1 price risk management and the futures market hedging

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Price Risk Management and

the Futures Market

Hedging

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Market Risk

• Economic vs. Product Risk– product deterioration in value ; product destruction

• Risk is a Marketing Function (Facilitative function)

• Risk as Cost; Risk Taking for Profit

• Farmers Have Unavoidable Price Risk

• Risk Transfer May Be Desirable, Profitable

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Examples of Your Risk Management

• Plant Now, Price Now by Contract

• College Tuition (Pay in July for Year)

• College Study (Protect Against Low Pay Job)

• Magazine Subscription: Pay for copies in advance

• Home rental contract ; Insurance

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Grain Farmers’ Market Risk

• Plant in Spring Without Knowing Fall Harvest Price

• Sell in Spring Without Knowing Fall Yield

• Sell in Fall Without Knowing Spring Price

• Store in Fall Without Knowing Spring Price

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Farmer Tools For ManagingPrice Risk

• Cash Sale (at Harvest or From Storage)

• Forward Pricing:– Forward Contracts: Cash and Basis

contracts– Hedging using Futures– Options

• Minimum Price Contract

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Futures Markets

• Futures Exchanges : CBOT, CME, KCBT etc.,

• Futures price is today’s price for products to be delivered in the future.– Contract specifications– Order execution process (open outcry)– Margin requirements

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Date Price per Bushel Action Margin Action Account Balance Initial margin = $500

Maintenance margin = $350

17-Jan $2.50 Sell July corn Deposit $500 $500 18-Jan $2.52 $400 19-Jan $2.54 $300

Margin Call $200 $500 20-Jan $2.53 $550 21-Jan $2.60 $200

Margin Call $300 $500 24-Jan $2.57 $650 25-Jan $2.55 $750 26-Jan $2.51 $950

W ithdraw $450 $500 27-Jan $2.49 $600 28-Jan $2.44 Buy July corn $800

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T able 1. M argin Account M aintenance.

D ate Price per Bushel Action M argin Action Account BalanceInitia l m argin = $500

M aintenance m argin = $350

17-Jan $2.50 Buy July corn D eposit $500 $50018-Jan $2.48 $40019-Jan $2.46 $300

M argin C all $200 $50020-Jan $2.47 $55021-Jan $2.40 $200

M argin C all $300 $50024-Jan $2.43 $65025-Jan $2.45 $75026-Jan $2.49 $950

W ithdraw $450 $50027-Jan $2.51 $60028-Jan $2.55 Sell Ju ly corn $800

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Futures Market Participants

• Speculators:– Risk Takers

– Profit From Correctly Anticipating Price Changes

– Could Not Deliver or Take Delivery of Futures Commodities

• Hedgers:– Have Inherent

Price Risk– Wish to Reduce or

Manage Risk– Could Deliver

Against Futures Contract

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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

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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?

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Hedging Guidelines

• Decide on a definite hedging objective - reasons, month

• Discuss hedging plan with those involved; e.g. bankers

• Know how to calculate your productions costs - FC, VC, BEP

• Follow basis patterns• Hedge reasonable amounts of commodity• Keep adequate records

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Production and Marketing Periods

SpringPlanting

FallHarvest

Spring/Summer

Pre-Harvest Period Storage Period

Risk: Plant without knowing Fall Price

Risk: Store without knowing Spring Price

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The Perfect Hedge(Falling Price Period)

CashPrice

FuturesPrice Basis

Nov. 1

Dec. 1

Buy @ $2.00 Sell @ $2.50 $.50

Sell @ $1.90 Buy @ $2.40 $.50

Cash sale = $1.90+ Futures Gain = .10

Return to Hedge = $2.00

10 cent gain

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Perfect Hedge Returns

For a Perfect Hedge (Basis = Constant), TheReturn To The Hedge (Cash Price + Futures)Will Always Be the Same.

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The Perfect Hedge(Rising Price Period)

CashPrice

FuturesPrice Basis

Nov. 1

Dec. 1

Buy @ $2.00 Sell @ $2.50 $.50

Sell @ $2.10 Buy @ $2.60 $.50

Cash sale = $2.10- Futures Loss = .10

Return to Hedge = $2.00

10 cent loss

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The Slightly Imperfect Hedge

CashPrice

FuturesPrice Basis

Nov. 1

Dec. 1

Buy @ $2.00 Sell @ $2.50 $.50

Sell @ $1.90 Buy @ $2.45 $.55

Cash sale = $1.90+ Futures Gain = .05

Return to Hedge = $1.95

$1.95 is betterthan $1.90…But not $2.00

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Characteristics of a SuccessfulHedge

• 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

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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

• Texas “Hedge” (Not a True Hedge)

– Same Position on Cash and Futures Markets

– Doubles the Risk

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Three Farmer Hedges• Perfect Hedge

– Useful for Learning; Rare in Practice

• Storage Hedge– Set During Storage; Oct. to May– Protects Against Falling Prices– Helps Earn Storage Returns

• Pre-Harvest Hedge– Set in Spring– Protects Fall Harvest Price

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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

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The Storage Hedge

CashPrice

FuturesPrice

Basis

Nov. 1

June 1

Buy/Store @ $2.00 Sell @ $2.50 $.50

Sell @ $2.30 Buy @ $2.40 $.10

Cash sale = $2.30+ Futures Gain = .10

=Return to Hedge = $2.40- Original Cost = $2.00

= Storage Return = $.40

- $.40

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Storage Hedge Rule

The Storage Hedger’s Carrying Charge(Return to Storage) Will Always EqualThe Change in Basis Over the Storage Period

The Storage Hedge Transfers the Basis Change From the Speculators to Hedgers

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Hedging Principle

The Basis Determines the Success of A Hedge

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Date Cash Market Futures Market

October Harvest Price = $3.00 Sell July Fut. = $3.50

Est. June Basis = $.10Storage Cost = $.30Forward Price = $3.50-.10= $3.40

Storage Profit= $3.40 -3.00 - .30= $.10

June Cash Sale @ $3.30 Buy Back Fut. @ $3.40

Return to Hedge: $3.30 + $.10 = $ 3.40

Corn Storage Hedge

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Pre-Harvest 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

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The PreHarvest Hedge

CashPrice

FuturesPrice

Basis

May 1Planting

Nov. 1Harvest

Plant at TargetPrice:$3.00-.40=$2.60

Sell @ $3.00

Sell @ $2.40 Buy @ $2.80 Expected $.40

Cash Sale = $2.40+ Futures Gain = .20

Return to Hedge = $2.60 = Spring Target

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Date Cash Market Futures Market

May Sell Dec Fut. = $2.80Cost of Production = $2.10

Forward Price = $2.80-.30 basis= $2.50Expected 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

Corn Pre-Harvest Hedge

Expected basis = $.30

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Calculating the ReturnTo 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 (Prodn. Or Storage)….…$3.20

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

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Combination Pre-Harvestand Storage Hedge

May 1998 Target $3.00 Sell@$3.40 $3.40-.20 Est. Spr. = $3.20 basis=$.20

Cash Dec. 98 June 99 Market Futures Futures

May 1999 $2.30 xxxx Buy@$2.50

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

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Why Don’t 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????

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Summary: Risk ManagementTools

• Hedging

• Options

• Forward Cash Contracts

• Basis Contracts

• Minimum Price Contracts