Hedging Against Rising Tin Prices using Tin Futures

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Contents

Hedging Against Rising Tin Prices using Tin Futures

Businesses that need to buy significant quantities of tin can hedge against rising tin price by taking up a position in the tin futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of tin that they will require sometime in the future.

To implement the long hedge, enough tin futures are to be purchased to cover the quantity of tin required by the business operator.

Tin Futures Long Hedge Example

A tin can manufacturer will need to procure 500 tonnes of tin in 3 months’ time. The prevailing spot price for tin is USD 11,550/ton while the price of tin futures for delivery in 3 months’ time is USD 12,000/ton. To hedge against a rise in tin price, the tin can manufacturer decided to lock in a future purchase price of USD 12,000/ton by taking a long position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin can manufacturer will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the tin can manufacturer will be able to purchase the 500 tonnes of tin at USD 12,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of tin makes a significant move either upwards or downwards by delivery date.

Scenario #1: Tin Spot Price Rose by 10% to USD 12,705/ton on Delivery Date

With the increase in tin price to USD 12,705/ton, the tin can manufacturer will now have to pay USD 6,352,500 for the 500 tonnes of tin. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 12,705/ton. As the long futures position was entered at a lower price of USD 12,000/ton, it will have gained USD 12,705 – USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total gain from the long futures position is USD 352,500.

In the end, the higher purchase price is offset by the gain in the tin futures market, resulting in a net payment amount of USD 6,352,500 – USD 352,500 = USD 6,000,000. This amount is equivalent to the amount payable when buying the 500 tonnes of tin at USD 12,000/ton.

Scenario #2: Tin Spot Price Fell by 10% to USD 10,395/ton on Delivery Date

With the spot price having fallen to USD 10,395/ton, the tin can manufacturer will only need to pay USD 5,197,500 for the tin. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 10,395/ton. As the long futures position was entered at USD 12,000/ton, it will have lost USD 12,000 – USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total loss from the long futures position is USD 802,500

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the tin futures market and the net amount payable will be USD 5,197,500 + USD 802,500 = USD 6,000,000. Once again, this amount is equivalent to buying 500 tonnes of tin at USD 12,000/ton.

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Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the tin buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising tin prices while still be able to benefit from a fall in tin price is to buy tin call options.

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

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In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Falling Tin Prices using Tin Futures

Tin producers can hedge against falling tin price by taking up a position in the tin futures market.

Tin producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of tin that is only ready for sale sometime in the future.

To implement the short hedge, tin producers sell (short) enough tin futures contracts in the futures market to cover the quantity of tin to be produced.

Tin Futures Short Hedge Example

A tin mining company has just entered into a contract to sell 500 tonnes of tin, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of tin on the day of delivery. At the time of signing the agreement, spot price for tin is USD 11,550/ton while the price of tin futures for delivery in 3 months’ time is USD 12,000/ton.

To lock in the selling price at USD 12,000/ton, the tin mining company can enter a short position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin mining company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the tin mining company will be able to sell the 500 tonnes of tin at USD 12,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of tin makes a significant move either upwards or downwards by delivery date.

Scenario #1: Tin Spot Price Fell by 10% to USD 10,395/ton on Delivery Date

As per the sales contract, the tin mining company will have to sell the tin at only USD 10,395/ton, resulting in a net sales proceeds of USD 5,197,500.

By delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 10,395/ton. As the short futures position was entered at USD 12,000/ton, it will have gained USD 12,000 – USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total gain from the short futures position is USD 802,500

Together, the gain in the tin futures market and the amount realised from the sales contract will total USD 802,500 + USD 5,197,500 = USD 6,000,000. This amount is equivalent to selling 500 tonnes of tin at USD 12,000/ton.

Scenario #2: Tin Spot Price Rose by 10% to USD 12,705/ton on Delivery Date

With the increase in tin price to USD 12,705/ton, the tin producer will be able to sell the 500 tonnes of tin for a higher net sales proceeds of USD 6,352,500.

However, as the short futures position was entered at a lower price of USD 12,000/ton, it will have lost USD 12,705 – USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total loss from the short futures position is USD 352,500.

In the end, the higher sales proceeds is offset by the loss in the tin futures market, resulting in a net proceeds of USD 6,352,500 – USD 352,500 = USD 6,000,000. Again, this is the same amount that would be received by selling 500 tonnes of tin at USD 12,000/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the tin seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling tin prices while still be able to benefit from a rise in tin price is to buy tin put options.

Learn More About Tin Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Using ETFs To Hedge Against Rising Rates

September 29, 2020

The September Federal Reserve meeting passed without much fanfare, quieting markets that had been getting jittery about a rate hike. The central bank―eyeing the uncertainty of a presidential election in November―chose to delay its much-anticipated interest rate increase, but not for long.

After the no-change decision, Federal Reserve Board Chair Janet Yellen told the press that she expects a rate hike sometime this year. That means that an increase may come either at the November or December meeting, with most economists targeting the latter as the likeliest option for a move.

If so, it will be deja vu, for it was last December when the Fed hiked rates for the first time in nearly a decade after months of anticipation. Another hike this December would push the federal funds rate up by 25 basis points to a range of 0.50-0.75% from 0.25-0.50%.

Rates Down From Start Of Year

Market-set rates are up from their lows ahead of the potential rate increase, though they’re down significantly from where they were at the start of the year.

The two-year Treasury bond yield, for example, is at 0.75%, up from a low of 0.50% in June, but down from 1.05% on Dec. 31. At the same time, the 10-year Treasury bond yield is at 1.56%, up from a record-low 1.32% in July, but down from 2.27% on Dec. 31.

It’s impossible to say whether the next Fed hike will be the catalyst that finally spurs a big rally in interest rates (and sell-off in bonds). But for investors who want to protect themselves, there are many tools available in the ETF world to minimize the impact of higher rates, or even capitalize on them.

Lower Duration Bonds

The classic advice given to investors in a rising rate environment is to reduce the duration of your bond portfolio. Duration is a measure of interest rate risk and is based on a bond’s maturity and coupon payments.

A higher-duration portfolio has more interest rate risk than a lower-duration portfolio. By reducing duration―for example, by buying shorter-term bonds―a portfolio will have less interest rate risk. The flip side is that the portfolio will probably have a smaller yield as well.

There are plenty of low-duration ETFs on the market that can help reduce the average duration of an investor’s portfolio, including the iShares 1-3 Year Treasury Bond ETF (SHY), the PIMCO Enhanced Short Maturity Active ETF (MINT) and many more.

Inverse Bond ETFs

Another method with which to hedge against rising rates is inverse ETFs. These funds short Treasury bonds, meaning they rise in price when interest rates increase (bond prices and rates generally move inversely).

The ProShares Short 20+ Year Treasury ETF (TBF) provides daily inverse exposure to Treasurys with maturities greater than 20 years.

Meanwhile, the Sit Rising Rate ETF (RISE) shorts futures contracts on two-, five- and 10-year Treasurys with a specific goal of maintaining a duration of negative 10. That means if interest rate rise by 1%, the ETF should rise by 10% (and vice versa).

TBF, RISE and similar ETFs can be used to hedge other bond funds in a portfolio or as stand-alone products to speculate on the direction of interest rates.

Keep in mind, however, that any product that shorts positive-yielding bonds will have to pay a cost to maintain that position over time. This can result in losses even if interest rates remain flat.

YTD Returns For TBF, RISE, TLT, IEF

Long/Short Bond Funds

Another group of ETFs attempts to reduce duration by simultaneously holding long and short positions in bonds. The WisdomTree Barclays US Aggregate Bond Negative Duration Fund (AGND) holds the bonds in the Barclays Aggregate Bond Index and a short position in Treasurys at the same time. The result is a portfolio of bonds with a duration of negative 5.

Once again, AGND could be used as a stand-alone product to speculate on interest rates or combined with, say, another position in the iShares Core U.S. Aggregate Bond ETF (AGG) (which incidentally has a duration of positive 5) to reduce an investor’s interest rate risk.

ETFs that use a similar strategy as AGND’s include the VanEck Vectors Treasury-Hedged High Yield Bond ETF (THHY) and the ProShares High Yield-Interest Rate Hedged ETF (HYHG), which short Treasurys to hedge a portfolio of high-yield bonds. Both target a duration of zero.

YTD Returns For AGND, THHY, HYHG, AGG, HYG

Floaters

For investors who want to do away completely with interest rate risk, a straightforward solution floating-rate ETFs. The iShares Floating Rate Bond ETF (FLOT) holds a basket of bonds with maturities of five years or less. As floating rate notes, the interest rates on these securities resets periodically based on market rates; so if rates increase, the payout increases too (the downside is that rates on floaters will tend to be lower to account for the smaller risk).

Floaters are attractive compared to fixed-rate bonds when rates are expected to increase, but not as attractive when rates are expected to decline.

The PowerShares Senior Loan Portfolio (BKLN) is another type of floating-rate ETF. It tracks an index of the 100 largest bank loans with floating rate coupons. The fund has little interest rate risk, but relatively high credit risk due to its below-investment-grade portfolio.

YTD Returns For FLOT, BKLN, SLQD, HYG

Best Binary Options Brokers: 2020 Ranking
  • Binarium
    Binarium

    Best Choice! The leader in our ranking!
    Perfect for beginners!
    Free Demo Acc + Free Trading Education!

  • Binomo
    Binomo

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