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

Under the Unhedged strategy, the price of CPO in March 2021 may rise to RM 3400/MT and the company might be required to pay that price

Under Hedging using forward, a price of RM 3600/MT can be locked in for March 2021 , which may be the required price to pay. This price becomes fixed for the company

Under Hedging using Futures, a price of RM 2280/MT can be locked in (with some basis risk) for the March 2021 purchase by purchasing 1000 Futures contracts (each of 25MT CPO). The Net purchase price would be RM 2280/MT only even if the  CPO closing price in March 2021 is RM3500 per MT. This is almost a perfect hedge, if the quality, delivery timing etc of the Futures contract match exactly with the company requirements.

The company would have to purchase call options on CPO to hedge , the maximum buying price becomes fixed at the (Strike price + premium) example, the maximum purchase price in case of 3300 call would be RM 3300+ RM 200 = RM 3500/MT. In this case , the maximum purchase price with all the call options exceed RM 3500/MT. Thus, these would be meaningless if the price is less than RM 3300/MT.

Out of the above possible alternatives, hedging using Futures is the best as it locks in a rate much lesser than the other alternatives, There is a very small upfront cost in the form of margin requirements, which is recovered at the end.