is $4.32 per pound. The six-month futures price for copper is $4.50 per pound. At this selling price, the company can maintain its earnings growth. The company expects to produce 500,000 pounds of copper in this six months. (Note: Copper futures are traded at a standard size of 250,000 pounds.)

If the company does not hedge the copper it produces, it can expect to earn a total revenue------ of at the end of six months.

If Green Catepillar places a hedge on its copper production in the futures market, it would------- contracts for delivery in six months at a delivery price of $4.50 per pound to generate profits that maintain its desired earnings growth.

When the contract comes due in six months, the spot price of copper is $3.06 per pound in the cash markets. Prices on the new six-month futures contracts in copper are $3.83 per pound. Calculate the expected revenue in the following markets:

Futures Market Net gain or loss in the futures market:

$1,915,000

$720,000

-$270,000

$2,250,000

Cash Market Net gain or loss in the cash market:

$1,915,000

-$270,000

$335,000

$180,000

The cost of production of copper is $1,800,000. Thus, Green Catepillar will ----in the futures market and---- in the cash market. This gain and loss offset each other, and the company benefits from placing the hedge. This hedging strategy would be referred to as a hedge, and it helps protect the producer to sell a commodity against falling prices.