QUESTION 6

Assume it is July 2013 and the future world demand for Crude Palm Oil (CPO) is predicted to be the same, but the world supply of CPO is expected to decrease due to adverse conditions in supplier countries. CPO prices are likely to be affected by the drop in supply. Detailed below are the October futures contracts for CPO and the current spot price: Assume Q = 20,000 Kilograms

RM per Kilo

Current Spot Price for CPO 4.25

3- months (October) Futures Price for CPO 5.50

Required

i. Explain the anticipated risk in this situation by Malaysian CPO products manufacturer and supplier. Also discuss how this firm can hedge the price risk using futures.

ii. Assess the outcome if prices in October on both the spot market and futures market increase to RM 7.00 per kilo?

iii. In October, a market intelligence report suggests that the price of CPO in the next six months could be as high as RM8 per kilo (futures goes to 7) or as low as RM4 per kilo depending on the situation in the major supplier countries. What hedging strategy would you suggest the Malaysian company should adopt in these circumstances?

ANSWER

a. A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date at a specified price, unless the holder's position is closed prior to expiration. Since the CPO price is expected to increase the company can mitigate this risk by entering into a futures contract with the CPO bean supplier in March 2012 to purchase 10,000 kilos of CPO (for example) at US RM5.50 per kilo in June.

If the price of CPO in June is greater than RM5.50 for example if it rises to RM6 per kilo then the futures market price will also increase to RM 6 (for example). As the change in the futures price occurs in the futures market, the account of the buyer will be credited with (6-5.50)× 10,000 = $ 5,000. Because at the close of the contract the buyer will purchase CPO at a price lower than the market price, thus gaining RM5,000.

The sellers account will be debited in the futures market with (6-5.50) × 10,000 = $ 5,000. This is because at the close of the contract the seller has to sell at a lower price than the market price and thus lose RM5, 000. The transactions on the futures market are settled in cash and not in the commodity as shown above. At the settlement of the contract, the US company buys the CPO from the producer on the spot market at $6 per kilo and thus pays 6×10,000 = RM60,000. However the company has made a profit of $5,000 on the futures market. Therefore the net payment is RM60,000 - RM5,000 = RM55,000 which is the contracted amount. Similarly at the settlement of the contract the CPO supplier sells 10,000 kilos of CPO to the US company at the market price of 6×10,000 = RM60,000. However he has incurred a loss of RM5,000 on the futures market. Therefore his net gain is 60,000 - RM5,000 = RM55,000 which is the contracted amount.

b. Assume that In March 2012 the US company has entered into a futures contract with a CPO supplier to purchase 10,000 kilos of CPO (for example) at RM5.50 per kilo in June. In June the prices on both the spot market and the futures market have increased to RM7 per kilo. As soon as the change in the futures price occurs in the futures market, the account of the UK company (buyer) is credited with (7-5.50) × 10,000 = RM 15,000. The CPO producer’s (seller’s) account is debited in the futures market with (7-5.50) × 10,000 = RM 15,000.At the settlement of the contract, the US company buys 10,000 kilos of CPO from the producer on the spot market at RM7 per kilo and thus pays 7×10,000 = RM70,000. However the company has made a profit of RM15,000 on the futures market. Therefore the net payment is RM70,000 - RM15,000 = RM55,000 which is the contracted amount.

Similarly after the settlement of the contract the CPO supplier sells 10,000 kilos of CPO to the UK company at the market price of 7×10,000 = RM70, 000. However he has incurred a loss of $15,000 on the futures market. Therefore his net gain is 70,000 - RM15,000 = RM55,000 which is the contracted amount.

c. Since the CPO prices in the next six months is expected to fluctuate between RM4 -RM8per kilo, the US company should enter in to a futures contract with an CPO producer at a price ideally of RM4 or close to RM4 if possible. This is because the US company can gain by hedging in the futures market as long as the futures contract price is lower than the spot price in six months time as shown in the answer to questions A and B above.

For example: If the spot price in six months is lower than the contracted price then the US company will incur a loss in the futures market which will offset the gain by purchasing CPO at lower price on the spot market.

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