Case 079Hedging a bookWarm up
A sugar mill has sold 60% of its output forward, and the spot price then falls 20%. Compute revenue with and without the hedge, and explain what the lender gains from the hedging policy.
1The situation
Gannaveer Sugars produces 2 lakh tonnes of sugar a year. Its board has a policy of selling part of the season's output forward, and this year it has sold 60%, 1.2 lakh tonnes, at Rs 38,000 a tonne. The budget assumes all 2 lakh tonnes sell at Rs 38,000, Rs 760 crore of revenue.
Before the season's sugar is sold, the spot price falls 20% to Rs 30,400 a tonne. The mill's cash costs, mostly cane, are about Rs 560 crore for the season and are fixed once the cane is crushed. Its bank term loan needs Rs 90 crore of debt service this year.
2Your task
What is revenue with and without the hedge, what happens to debt service cover, and why does the lender care about the hedging policy?
Quick check
The price falls 20%. How much of the unhedged revenue fall does the forward sale prevent?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Hedged revenue is Rs 699.2 crore against Rs 608 crore unhedged, and debt service cover holds at 1.55x instead of falling to 0.53x. The 1.2 lakh tonnes sold forward still earn Rs 38,000; only the other 0.8 lakh tonnes take the 20% fall. The lender gains a narrower range of outcomes to underwrite: the hedge gives up some upside to make the bad year survivable.
Step 1What does selling forward actually fix?
A forward sale fixes the price on the tonnes it covers, whatever the market does later. A farmer who agrees in June to sell half his wheat to a flour mill at a set price has made the same trade: he will not share in a price spike, and he will not suffer a price collapse on that half. Gannaveer's 1.2 lakh tonnes earn Rs 38,000 a tonne, Rs 456 crore, whether spot is Rs 30,400 or Rs 45,600. Only the unsold 0.8 lakh tonnes are exposed to the spot priceThe price for sugar sold for immediate delivery today, as opposed to a price agreed now for delivery later..
Step 2What is revenue in each case after a 20% fall?
Unhedged, all 2 lakh tonnes sell at Rs 30,400: Rs 608 crore, Rs 152 crore short of budget. Hedged, 1.2 lakh tonnes at Rs 38,000 give Rs 456 crore and 0.8 lakh tonnes at Rs 30,400 give Rs 243.2 crore. Hedged revenue is Rs 699.2 crore, only Rs 60.8 crore short, so the forward sale absorbed 60% of the fall. The share of the fall absorbed always equals the share sold forward, which is a quick check worth saying out loud.
| Rs crore | Budget | Price -20%, unhedged | Price -20%, 60% hedged | Price +20%, 60% hedged |
|---|---|---|---|---|
| Revenue | 760.0 | 608.0 | 699.2 | 820.8 |
| Cash costs | 560.0 | 560.0 | 560.0 | 560.0 |
| Cash for debt service | 200.0 | 48.0 | 139.2 | 260.8 |
| Debt service cover (Rs 90 crore due) | 2.22x | 0.53x | 1.55x | 2.90x |
Step 3Why does the lender care about the policy, not this one season?
Because a lender is paid from the bad year, not the average one. Unhedged, cash for debt service swings between Rs 48 crore and Rs 352 crore; hedged, between Rs 139.2 crore and Rs 260.8 crore, a range 40% as wide. Unhedged, a 20% fall means the mill cannot meet Rs 90 crore of debt service from the season's cash. Hedged, it covers it 1.5 times. The equity holder gives up Rs 91.2 crore of upside in the good year; the lender, who never shares in upside, loses nothing from that trade.
Close with what a lender writes into the loan. A board policy can be changed next season, so lenders often ask for a minimum hedge ratio as a covenant, a limit on how much can be sold forward, so a poor harvest does not leave the mill short of sugar to deliver, and forwards placed with sound counterparties. Over-hedging is its own risk: if the cane crop fails and output falls to 1 lakh tonnes, a 1.2 lakh tonne forward sale forces the mill to buy sugar in the market to deliver.
Where candidates lose it
The common error is saying the hedge lost money when prices rose, and so was a mistake. A hedge is judged on what it did to the range of outcomes, not on the outcome in one season; a lender would rather have Rs 820.8 crore for certain in a rising market than bet on Rs 912 crore.
The second is forgetting volume risk. A forward sale is a promise to deliver sugar; hedging more than the mill is sure to produce turns price protection into a short position.
What the interviewer asks next
- Output comes in at 1.1 lakh tonnes. What does the 1.2 lakh tonne forward sale cost if spot has risen 20%?
- Would you rather the mill use put options than forwards? What does that cost it?
- What hedge ratio keeps debt service cover above 1.2x after a 20% fall?
Company names and figures are illustrative.