Suppose that a company is going to purchase a certain amount of a commodity one year from now, but the price they pay will be determined by the average closing spot price during the month before the contract closes out. Is there a standard way of addressing this problem, i.e. hedging this risk away with futures contracts? If so how is it done.

You could buy a forward start Asian forward, but this would almost certainly be overkill for this situation.A much simpler approach that should be reasonably accurate is to use the closest public futures contract, or a barbell of the two contracts on either side. As you get into the averaging month, you reduce your hedge linearly throughout the month. This does not eliminate risk, but it should fix the price reasonably well. Be sure there are no big seasonal effects that might cause problems for this strategy.

Aaron is on the right track when he says that you can approximate an average price by establishing a position in futures and reduce the position over the course of the averaging month. I actually wrote an article on this subject for the NYMEX Energy in the News magazine. Unfortunately, I do not have a cite, but you could ask NYMEX if they could locate an article in their back issues on this subject. Since futures expire before the end of the calendar month, it might be necessary to carry a small position in the next most distant futures.It is not possible to get the precise closing price on a futures - it trades in a closing range, but it can be approximated by transacting throughout the closing range. Experienced traders may actually be able to improve upon the closing price, meaning this strategy could beat the average price contract.

Thanks alot AaronYou mentioned that this would fix the price, but not eliminate all the risks. What other risks would still be present. There wouldn't be any interest rate risk, since I'm hedging with something that has the same relationship with interest rates. Or would there?Kritchey, How long ago did you write that article? Do you think they would have it in an archive?Thanks

Colin-I think I wrote it in the 1996-1998 period. There may be other, more recent articles by others, in which case you may be able to obtain a copy. I may have a copy of the article somewhere. Also I'll try to find a reference on the web.

QuoteOriginally posted by: ColinlYou mentioned that this would fix the price, but not eliminate all the risks. What other risks would still be present. There wouldn't be any interest rate risk, since I'm hedging with something that has the same relationship with interest rates. Or would there?Most of the risk would be mismatch. If you use public futures, the delivery date will probably not match your delivery date exactly (in fact, it can't match exactly because there is a window). The prices you close out at during the averaging month will probably not match the ones used to compute the average price exactly. In addition, you have a small interest rate risk from the mark-to-market payments.If you had a forward contract that came due exactly on the contract delivery date, and you could offset it on the averaging days for exactly the price used in the average computation, then your only risk would be a small interest rate risk on the gains and losses before delivery.