Question

4.7 If Telco does nothing to manage copper price risk, what is its profit 1 year from now, per pound of copper that it buys? If it hedges the price of wire by buying copper

Answer 1

Calculation of Hedged and Unhedged Profit:

At the expiration of the forward contract, that profit that agrees to the party with short position i.e. the party that has bought the commodity or currency forward can be calculated as the difference between the spot rate on expiration and the agreed future rate at time 0. The following formula can be used:

Profit to long position

= (St − F0) × Q

Where St is the spot rate at time t i.e. the expiration rate, F0 is the forward rate agreed at inception of the contract i.e. time 0 and Q is the quantity of commodity or currency, etc.

A forward contract is a zero-sum game. Any profit (loss) that accrues to the long position is the loss (profit) of the short position.

When Company Hedges the Price of Copper by buying Forward:

It is 31st January 2019 and you work in an Telco Co.. Your company needs to buy Copper in 1 year’s time. The spot rate is $2.78 per pound and you expect the price to decrease to $2.52 after weak manufacturing data stoked new worries about global growth. You can negotiate a forward contract with CME Group (Chicago Mercantile Exchange & Chicago Board of Trade) for delivery of Copper on 31st January 2020 at $2.4 per gallon. By entering into the contract, you commit to the trade if the copper prices do not increase as you expect or even if they decrease.

On 31st January 2020, you can close the contract by buying Copper from CME Group requiring physical delivery or you can just settle it by paying (receiving) the difference between the new stop rate and the agreed rate.

Let’s say that actual price of the fuel is $2.52 per pound on 31st January 2020, you can purchase pay $2.4 per pound to the CME Group and obtain the delivery. Alternatively, you can buy the fuel from any other vendor for an amount of $2.52 per pound and receive $0.12 in cash from the CME Group. The amount that you receive is your gain on the forward contract:

Profit to long position

= ($2.52 − $2.4)

= $0.12 per pound

Your net cost is still $2.4 i.e. $2.52 paid to purchase fuel in spot market minus the profit on your forward position.

In a parallel universe, the countries increase their copper production decreasing the copper price to $2.3 per pound by 31st January 2020. You still need to pay the CME Group an amount of $2.4 for physical delivery. Alternatively, you can buy the fuel in spot market for $2.3 but you must pay the loss that you incurred on the forward position to the CME Group. Your loss amounts to $0.1 and your net/total cost of fuel is $2.4 per pound i.e. price paid in spot market of $2.3 per pound plus the loss incurred of $0.1 per pound

You can see that you have locked a price of $2.4. Your total payoff is $2.4 per pound no matter what happens to the spot market by the expiration time. However, forward contracts expose you to counterparty risk, the risk that seller in the exchange i.e. CME Group might not be able to honor its obligation. It is better to engage in future contracts which differ from forward contracts in two ways: (a) they are traded on an exchange which guarantees payment and the risk of default is very low and (b) your profit or loss on the contract is recalculated frequently and adjusted in cash right away.

Therefore Hedged Profit is Unhedged Profit + Profit/(loss) on Short Position:

a. When expected price in one year is $2.3:

Hedged Profit = 0.48-0.1 = 0.38$

b. When expected price in one year is $2.52:

Hedged Profit = 0.26+0.12 = 0.38$

When Company does not hedge the Price of Copper:

When no hedging is done, the unhedged profit is calculated as follows:

Total Cost incurred today – Total cost incurred after a year.

Therefore,

a. When expected price in one year is $2.3 and Spot price today is $2.78:

The unhedged profit = 2.78-2.3 = 0.48

b. When expected price in one year is $2.52 and Spot price today is $2.78:

The unhedged profit = 2.52-2.3 = 0.26

Graph illustrating Hedged and Unhedged profit is attached.

in Profit Diaguam of Hedged T & hedged position. Thor y Hedged Profit Unhedged Profit 23 24 152278 loppen Pence