A designer’s guide to hedging leather prices

David Becker discusses the way to lock in future leather prices using a financial product

One of the benefits of designing shoes and apparel is the material’s flexibility. Using leather, designers can make a fantastic wearable at a price point that has proven profitable.

Of course, when leather prices are low, the possibilities are endless. The only hiccup is that the design-to-market process can take about 6-months. Fortunately, there is a way to lock in future leather prices using a financial product.

Managing your costs

Since leather is priced similar to hides, you can use Heavy Texas Steer levels as a gauge to track leather prices. Since the goal is to generate robust margins, it helps if you can forecast your costs before you move forward with a project.

The last several years have been great for leather designers. The long-term chart shows a downward trend (the 5-year average is at a 20-year low) in hide prices, which might have bottomed during the pandemic’s beginning.

A tremendous financial management technique is to protect yourself against rising hide prices, and still be able to purchase at lower levels if Heavy Texas Steer prices continue to fall?

Commodity hedging using average prices

If you plan to purchase leather in 6-months, you can buy a derivative that allows you to profit if the price of hides climbs above a specific level. You essentially buy an insurance policy that pays you if hide prices rise. You can pay another party a premium, and they will pay you if the average monthly price of Heavy Texas Steer rises above a certain level.

Commodity price risk management using average priced options

An average-priced call spread is a financial product that acts like an insurance policy capped at a defined payout. You would purchase a lower strike call option to benefit from rising leather prices and sell a higher strike call option.

Ag_Leather_Heavy-Texas-steer-call-spread_graph_png.

Heavy Texas steer call spread

©Fastmarkets

Here’s an example

You decide that you want to move forward with a shoe design as long as you can buy Heavy Texas Steer at an average monthly rate of $35 per piece or below six months from today. You decide to cap your gains at $45 per piece, which will help reduce the premium.

These insurance policies can be created on a futures exchange for some commodities, but since hides are not traded on a futures exchange, you will need a market-maker to transact a call spread.

Fortunately, some market-makers will provide call spreads on Heavy Texas Steers. These products are considered over-the-counter (OTC) derivatives. These OTC derivatives are usually financially settled. Only cash will change hands, and you will never receive Heavy Texas Steer.

You can see from the payout diagram that you have an unrealized loss until the price of Heavy Texas Steer rises above your breakeven level, which is $35 plus the premium you pay for the call spread. You start accruing unrealized profits until the average price rises above $45, where your earnings are capped.

If the price of Heavy Texas Steer continues to decline, you can purchase them at lower prices. The most you can lose is the premium you pay. The most you can earn is the difference between the lower and upper strikes minus the premium.

The average-priced call spread is customized, and you can choose most strike spreads and time horizons.

Summary

The bottom line is that financial products can allow you to lock in your leather costs and move ahead with a project. One of the best ways to protect yourself from rising leather prices is to trade a financial derivative. Heavy Texas Steer is not traded on an exchange, so you will need a market-maker to transact an over-the-counter call spread. The Fastmarkets risk solutions team can describe how these hedges work and can put you in touch with a market-maker.

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