Digital Sign Hedging Agreement Made Easy

Countersign hedging agreement

hello and welcome to this presentation on the subject of hedging with for contracts in this example we're going to look at how a farmer interacts with a manufacturer in order to lock in a favorable price for their commodity now in this example we're going to ignore the intervention or intermediation of a broker or a market maker or dealer just to keep the example simple later on in further presentations we'll see how these participants interact however let's just imagine that we have a farmer here who is that grower of wheat or barley or sugar or coffee or cocoa as such we refer to the farmer as a natural long what we mean is that the farmer owns the crops and as such he's going to be thinking about some staging in the near future selling his crops now what he's concerned about is that if his crops are still in the ground and he's still waiting for harvest time he's worried that between now and the point of bringing his crops to market prices may fall so what the farmer may wish to do is to enter into an agreement with somebody who is on the proverbial other side of the fence so to speak that is maybe the manufacturer and try and agree today to lock in a for selling price for his crops now let's suppose we have the the manufacturer or the refiner or the rose through Allen Miller they by contrast are considered to be a natural short that is to say today they may have a certain amount of the raw material inventory which they use for production processes and opening next few weeks or months of course that inventory is going to be depleted so they're going to be looking to replenish their inventory in the near future so therefore what they are worried about in the intervening period is that they're worried about prices rising so it makes good commercial sense for the other farmer on the one hand and the manufacturer on the other to enter into a forward contract where they can agree to buy and sell on a forward basis at a mutually convenient price in this example we'll assume that that price is $100 per unit and that they're trading say 1,000 units which of course could be barrels of oil or bushels of wheat or tons of sugar for example so what the farmer is going to do today is to sell forward at $100 and the manufacturer or the refiner or other roaster or the Miller is going to buy on forward basis at $100 so therefore today what happens is that the forward price of $100 is struck and then come delivery day what happens is that the farmer will deliver the correct amount of quantity and the quality of the online asset in the right location and the buyer will pay the agreed price which in this case was $100 so what's happened then during the hedging period is that the farmer and the manufacturer have been able to lock in price certainty now of course we have to consider what happens if on delivery day in the local market prices happen to be above or below $100 well let's just apply is that on delivery day in the local market prices are trading at say $150 in that example the manufacturer then would be somewhat pleased with their hedge outcome because they've locked in an agreed price of $100 now at the money the farmer by contrast would be somewhat perturbed because what they have is an obligation to deliver their crops at a price of $100 not being able to achieve the local price of 115 by contrast of course if in the local market the prices were saying at $50 in that situation then the farmer would be very pleased with their hedge outcome because they're able to lock in through the forward contract to selling price of 100 and by contrast again the manufacturer would be somewhat perturbed by the outcome because they're committed through the full contract to buy a hundred dollars and not get their crops in the local market at $50 what we witness here of course is the the cost if you like of hedging because a hedge in the case of a forward contract lots in price certainty the cost of the hedge is to forego any profit opportunity now the other consideration in a Ford contract is what happens if during the life of the full contract either the farmer or the manufacturer fails to honor their obligation in terms of delivering well that can be the subject of the the next presentation when we look at the consequences of either the farmer or the manufacturer defaulting on their obligation