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Reading a book where author uses "Effective price" term. After googling it found this:

The effective price is the price at which a commodity is sold or bought after the hedge has been lifted (liquidated). It can be calculated either by adding/substracting the basis change to the original cash price, or by adding/substracting the hedge of the futures (the original futures price at the time the hedge was placed minus the futures price at the time the hedged was lifted) to the final cash price.

Author calculates it using Spot price after at the end of hedge + difference of futures (example about futures hedging) prices F1 - F2, where F1 - futures price at the start of hedging and F2 - at the end.

I understand effective price as price of the asset with which you would have the same profit/loss buying/selling this asset on the Spot market, as buying/selling it on Futures market with difference F1 - F2, is it right?

P.S. What is unclear for me is price at which a commodity is sold or bought after the hedge has been lifted (liquidated). What does lifted (liquidated) mean and why should it affect the price?

CONTEXT:

We will assume that a hedge is put in place at time t1 and closed out at time t2. As an example, we will consider the case where the spot and futures prices at the time the hedge is initiated are $2.50 and $2.20, respectively, and that at the time the hedge is closed out they are $2.00 and $1.90, respectively. This means that S1 = 2.50, F1 = 2.20, S2 = 2.00, and F2 = 1.90. (Where S1 - spot price at t1, S2 spot price at t2, F1 and F2 the same).

Consider first the situation of a hedger who knows that the asset will be sold at time t2 and takes a short futures position at time t1. The price realized for the asset is S2 and the profit on the futures position is F1 - F2. The effective price that is obtained for the asset with hedging is therefore S2 + F1 - F2 = F1 + b2. In our example, this is $2.30

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  • This is a little confusing to parse. What is the sentence used by the author of the book you are reading [context matters as many finance terms are not universal]? Feb 8, 2023 at 19:42
  • @Grade'Eh'Bacon there is not only a sentence : We will assume that a hedge is put in place at time t1 and closed out at time t2. As an example, we will consider the case where the spot and futures prices at the time the hedge is initiated are $2.50 and $2.20, respectively, and that at the time the hedge is closed out they are $2.00 and $1.90, respectively. This means that S1 = 2.50, F1 = 2.20, S2 = 2.00, and F2 = 1.90. (Where S1 - spot price at t1, S2 spot price at t2, F1 and F2 the same).
    – Vanconts
    Feb 8, 2023 at 19:55
  • @Grade'Eh'Bacon Consider first the situation of a hedger who knows that the asset will be sold at time t2 and takes a short futures position at time t1. The price realized for the asset is S2 and the profit on the futures position is F1 - F2. The effective price that is obtained for the asset with hedging is therefore S2 + F1 - F2 = F1 + b2. In our example, this is $2.30.
    – Vanconts
    Feb 8, 2023 at 19:56
  • @Grade'Eh'Bacon so basically I want to understand two things, what "The price realized for the asset is S2" means, and what 'effective price' is.
    – Vanconts
    Feb 8, 2023 at 19:57
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    please incorporate that full explanation into the body of the question; if you re-write the question to be more readable, you are likely to get more attention / responses. Feb 8, 2023 at 20:04

1 Answer 1

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The effective price is just the price you get for your asset +/- the cost/benefit realized from your hedge.

Let's pick a more concrete example:

Let's say we're producing natural gas (any asset or commodity will work though), which currently trades at $2.50/MMBtu (really $2.43 but let's go with the example) for sale in March. We will assume that a hedge is put in place in February and closed out in March.

As an example, we will consider the case where the spot and futures prices at the time the hedge is initiated are $2.50 and $2.20, respectively, and that at the time the hedge is closed out they are $2.00 and $1.90, respectively.

This means that S1 = 2.50, F1 = 2.20, S2 = 2.00, and F2 = 1.90. (Where S1 - spot price at t1, S2 spot price at t2, F1 and F2 the same).

  • So let's say we know we're producing gas to be sold in March. In order to lock in the price, we sell March futures short in February for F1 = 2.20. Come March, we'll close the futures position by buying it back for F2 = 1.90. So we make 2.20 - 1.90 from the futures, our hedge.
  • At the same time, we sell our gas for S2 = 2.00.
  • Effectively, we get 2.00 + (2.20 - 1.90) = 2.30, thanks to our hedge.

Note that we didn't use S1 in this example and that the hedge could very well work against us, lowering the effective price.

What does lifted (liquidated) mean and why should it affect the price?

It just means closing your position.

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