2013

Research Department

Century Financial Brokers

3/13/2013

Aluminum Hedging

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

futures market. These companies can employ what is known as a long hedge to secure a purchase price for a supply of aluminum that they will

require sometime in the future.

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

Aluminum Futures Basics

Aluminum futures are standardized, exchange-traded contracts in which the contract buyer agrees to take delivery, from the seller, a specific

quantity of aluminum (eg. 25 tonnes) at a predetermined price on a future delivery date.

Aluminum Futures Exchanges

You can trade Aluminum futures at London Metal Exchange (LME) and Singapore Exchange (SGX)

LME Aluminum futures prices are quoted in dollars and cents per metric ton and are traded in lot sizes of 25 tonnes (55116 pounds).

Exchange & Product Name Symbol Contract Size Initial Margin Maintain Margin

LME Aluminum Futures

AH 25 tonnes

USD 3,250

USD 2437

Consumers and producers of aluminum can manage aluminum price risk by purchasing and selling aluminum futures. Aluminum producers can

employ a short hedge to lock in a selling price for the aluminum they produce while businesses that require aluminum can utilize a long hedge to

secure a purchase price for the commodity they need.

Aluminum futures are also traded by speculators who assume the price risk that hedgers try to avoid in return for a chance to profit from

favorable aluminum price movement. Speculators buy aluminum futures when they believe that aluminum prices will go up. Conversely, they

will sell aluminum futures when they think that aluminum prices will fall.

Aluminum Futures Long Hedge Example

An aluminum mill will need to procure 2,500 tonnes of aluminum in 3 months' time. The prevailing spot price for aluminum is USD 1,470/ton

while the price of aluminum futures for delivery in 3 months' time is USD 1,500/ton. To hedge against a rise in aluminum price, the aluminum

mill decided to lock in a future purchase price of USD 1,500/ton by taking a long position in an appropriate number of LME Aluminum futures

contracts. With each LME Aluminum futures contract covering 25 tonnes of aluminum, the aluminum mill 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 aluminum mill will be able to purchase the 2,500 tonnes of aluminum at USD

1,500/ton for a total amount of USD 3,750,000. Let's see how this is achieved by looking at scenarios in which the price of aluminum makes a

significant move either upwards or downwards by delivery date.

Future Price (per tonne)

•$1,500

Quantity (1 contract = 25 tonnes)

•100 contracts

Value

•$3,750,000

Scenario #1: Aluminum Spot Price Rose by 10% to USD 1,617/ton on Delivery Date

With the increase in aluminum price to USD 1,617/ton, the aluminum mill will now have to pay USD 4,042,500 for the 2,500 tonnes of aluminum.

However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,617/ton. As the long

futures position was entered at a lower price of USD 1,500/ton, it will have gained USD 1,617 - USD 1,500 = USD 117.00 per tonne. With 100

contracts covering a total of 2,500 tonnes of aluminum, the total gain from the long futures position is USD 292,500.

In the end, the higher purchase price is offset by the gain in the aluminum futures market, resulting in a net payment amount of USD 4,042,500 -

USD 292,500 = USD 3,750,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of aluminum at USD 1,500/ton.

Scenario #2: Aluminum Spot Price Fell by 10% to USD 1,323/ton on Delivery Date

With the spot price having fallen to USD 1,323/ton, the aluminum mill will only need to pay USD 3,307,500 for the aluminum. However, the loss

in the futures market will offset any savings made.

Again, by delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,323/ton. As the

long futures position was entered at USD 1,500/ton, it will have lost USD 1,500 - USD 1,323 = USD 177.00 per tonne. With 100 contracts covering

a total of 2,500 tonnes, the total loss from the long futures position is USD 442,500.

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the aluminum futures market

and the net amount payable will be USD 3,307,500 + USD 442,500 = USD 3,750,000. Once again, this amount is equivalent to buying 2,500

tonnes of aluminum at USD 1,500/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the aluminum buyer would have been better off without the

hedge if the price of the commodity fell.

Aluminum Price Chart

Last Price 1939

Volatility (30 day) 15.80 Volatility (180 day) 21.69

Current Volume 24787