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A goldsmith has bought 100oz physical gold for his trade and paid $1300/oz. He is going to be ready to sell his jewels in 3 months from purchase.

In order to hedge against falling prices of gold, he decides to buy 1 future contract of 3 months duration.

If we ignore commissions and fees, how does this work mathematically in the cases of falling, rising and stable prices? Please try to avoid market jargon to make it easy for non-native speakers of English to understand.

3

Your premise is wrong.

The goldsmith has 100oz. If he enters into a long contract, he has just doubled his risk, he, in effect, owns 200 oz.

I suppose he can sell a contract. Now he's neutral. The price drops, and his gain on the contract is offset by the loss from his goods he'll sell. The price goes up, and the gain from his goods offset the contract loss.

I don't know what this guy is making, but in the real world, there are two issues with such scenarios. Jewelry is sold for a multiple of metal cost. I found a 1000 gram chain selling for $42,000 containing 15 oz of gold. This is $2800/oz. Monthly fluctuations aren't going to impact such a dealer. Second, in the long run, prices are stable. Yes, there are the ups and downs, but not enough for an ongoing business to need to use futures in this way to offset these fluctuations. Big companies, perhaps, but not "a goldsmith." Even in electronics, a $100 computer chip might contain a dime's worth of gold. The manufacturer might buy enough to warrant buying a futures contract, but even then, I doubt it.

  • Thks Joe. This was a purely hypothetical scenario, that was supposed to help me understand the mechanics of hedging through futures contracts. And it did help me many times more than the lengthy texts I read in Investopaedia and elsewhere. – Kalypso Jul 22 '14 at 14:21
  • No problem. The options discussion would have made my answer twice as long. – JTP - Apologise to Monica Jul 22 '14 at 16:39

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