An example of a commodity futures trade is a cereal company buying wheat futures to lock in a price for wheat, a key ingredient in their cereal production. This helps them manage price volatility and ensure predictable costs.
Here's a breakdown of why and how this works:
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The Situation: A cereal company relies heavily on wheat to manufacture its products. Fluctuations in the price of wheat can significantly impact their profit margins.
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The Solution: Buying Wheat Futures: To mitigate this risk, the company enters into a wheat futures contract. This contract obligates them to purchase a specific quantity of wheat at a predetermined price on a future date.
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How it Works:
- The cereal company buys, for example, a December wheat futures contract.
- This contract guarantees them a specific price per bushel of wheat in December, regardless of the actual market price at that time.
- If the market price of wheat rises above the contract price in December, the company benefits because they are buying wheat at a lower, pre-agreed price.
- Conversely, if the market price of wheat falls below the contract price, the company effectively pays more than the market price. However, this is the cost of the price certainty and risk management the futures contract provides.
- Many commercial users of commodities don't take delivery of the underlying commodity. Instead, they "offset" their futures position by selling a matching contract before the delivery date. This allows them to realize the profit or loss on the contract and purchase the physical commodity in the spot market if they need it.
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The Benefit: By using wheat futures, the cereal company can better predict its costs, protect its profit margins, and plan its business operations more effectively. This also translates to more stable pricing for consumers.
Another example could be an airline purchasing jet fuel futures to hedge against rising fuel costs, or a gold mining company selling gold futures to lock in a price for their future production.
