evaluating risk management tools
DESCRIPTION
Evaluating Risk Management Tools. John D. Lawrence Extension Livestock Economist Iowa State University. Tools. Futures Forward contracts Options Livestock Revenue Protection Livestock Gross Margin Option combinations. Y-axis is the net price received. Cash is a 45 o line. - PowerPoint PPT PresentationTRANSCRIPT
1
Evaluating Risk Management Tools
John D. Lawrence
Extension Livestock Economist
Iowa State University
2
Tools
• Futures
• Forward contracts
• Options
• Livestock Revenue Protection
• Livestock Gross Margin
• Option combinations
3
Net Cash Pay Off from Risk Strategy
72
74
76
78
80
82
84
86
88
90
92
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
Net
Cash is a 45o line
X-axis is possible futures prices at end of contract
Y-axis is the net price received
4
Futures and Options DataJUNE 2009 LIVE CATTLE
Dec 17 Closing Prices
Futures $85.80
Expected Basis $0.56
Strike Premium
Price Call Put
80 8.70 3.20
82 7.40 3.88
84 6.20 4.65
86 5.10 5.55
88 4.18 6.60
90 3.35 7.78
92 2.65 9.05
94 2.10 10.50
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Futures Hedge
Futures price F 85.80
Expected basis +B 0.56
Commission -C 0.12
Expected Hedge Price EHP 86.24
Establishes a flat price with basis risk around it.
•If Futures fall to $80: Cattle are worth $80.56 + Futures gain of $5.80 – Com of $.12
•If Futures rise to $90: Cattle are worth $90.56 – Futures loss of $4.20 – Com of $.12
•In either case the net price is $86.24 +/- the change in basis from expected
6
Net Cash Pay Off from Risk Strategy
72
74
76
78
80
82
84
86
88
90
92
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
Futures
Net
Futures Hedge
Futures price F 85.80
Expected basis +B 0.56
Commission -C 0.12
Expected Hedge Price EHP 86.24
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Forward Contract v. Futures
• They look the same on the graph
• Flat price
• Difference: Forward contact – Contract with buyer– Must deliver commodity (deliver specs)– Basis is known and no basis risk– No margin calls– Typically flexible sizes
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Establishes a floor price, but not a ceiling and has basis risk
• At Futures prices below SP: Net price is the Floor Price because the futures gains off set cash price decline, but subtract premium and commission.
•At Futures prices above SP: Net price is the cash price minus the premium and commission that have already been paid.
Buy Put option
Strike price SP 84.00
Premium -P 4.65
Expected basis +B 0.56
Commission -C 0.12
Floor Price: SPp-Pp+B-C FP 79.79
9
Net Cash Pay Off from Risk Strategy
72
74
76
78
80
82
84
86
88
90
92
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
ATM Put
Net
Buy Put option
Strike price SP 84.00
Premium -P 4.65
Expected basis +B 0.56
Commission -C 0.12
Floor Price: FP 79.79
P+C
Corner at intersection of Strike and Floor Prices
10
Net Cash Pay Off from Risk Strategy
72
74
76
78
80
82
84
86
88
90
92
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
Futures
ATM Put
Net Compare Futures hedge to ATM Put
Futures has higher net price until the lines
cross
45o line so rise/run = 1. “Rise” is P+C is also “Run” from
current futures to the futures price where the lines cross
11
Net Cash Pay Off from Risk Strategy
72
74
76
78
80
82
84
86
88
90
92
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
Futures
ATM Put
Low Put
Net
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Livestock Revenue Protection
• Looks like buying put option on graph
• Floor price with upside potential
• Difference: LRP– Is both through insurance agent– Flexible size of contract– Expiration time is fixed – Cannot be resold– Basis is slightly different as is basis risk
13
Livestock Gross Margin
• Protect a “margin” – Revenue – feed cost – feeder cost– Budgeted quantities and weights– Uses futures prices
• Focus on profits not price
• Flexible size
• Purchased from insurance agents
14
Combination Option Strategies
• Buy one option and sell another– Income from option sold raises the floor– Get premium, but give up something else
• Option sellers– Must establish an margin account and will get
margin calls if futures price moves against you
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Fence or Window Strategy
Buy Put SPp 82.00
Put Premium -Pp 3.88
Sell Call SPc 90.00
Call Premium +Pc 3.35
Net Premium NP -0.53
Expected basis +B 0.56
Commission x 2 -2C 0.24
Fence Floor: SPp+NP+B-C FF 81.79
Fence Ceiling:SPc+NP+B-C FC 89.79
In Between: Cash price + NP - 2C, Cash price + -0.77
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Net Cash Pay Off from Risk Strategy
72
74
76
78
80
82
84
86
88
90
92
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
Futures
ATM Put
Fence
Net
Buy 82 Put @ $3.88
Sell 90 Call @ $3.35
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Put Spread
Buy ITM put SPi 88.00
ITM Put Premium -Pip 6.60
Sell OTM Put SPo 82.00
OTM Put Premium +Pop 3.88
Net Premium NP -2.73
Expected basis +B 0.56
Commission x 2 -2C 0.24
Between SPi and SPo = SPi + NP + B – 2C 85.60
Above SPi = Cash price + NP – 2C, Cash + -2.97
Below SPo = Cash price + (SPi - SPo)+ NP – 2C
Cash + 6.00 -3.35 -.3 = Cash + 3.04
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Net Cash Pay Off from Risk Strategy
73
75
77
79
81
83
85
87
89
91
93
72 74 76 78 80 82 84 86 88 90 92
Futures Price at Maturity
Cash
Futures
ATM Put
Put Spread
Net Price
Buy 88 put at $6.60
Sell 82 Put at $3.88
This not a floor. It is a shelf
There is down side risk, but no ceiling and higher over range of prices.
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Summary
• Tools are available to include into a well developed marketing plan
• Tools have different strengths and weaknesses to achieve different objectives
• Understand the math and basis first
• Marketing clubs are good ways to learn