Finalizations
Finalizations
Since it’s month-end, I thought we should talk about finalizations. Physical contracts are typically booked in round numbers, 200mt/500mt/1,000mt/etc. A tolerance is usually built into contracts, anywhere from 1 percent to as high as 10 percent depending on the business. This is to allow for trucks or containers to be loaded as close to the maximum weights, but knowing that it’s impossible to load exactly 25.000mt on a container. The same is true for a truck, you will never get exactly 20.000mt (USA) or 25.000mt (ROW) loaded. However, once contracts have been performed, you will end up with a final tonnage that is different to the one contractually booked.
Let’s say you are delivering 1,000mt of copper cathode against a sales contract in Europe, DDP Rotterdam for example. You request your warehouse to load 40 trucks as close to 25.000mt as possible. When all of your deliveries are completed, the warehouse will have sent you 40 truck bill of ladings that you will total up to give you an exact final weight for your sale contract.
In this instance, due to the way the bundles were stacked and the loading of the trucks, the final weight of the sale is 977.462mt, within the contract tolerance of 3 percent. Everyone knows that it is important to adjust the contract down from 1,000mt to 977.462mt - your customer is not going to pay you for 1,000mt when you only delivered 977.462mt, a difference of 22.538mt.
It is vitally important to adjust contracts to their final tonnages as soon as they are known. It can be easily overlooked that by waiting to adjust that contract down by 22.538mt, you could be creating a large hedge loss without realizing it.
In this example, you fixed the price of your 1,000mt physical sale of copper cathode on the LME cash settlement price (CSP) of the Monday prior 3rd Wednesday of the month of delivery. LME futures contracts trade in specific, round lot sizes - in the case of copper, 25.000mt. This means to hedge your physical sale you bought 40 lots of copper futures at the same price as you fixed the physical contract, in this case $8,500/mt. For the time being, you are perfectly hedged.
Let’s say that these deliveries finished a few days after the contract priced. If you had been diligently tracking the deliveries as they are reported by the warehouse, you would have all the information you needed to adjust the 1,000mt down to 977.462mt soon after pricing
Because the final tonnage is 22.538mt less than the 1,000mt futures you had bought when you hedged, this means you are now over-hedged, you bought 1 lot more than ended up being required. In order to correct this and ensure the risk is as close to perfectly hedged as possible, you would need to sell one lot of copper futures, to reduce the hedge to 39 lots. Because you acted swiftly, the price of copper has only moved by $30/mt from the original pricing, and is now at $8,470/mt. The hedge on this contract has still made a small loss, but it is more than manageable.
You bought the extra lot of copper at $8,500/mt, and the market is now trading at $8,470, so the calculation on the hedge gain or loss is: ($8,470 - $8,500) = $30 * 25mt = -$750. This does not mean that you hedged incorrectly to begin with - you hedged as you should given the information you had at the time. But now that information has been updated, so you must act accordingly and adjust the hedge.
Now, if instead of adjusting the sales contract as soon as you had the information to do so, you waited a few weeks, the outcome could be drastically different. We’ve all been there - you needed to finish the P&Ls, you were bogged down with your other 30+ shipments you were trying to deliver by month end, and your trader had already made you work late the last 7 nights in a row! But finalizations are one of the most important concepts when it comes to hedging and here is why. In those three weeks that you waited to issue the finalization, the price of copper has decreased by $1,000/mt and is now at $7,500/mt. When you inevitably sell back the 1 lot of futures you are over-hedged, it will now result in a much bigger loss: ($7,500 - $8,500) = $1,000 * 25mt = -$25,000. The simple act of waiting to finalize your contract has lost the company $25,000, over $24,000 more than was necessary. If this contract was originally making a P&L of $50/mt, this error on only a single lot, has reduced the P&L of the entire contract by 50%.
If you had been paying attention to the price of copper, along with the tonnage of the contract, you could have worked out what the P&L impact would be, and it might have been prudent to ask the warehouse to ship an additional truck to take the tonnage of the contract closer to the original contractual weight of 1,000mt. There may even have been an opportunity to over-ship the contract and actually generate additional P&L. However you are now 3 weeks past the deliveries and the likelihood of your customer accepting additional material against a previous month’s quota are slim to none.
This is also not to mention that by not updating the sales contract, there would likely have been a spread exposure that was not taken into account. Not only would you need to sell back the over-hedge, but you would also likely need to borrow the additional material you were now not delivering. Copper spreads in particular can be very volatile, which would increase the likelihood of a loss even further…but we will discuss spreads a different day.
Now some of you may be thinking - what if the price had actually increased in those three weeks, when we went to sell back the 1 lot over-hedge we would have made money. While that is absolutely true, your job is not to speculate on what direction the price of copper, or any commodity is going to move. Trading firms hedge their physical business precisely because they don’t know which way the price of a commodity is going to move on any given day. While you may get lucky and have a price move in your favor, you cannot take that chance and the way to mitigate as much of that exposure as possible, is to act as quickly as you can when it comes to finalizing your contracts.
