USING FUTURES TO MANAGE RISKUSING FUTURES TO MANAGE RISK

RICHARD BRIGGS

RBC Dominion Securities

What is a Basis?

Basis

Spot price of hedged asset - Futures price of contract

A negative number means futures above spot price. A positive number means spot price above futures.

Basis varies less then spot or futures prices

Basis

Spot prices reflect current conditions where as futures reflect anticipatory conditions

Seasonality may affect the basis

• Narrow basis occur during Aug-Sept period

• Increasing supply conditions

• Widening basis occur during Dec-Jan period

• Decreasing supply conditionsAt futures maturity both prices will be about the same

Spot and Future Price

-Daily Spot Price -Daily Future Price

Using Futures to Hedge Price Risk

Futures and Spot prices will move up or down together

Hedging involves taking the opposite side of the spot position

Remaining risk is Basis which has a lower risk profile then remaining un-hedged

CME Lean Hog contract is for 40000 lbsCurrency of contract is USDMargin requirement per contract $1250

Hedging - Upward moving marketDate Spot Market Futures Market Basis

January 5 2012 Hedge is

placed

81.40 87.55 cwt

Sell 1 CME LH J2

81.40 - 87.55

-6.15

April 16 2012 Hedge is lifted

83.25 89.40cwt

Buy 1 CME LH J2

83.25 – 89.40

-6.15

Operation in futures market results in loss of

(87.55-89.40)x40000= -$740 usd per contract

FINAL PRICE RECEIVED

Spot Price + G/L on Futures Operation

83.25 – 1.85= 81.40 cwt

Hedging - Downward moving marketDate Spot Market Futures Market Basis

January 5 2012 Hedge is

placed

83.25 87.55 cwt

Sell 1 CME LH J2

83.25 - 87.55

-4.30

April 16 2012 Hedge is lifted

81.40 85.70 cwt

Buy 1 CME LH J2

81.40 – 85.70

-4.30

Operation in futures market results in gain of

(87.55-85.70)x40000= +$740 usd per contract

FINAL PRICE RECEIVED

Spot Price + G/L on Futures Operation

81.40 + 1.85= 83.25 cwt

How many contracts does one need to hedge?

1.Verify the impact of $1 cwt change in futures

2.Divide 400 by this (LH contract is 40k lbs, about 150 market ready pigs each penny change represents $400.00

3.This number represents the amount of contracts to place on your hedge

Number of Pigs per 1 LH Contracts = 400 1 X % of futures used for pig price

Example: finisher buys 100 feeder pigs for 85% of July LH futures price

Number of Pigs per 1 LH Contracts = 400 1 X .85

Number of Pigs per 1 LH Contracts = 470

Using Options to Hedge

Using options is another way to hedge your production

Can sell calls or buy puts when prices falling

Can buy calls and sell puts when prices are rising

Can create neutral, bullish and bearish option strategies through options

Using Options to Hedge (cont’d)

Options can be combined with futures to enhance risk profile

Buying options to hedge = producer knows maximum cash outlay

Options provide flexibility in your hedge

Reasons to Hedge with Futures

Most Marketing contracts don’t have a fixed price

Many contractors use LH futures to determine a sales price

Usually restricted on how far out you can hedge your price

Can protect against un-priced physical

Producers can use futures to manage price risk

Flexible, offset at any time

Reasons to Hedge with Futures (cont’d)

Futures can be used to manage input price risk and currency risk

Basis may change but the reduction in risk through hedging outweighs being un-hedged.

Will enhance your credit profile with lenders

Flexible, offset at any time

Hedging no Panacea

Hedging does not always guarantee best selling price

Basis does change

• Quality of hogs

• Delivery location

• Time

Contracts may not match exactly with production

Using Futures to Manage Risk

Thank You

Using Futures to Manage Risk

Thank You

Richard Briggs

Tel# 1-855-602-4113

Email : richard.briggs@rbc.com

RBC Dominion Securities

RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. ®Registered trademark of Royal Bank of Canada. Used under licence. RBC Dominion S®Registered trademark of Royal Bank of Canada. Used under licence. RBC Wealth Management is a registered trademark of Royal Bank of Canada. Used under licence. ©Copyright 2011. All rights reserved.