Wheat Hedge: Futures, Forward or Split?
Northwind Foods, a UK biscuit manufacturer, must buy 5,000 tonnes of milling wheat in three months. The treasurer wants to hedge 80% of the exposure. The relevant futures contract is 100 tonnes; the current futures price is £220 per tonne. A bank offers a three-month forward at £218 per tonne for the full 5,000 tonnes. Futures initial margin is £12,000 per contract and maintenance margin £9,000; variation margin is paid daily. Northwind has £500,000 of immediately available liquidity and a policy that hedging must not create a cash call it cannot meet. The treasurer expects the futures-minus-spot basis to be +£8 per tonne at expiry, but it could move to -£5. After one month the futures price has fallen 10% and the basis has moved to -£5. The finance director asks whether the futures hedge was appropriate and whether the company should switch to the forward for the remaining exposure.
1. Calculate the number of futures contracts and the initial margin required for an 80% hedge. If the futures price falls 10%, what variation margin is due, and can Northwind meet it from its stated liquidity?
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Hedge ratio: 5,000 tonnes × 80% = 4,000 tonnes. Number of contracts: 4,000 ÷ 100 = 40 contracts. Initial margin: 40 × £12,000 = £480,000. Free liquidity after posting initial margin: £500,000 − £480,000 = £20,000. A 10% fall in the futures price is £220 × 10% = £22 per tonne. Because Northwind is long futures to hedge a future purchase, the loss is £22 × 4,000 = £88,000. That is a variation margin call of £88,000. Maintenance margin is 40 × £9,000 = £360,000; after the loss the margin account equity is £480,000 − £88,000 = £392,000, still above maintenance. But the cash call is £88,000 against only £20,000 of free liquidity, so Northwind cannot meet it without new cash. The hedge is economically sensible but the position size is too large for the stated liquidity policy.
2. Compare the effective wheat purchase price under the futures hedge for the expected basis (+£8) and the adverse basis (-£5) with the forward price. Show the calculations and the risk being accepted.
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Define basis as futures minus local spot, so spot at expiry = futures price − basis. For a long futures hedge, effective purchase price = opening futures price − basis at expiry. Expected case: £220 − £8 = £212 per tonne. Adverse case: £220 − (−£5) = £225 per tonne. On 4,000 hedged tonnes: expected futures cost = £212 × 4,000 = £848,000; adverse futures cost = £225 × 4,000 = £900,000. Forward cost on the same 4,000 tonnes = £218 × 4,000 = £872,000. So the futures hedge is £24,000 better than the forward in the expected basis case but £28,000 worse in the adverse case. The risk being accepted is basis risk, not outright price risk: the futures price and the local wheat price do not move one-for-one. The forward fixes the price but introduces bank credit exposure and less flexibility.
3. Recommend an approach that satisfies the liquidity policy. Consider using the forward, reducing the futures position, or splitting the hedge.
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The futures hedge fails the treasury policy test because initial margin consumes 96% of available liquidity and a plausible adverse move creates an £88,000 call against a £20,000 buffer. The forward at £218 removes daily margin and fixes the cost, but it is for 5,000 tonnes while the company only wants to hedge 4,000 tonnes; taking the full 5,000 tonnes would overhedge 1,000 tonnes. A practical solution is to negotiate a 4,000-tonne forward if the bank credit line is acceptable, leaving 1,000 tonnes unhedged. Alternatively, split the hedge: use a smaller futures position, for example 30 contracts (3,000 tonnes), which requires £360,000 initial margin and leaves £140,000 for variation margin, and hedge the balance with a 1,000-tonne forward. The choice should be documented: the forward eliminates margin liquidity risk but accepts counterparty risk; futures reduce counterparty risk but require a cash buffer and active margin management.