Risk Management, Hedging and the Futures Market

EPT 4301

Objectives
1. What is Market Risk? 2. Understand how the futures market can assist firms in protecting against price risk. 3. Discuss how and when farmers and marketing firms use hedges and options to protect themselves. 4. Understand the differences between hedges, options, and forward contracts. 5. Evaluate criticisms of the futures market.

Market Risk
Risk vs. Uncertainty Economic vs. Product Risk Risk is a Marketing Function (Chapter 2) Risk as Cost; Risk Taking for Profit Farmers Have Unavoidable Price Risk Risk Takers, Risk Averters Risk Transfer May Be Desirable, Profitable

Managing Risks In Your Life

Risk: The possibility of a gain or loss from your behavior
Examples How to Protect Yourself:

1. 2. 3. 4. 5. 6. 7.

Grade risk Health risk Career risk Marriage risk Bankruptcy Disease Other?

Examples of Risk Management

Plant Now, Price Now by Contract College Tuition College Study Magazine Subscription Stud Service

Market Risks Ownership implies risk Risks must be borne by someone Risk cant be eliminated Types of risk: 1. Product destruction 2. Product value deterioration

Product Destruction Destruction from natural hazards Fire, wind, pests, flood, spoilage Marketing firms can protect themselves by: Protection fund Insurance

Product Value Deterioration Quality deterioration Price variation Consumer preferences Supply situations General business conditions

Greatest Marketing Risk Uncertain cost levels because of uncertain

production levels. Ways to reduce or transfer price risk from producers and handlers: Government price -supporting Government storage Vertical integration Sell products in advance Futures market hedging and options

Farmer Tools For Managing Price Risk

Cash Sale (at Harvest, From Storage) Forward Contract Sale (at Planting, Harvest, Storage) Delayed Contract Pricing Hedging Derivatives: Options Market Information

Grain Farmers Market Risk

Assume annual crop (paddy) Plant in Oct, Harvest in Feb Plant in Oct Against Feb Harvest Price Sell in Feb Without Knowing Oct Yield Sell in Oct Without Knowing Feb Price Store in Oct Without Knowing Feb Price

Futures Market A place where sellers make promises to deliver something they do not have to buyers who promise to accept delivery of something they do not want and both legally break their promises!

Futures Market Mechanism for trading promises of future commodity deliveries among traders. Ag commodities Magazine subscriptions Pick-of-the-litter stud service College tuition

Cash Market vs Futures Market

Spot price todays price for products to be delivered immediately. Pricing and delivery occur simultaneously Futures price todays price for products to be delivered in the future. Pricing and delivery occur at different times

Futures Market Exchanges Marketplaces designed to facilitate trading in futures contracts Chicago Board of Trade Chicago Mercantile Exchange -- MDEX Like the stock market

Commodity Exchanges
Member-traders Authorized to buy and sell futures contracts for the public Trading floor Where buyers and sellers meet Governing board Sets and enforces rules for orderly trading Clearinghouse Facilitates trading and delivery of commodities

Commodity Exchanges
Exchange floor & trading pits Where trades are made Communications network Links brokers to traders in the pits Daily price quotes and exchange prices Newspapers, brokers, internet Close to a perfectly competitive market

Futures Contracts
Forward pricing of commodity deliveries. Seller promises to: Deliver the commodity at the price agreed upon when the contract is traded Buyer is assured of: Receiving the commodity in the specified month at the specified price

Futures Contracts
Standardized quantity & quality of commodities. Corn 5,000 bu. Soybeans 5,000 bu. Cattle 40,000 lb. Feeder Cattle 44,000 lb. Pork Bellies 38,000 lb. -- CPO 25 metric tonnes

Futures Contracts
Each commodity has different delivery (maturity) months. Wheat July, September, December, March, May Feeder Cattle January, March, April, May, August, October Unleaded Gasoline Every month

Where do futures market contracts come from?

Anyone can legally create a futures contract to buy or sell commodities at any time. Just call a broker Farmers Merchants Doctors, lawyers, students

Market Traders
1. Speculators Try to profit from anticipated price changes Incapable & uninterested in taking or making delivery at contract maturity 2. Hedgers Try to profit from anticipated price changes Usually take or make delivery at contract maturity Rarely allow futures contracts to mature

Fulfilling Contract Promises

1. Deliver or accept commodity at contract maturity 2. Nullify promise before contract maturity Make an equal and opposite transaction from the original Sellers can buy back their promise Buyers can sell out their promise Most are nullified before maturity Few contracts result in product delivery

Fulfilling Contract Promises

Generally more profitable to nullify a contract than to deliver or take delivery. Example 1: Sell a May futures contract for $2.50 on January 5 Buy contract back later at $2.40 10 cent profit (ignoring brokerage fees) Example 2: Buy a November futures contract in June at $4.00 Sell contract later at $4.20 20 cent profit Traders on the other side would have lost the same amount

Futures Terminology
Sellers short position Owe the commodity Buyers long position Committed to take delivery Bulls think prices will rise Go long Bears think prices will fall Go short Takes a bull and a bear to make a transaction

Speculator Attraction
Potential for frequent, large, and somewhat unpredictable, commodity price swings. Uncertainty assures that there will be a large number of buyers and sellers at all times! Buyers can always sell Sellers can always buy

Speculator Attraction
Speculative profits can be made from either rising or falling prices. Bull - Buy today, watch the price rise, sell Bear - Sell today, watch the price fall, buy Profits depend on correct price anticipation! Always: Bull and a bear Long and a short Winner and a loser (ZERO SUM GAME)

What determines the price of a futures contract?

How much buyers are willing to buy it for How much sellers are willing to sell it for Buying and selling attitudes reflect the expected value of the actual product at maturity.

Scenarios
Why would anyone pay $2.50 for a contract calling for November delivery of soybeans if they thought the cash price of soybeans would be less than $2.50 in November? Why would anyone sell a promise to deliver soybeans next November if they thought soybeans might sell for more than $2.50 next November? Possibility of delivery or accepting delivery

Futures & Cash Prices

Futures and cash prices of a commodity are closely related Cash price what is Futures price the market as traders think it will be Always a wide difference of opinion as to the correct futures price Time lag between pricing and delivery Uncertainties of agricultural prices

Futures Prices
As commodity conditions and attitudes toward buying and selling futures contracts change, the futures price will also change. Differences of opinion and unpredictable price changes ensure that there will always be plenty of buyers and sellers. Prices will adjust to make this so. More and more buyers than sellers will raise prices, transforming some buyers into sellers, and more sellers will lower prices, changing some bears into bulls

Two Costs
1. Brokerage fee Fee for executing orders 2. Margin requirement Earnest money/down payment Small portion of the value of the commodity Example: $500 margin Cover losses and brokerage fees Returned to the trader if the event is profitable

Financial Leverage
The ability to trade a large value of

product with limited capital Futures markets are highly leveraged Opportunities for large profits and large losses

Basis
Basis the difference between the

cash price and a futures price. Basis level and basis changes tend to follow predictable patterns from year to year. Basis is more predictable than cash prices.

Relationships Between Cash & Futures Prices

1. The cash price and the futures price will be almost the same as the contract approaches maturity. 2. Before contract maturity, futures prices are normally above cash prices by the cost of holding the commodity until contract maturity. 3. Cash and futures prices tend to move up and down together because both are affected in the same way by changes in supply and demand.

Hedging & Risk Management

Price risk is inherent in the ownership of

agricultural commodities. Food processors inventory price risk Elevator price risk between purchase and sale Farmer price risk between planting and harvesting

Hedging & Risk Management

Hedging is a risk-management device.

Making equal and opposite transactions on the cash and futures markets. Protection against adverse cash price movements

Hedge Terminology
Short hedge when a sale of

futures is made as a temporary substitute for the cash sale of a commodity. Long hedge when the firm makes a promise today to deliver commodities, not yet owned, to the cash market at a specified future time.

Hedge Definitions
Using the Futures (or Options Markets) To Manage Price Risks A Temporary Substitution of A Futures Market Transaction for a Planned Cash Market Transaction Taking Equal and Opposite Positions on the Cash and Futures Markets

Hedging Rules
Risk Can Be Expensive Breaking Even Is Better Than Losing Money If You Cant Afford a Loss, Insurance Doesnt Cost, It Pays

Who Trades Futures Contracts?

Bulls

Bears

Hedgers
Bears

Speculators
Bulls

Futures Market Participants

Speculators:
Risk Takers Profit From Correctly Anticipating Price Changes Could/Do Not Deliver or Take Delivery of Futures Commodities

Hedgers:
Have Inherent Price Risk Wish to Reduce or Manage Risk Could Deliver Against Futures Contract

Production and Marketing Periods

Next planting

Planting

Harvest

Pre-Harvest Period
Risk: Plant without knowing Fall Price

Storage Period
Risk: Store without knowing Spring Price

The Perfect Hedge

Example: Grain elevator owner

Buys cash grain from farmers and ships it to a terminal market for cash sale one week later Wants protection against falling prices When cash grain is purchased, futures contracts are sold When the cash grain is sold, the futures contracts are purchased back

The Perfect Hedge (Falling Price Period)

Cash Price Nov. 1 Dec. 1
Buy @ $2.00 Sell @ $1.90

Futures Price
Sell @ $2.50 Buy @ $2.40

Basis
$.50 $.50

10 cent gain Cash sale = $1.90 + Futures Gain = .10 Net selling Price/Return to Hedge = $2.00

Perfect Hedge Returns

For a Perfect Hedge (Basis = Constant), The Return To The Hedge (Cash Price + Futures) Will Always Be the Same. Return To
Cash $2.50 $.10 $100 Futures $3.50 $3.00 $.60 $100.50 Basis $.50 $.50 $.50 $.50 $3.00 $3.00 $3.00 Hedge

Original: $3.00 Case 1 Case 2 Case 3

The Perfect Hedge (Rising Price Period)

Cash Price Nov. 1 Dec. 1
Buy @ $2.00 Sell @ $2.10

Futures Price
Sell @ $2.50 Buy @ $2.60

Basis
$.50 $.50
10 cent loss

Cash sale = $2.10 - Futures Loss = .10 Return to Hedge = $2.00

The Imperfect Hedge

Cash Price Nov. 1 Dec. 1
Buy @ $2.00 Sell @ $1.90

Futures Price
Sell @ $2.50 Buy @ $2.45

Basis
$.50 $.55

Cash sale = $1.90 + Futures Gain = .05 Return to Hedge = $1.95

$1.95 is better than $1.90 But not $2.00

Characteristics of a Successful Hedge

Equal and Opposite Positions on Cash and Futures Markets Cash and Futures Markets Move In Same Direction Predictable Basis Pattern Nullify Futures Position, Sell on Cash Market Loss on One Market = Gain on Other Market Transfer of Risk from Hedgers to Speculators No Tears, No Regrets

Types of Hedges
Short Hedge (Protects Against Falling Prices) Long Cash, Short Futures Sell Cash, Buy Back Futures Long Hedge (Protects Against Rising Prices) Short Cash, Long Futures Buy Cash, Sell Futures

Three Producer Hedges

Perfect Hedge
Useful for Learning; Rare in Practice

Storage Hedge
Set During Storage periods Protects Against Falling Prices Helps Earn Storage Returns

Pre-Harvest Hedge
Set planting season Protects Harvest Price

Storage Hedges
Harvest-to-Sale Period (Storage Season) Risk of Price Decline, Inventory Loss Will Price Rise Cover Storage Costs? Carrying Charges:
Storage Costs Handling Charges Insurance and Interest Costs

Key to Success: Narrowing Basis Pattern

The Storage Hedge

Cash Price Futures Price Basis

Nov. 1 Buy/Store @ $2.00 Sell @ $2.50 $.50 June 1

Sell @ $2.30 Buy @ $2.40 $.10 - $.40 Cash sale = $2.30 + Futures Gain = .10 =Return to Hedge = $2.40 - Original Cost = $2.00 = Storage Return = $.40

Storage Hedge Rule

The Storage Hedgers Carrying Charge (Return to Storage) Will Always Equal The Change in Basis Over the Storage Period The Storage Hedge Transfers the Basis Change From the Speculators to Hedgers

Hedging Principle

The Basis Determines the Success of A Hedge

Basis
Basis = Futures - Cash Price ( or CashFutures Price) Calculated From Nearby Futures (Cash Next Futures Contract to Mature) Has Predictable Patterns (More Predictable Than Cash Prices) Not Perfectly Predictable (Basis Risk) Determines the Success of Hedge

Typical Grain Basis Pattern

Futures Price
Weakening (wide) Basis Cash Price planting Strengthening (narrow) Basis

Harvest Basis Largest Harvest Storage/Next planting

Basis and Storage Costs

$
Futures Price

Basis

Storage Costs

Cash Price Harvest price

Harvest

Next planting

Predictable Basis Patterns

Futures > Cash Prior to Contract Maturity Futures = Cash Price at Contract Maturity Basis Widens Into Harvest Basis Narrows During Storage Season Futures and Cash Prices Move Together Basis is Predictable From Year to Year

Two Types of Basis

Time Basis: Cash Price Less Futures Price Zero at Contract Maturity Location Basis: Central Cash Price Less Your Local Cash Price Localizing the Basis

Corn Storage Hedge: Farmer

Date
October

Cash Market

Futures Market

Harvest Price = $3.00 Sell July Fut. = $3.50 Est. June Basis = $.10 Storage Cost = $.30 Forward Price = $3.50-.10= $3.40 Storage Profit= $3.40 -3.00 - .30= $.10 Cash Sale @ $3.30 Return to Hedge: Buy Back Fut. @ $3.40 $3.30 + $.10 = $ 3.40

June

Corn Storage Hedge: Elevator

Date Cash Market Futures Market

October

Buy Corn = $3.00 Sell July Fut. = $3.50 Est. June Basis = $.10 Storage Cost = $.30 Cash Sale @ $3.30 Buy Back Fut. @ $3.40

June

Return to Hedge: $3.30 + $.10 = $ 3.40 Storage Profit: $3.40 - $3.00 - .30 = $.10

Two Ways to Calculate the Return to the Storage Hedge

Cash Price Nov. 1 June 1 Buy/Store @ $2.00 Sell @ $2.30 Futures Price Basis

Sell @ $2.50 $.50 actual Buy @ $2.40 $.10 actual

Carrying Charge = 2.30 + .10 2.00 = 40 cents = change in basis

Cash Price Nov. 1 June 1

Futures

Basis

Store @ 2.50 .10=2.40 Sell @ $2.50 $.10 expected Sell @ $2.30 Buy @ $2.40 $.10 actual
Carrying Charge = 2.30 + .10 = 2.40 - 2.00 = 40 cents

PreHarvest Hedge
Set During Planting or Growing Period Protects Against Harvest Price Risk
Will Harvest Price Cover Production Costs?

Locks-In Fall Harvest Target Price Key to Success: Requires Accurate Harvest Basis Prediction

The PreHarvest Hedge

Cash Price May 1 Planting Nov. 1 Harvest
Plant at Target Price: $3.00-.40=$2.60 Sell @ $2.40

Futures Price
Sell @ $3.00 Buy @ $2.80

Basis

Expected $.40

Cash Sale = $2.40 + Futures Gain = .20 Return to Hedge = $2.60 = Spring Target

Corn PreHarvest Hedge

Date
May

Cash Market

Futures Market
Sell Dec Fut. = $2.80

Cost of Production = $2.10 Expected basis = $.30

Forward Price = $2.80-.30 basis= $2.50 Expected Profit= $2.50 -2.10 = $.40 Oct. Cash Sale @ $2.40 Buy Back Fut. @ $2.70

Net Return to Hedge:

$2.40 + $.10- $2.10 = $ .40

Calculating the Return To a Hedge

Today:
Current Futures Price...$4.00 Less: Expected Basis at Sale Time .. .50

Equals: Lock-In Forward Price..$3.50

Future Sale:

Cash Price..$3.00 Plus/Minus Futures Transaction $.50 Equals: Total Return to Hedge... $3.50 Less: Costs (Prod Or Storage).$3.20

Equals: Net Return To Hedge...$.30

Combination PreHarvest and Storage Hedge

Cash Market May 1998 Target $3.40-.20 = $3.20 $2.30 Dec. 98 Futures $3.00 June 99 Futures Sell@$3.40 Est. Spr. basis=$.20 Buy@$2.50

May 1999

xxxx

Return to Hedge: $2.30 + .90 =$3.20

Farmers Uses of Futures Market Price Discovery, Monitoring Prices Formula Pricing Forward Contracts Hedging

Hedging Decisions
What is my attitude toward price risk? What do I expect price to do? What are my costs? When should I set the hedge? When to lift it? What are my alternatives to hedging?

Why Dont More Farmers Hedge?

Lack of Understanding of Hedging Mistrust of Futures Market Prefer Ease of Forward Contracts Like Risk; Prefer to Speculate on Cash Market Dislike Margin Calls Other?

Top Reasons Why Farmers Dont Manage Risk

There is no free cap or jacket for doing so Theyre waiting for the neighbor to do it first Risk builds character The IRS would just take all my profit Life would be dull without fear

Agricultural Options
Option: The right, but not the obligation, to buy or sell a futures contract at a predetermined price for a specified period of time.
Strike Price: The predetermined price of the futures contract Premium: The cost of the right to buy or sell a futures contract

Put and Call Options

Put Option:
The right to sell a futures contract Provides protection against falling prices Sets a minimum price target

Call Option:
The right to buy a futures contract Protects against rising prices (e.g. feed costs) Allows participation in seasonal price rises

How Is the Premium For An Option Determined?

Question: What would you be willing to pay for the right to sell a futures contract at $3.00 if the current futures price is $2.80?

Answer: If the premium is under $.20, you could make a profit by exercising the option (sell @ $3) and buy a futures contract for $2.80 at the same time.

What Happens to An Option Which You Own?

It Can Expire
Unexercised Options Die You Must Still Pay the Option Premium

You can Exercise the Option

Put: Sell the Futures Contract, Buy Another Call: Buy the Futures Contract, Sell Another

Offset, By Selling the Put or Call Option

Put Option Example

Date Cash Market Futures Market Sell Dec. @$4 Option Market Buy Dec Put Strike=$4 Premium=$.20 Sell Dec Put Strike=$4 Premium=$1.20

Planting

Harvest

$2.50

Dec. Fut=$3 Sell Dec@$4 Buy Dec@$3

GAIN..$1$1

Summary: Risk Management Tools Hedging Options Forward Contracts Basis Contracts Market Information, Intelligence

Futures Market Debates

Are Speculators Necessary? Do Futures Prices Determine Cash Prices? Does Futures Trading Increase Market Volatility? Do Futures Markets Increase Marketing Cost? Can Futures Prices Be Manipulated?

Pricing Alternatives (Falling Market)

Date Cash Sale At Harvest Forward Contract $3.40 offer Deliver @$3.40 PreHarvest Hedge Sell Dec @$4 Buy Dec @$3 Option ($.20 prem.) Buy Put $4 strike Sell Dec@$4 Buy Dec@$3 $2.50 cash +$1 fut-.20=$3.30

Spring Planting Fall Sell@2.50 Harvest Net Return $2.50

$3.40 $2.50 cash +$1 fut.=$3.50

Pricing Alternatives (Rising Market)

Date Cash Sale At Harvest Forward Contract $3.40 offer Deliver @$3.40 PreHarvest Hedge Sell Dec @$4 Buy Dec @$5 Option ($.20 prem.) Buy Put $4 strike Let Option Lapse/Die $4.50 cash -.20=$4.30

Spring Planting Fall Sell@4.50 Harvest Net Return $4.50

$3.40 $4.50 cash -$1 fut.=$3.50

Pricing Comparisons
Cash Sale Downward Price Protection Profit Opportunity Flexibility Degree of Difficulty Lo Forward Contract Hi Hedge Option

Hi

Hi

Hi Hi Easy

Lo Lo Easy

Lo Med. Med.

Hi Hi Hi