Cotton / Rice Risk Cotton / Rice Risk Management & Marketing Management & Marketing

StrategiesStrategies

Carl Anderson

Texas A&M University

Plan to Manage Price RiskPlan to Manage Price Risk

Producers control when & how to price

Prices are volatile– Cotton price can vary by 75 % from

season to seasonMarketing plan is essential

Markets are not going to GIVEyou anything; TAKE pricing opportunities from the market

Marketing PlanMarketing Plan

Financial condition Estimated costs (Breakeven Price) Develop market expectations Pricing alternatives Discipline Consider worst case scenario Risk bearing ability Cash flow needs Implement your plan

Understand MarketUnderstand Market

Supply / DemandBasic patternsSeasonal variation– high for 13 out of last 16 years

between May and September– but 7 of the 13 in year prior to harvest

Cotton Futures High & Low Cotton Futures High & Low Prices (1980-1997)Prices (1980-1997)

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1201980

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84

86

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96

Year

Cen

ts /

Lb

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OptionsOptions

Offer additional flexibilityUsed alone, with forward contracts

& with futures– eg., hedging with put options allow

upside opportunities

Pricing AlternativesPricing Alternatives(1997 Crop Example)(1997 Crop Example)

Pre-harvest: (between January & August)1. Buying put2. Forward contract3. Forward contract & Buy call4. Synthetic put - Sell futures & buy call5. Sell futures6. Buy put & Sell call

Harvest:7. Sell at harvest & buy call

1. Buying Put for 1997 Crop1. Buying Put for 1997 Crop

Buy Dec ’97 put cents/ lbStrike price 78.00Premium - 3.75Basis - 5.00Net (excluding commissions) 69.25

1. Buying Put for 1997 Crop1. Buying Put for 1997 Crop

Result: Downside price move covered

Advantages: Benefit from price increase, no margin deposit, easy to use

Disadvantages: Premium cost, fixed quantities,basis risk, commission fees

2. Forward Contract2. Forward Contract

cents/ lbFutures price 78.00Basis - 5.00Net (excluding commissions) 73.00

2. Forward Contract2. Forward Contract

Result: Fixed price

Advantages: Easy, no margin deposit, no brokerage fees, flexible quantity, avoid storage costs

Disadvantages: Limits gain, not flexible once signed, local contractor may not exist, payment hinges on solvency of contractor

3. Forward Contract & Buy 3. Forward Contract & Buy CallCall

cents/ lbForward contract 73.00

(as in #2)Premium Dec ’97, 78 call - 4.00Net (excluding commissions) 69.00

3. Forward Contract & Buy 3. Forward Contract & Buy CallCall

Result: Minimum price contract, floor set, potential for higher price

Advantages: Minimum price helps in obtaining credit, no margin calls

Disadvantages: Premium payment required, brokerage fees, may lose time value

4. Synthetic Put - Sell futures 4. Synthetic Put - Sell futures & Buy Call& Buy Call

cents/ lbSell Dec’97 futures 78.00Basis - 5.00Premium Dec’97, 78 call - 4.00Net (excluding commissions) 69.00

4. Synthetic Put - Sell futures 4. Synthetic Put - Sell futures & Buy Call& Buy Call

Result: Protection from price drop, upside protected from margin costs

Advantages: Protect margin risk, may cost less than a put, flexibility

Disadvantages: Margin deposit and possible margin calls, fixed price level

5. Sell Futures5. Sell Futures

cents/ lbSell Dec’97 futures 78.00Basis - 5.00Net (excluding commissions) 73.00

5. Sell Futures5. Sell Futures

Result: Establishes price subject to basis variationAdvantages: Reduces risk of price decline, many buyers, formal exchange rules

Disadvantages: Limits gain, margin deposit, basis risk, brokerage fees, standardized quantity

6. Buy Put-Sell Call for 1997 6. Buy Put-Sell Call for 1997 Crop WindowCrop Window

Cents / lbPremium, buy ’97, 78 put -3.75Sell ’97, 84 call +1.75Net (excluding commissions) -2.00

Min selling price = (78.00-3.75-5.00)+1.75 = 71.00Max selling price = (84.00-5.00)-2.00 = 77.00

6. Buy Put-Sell Call for 1997 6. Buy Put-Sell Call for 1997 Crop WindowCrop Window

Result: Both a ceiling and floor price

Advantages: Best when prices are likely peaking, lowers cost of options, higher minimum price

Disadvantages: Margin deposit required, basis risk, ceiling unless further action, brokerage fees

7. Sell at Harvest, Buy Call 7. Sell at Harvest, Buy Call OptionOption

Marketing Alternative: Sell crop instead of storing and purchase call option

Example Cents / lbCash price in November $0.65July $0.70 call premium -0.035Net to farmer $0.615

7. Sell at Harvest, Buy Call 7. Sell at Harvest, Buy Call OptionOption

$ 0.0080 (80 points) per pound per month for holding costs (estimated holding costs per bale per month, $2.25 for interest, $1.75 for storage; $4.00 per month total holding costs divided by 500 pounds per bale)

$3.50 Call premium = 4.38 months for 80 points/lbs./mth./storgae storage costs to

equal to premium cost of option

7. Sell at Harvest, Buy Call 7. Sell at Harvest, Buy Call OptionOption

Advantages: No storage cost, benefit from price increase, no margin calls, can “roll” to distant futures, flexible

Disadvantages: Premium & brokerage costs, fixed expiration, fixed contract size, quality may differ from futures