© ChicagoBoardof Trade OPTIONS ON AGRICULTURAL FUTURES AHOME STUDY COURSE Revision—January 1995CHAPTER 2 Hedging and Basi Hedging is based on the principle that cash market prices and furs market pices tend to move up and flown together. This movement Is not necessarily cont {or cont, butt usual is close enough that itis poss Do to lesson the risk ofa loss in the cash market By {aking an opposite position In the fulures market. ‘Taking opposte postions allows losses in one markei to be offeat by gals inthe other. n this manner, the edger is ablo.o establish a price level for a cash ‘market transaction that may not actully take place for Several mons. Hedging Examples ‘To give some examples of how hedging works, sup- pose lis May and you are a soybean farmer wih. op inthe fel, or perhaps an elevator operator with ‘Soybeans you have purchased but not yo sol. nthe terminology ofthe market, you have a long cash mar- et ‘The eurrent cash market pice for 80y- bboans is $70.1 the price goes up between now and ‘November when you plant sel, you wil gain On the ‘ther hand, # tha pee gous down during that ime, you wil os. To protect yourself against a possible prco docine luring the coming morins, you ean hedge by soling a fSorrespanding numbor of bushels nthe futures mar et now and buying them back ater when Ii imo to ‘ef your ops In the cash market. I the cash price ‘ectines by Rares, ary loss cured wil be offset by ‘gain fom he hedge tho futures market. With futures. a person can sell first and then buy later or buy test and then sol later. Regarlass ofthe ‘reer In which the Wansactions occur, buying at's fowor pice and soling ata higher pice wil rest in ‘gain on the ftures positon. Seling now with the intention of buying back at a later date gives you a shor futures market postion. A price decrease wil result in a gain because you wil Fave sold aia higher price and bought at & lower pre, For example, let's assume that cash and futures pices are geal. What happens if prices decine by {$1.00 per bushel? Altiough the value of your long ‘cash market positon decreases by $1.00 pex bushel. the value of your short futures market position Increases by $1 00 pr bushel. Because the gain on your futures aoson is equal to the loss on the cash " positon, your net saling price is stl $700 per bushel. ‘Cash market Futures market ay cash soyboans are sell Nov soybean ‘$7.00 futures at §7.00rbu Nov cash soybeans are buy Nov soybean ‘$6000 futures $6.0000 change $1.00 oss $1.00 gain cash price when soybeans are sold $8.00hbu gain on futures positon 1.00 et seling ce $s7.00bu What If soybean prices had instoad ison by $1.00 per bushel? Onca again, the net sollag price would: Rave beon $7.00 por bushel, as a $1 00 por bushel loss onthe shor futures postion would be offset by a. ‘1.00 per bushel gain on the long cash poston. (ash market Futures market ‘jay cash soybeans are soll Nov soybean 57.00% ftqures at $7.00%00 Nov cash soybeans are buy Nov soybean Se.00b0 futures at $8.00%u change $1 00% gain $1.00/bu loss cash pica when soybeans ae old $8.00 'css on ures poston 21.000 et seing pice ‘$7.00 Notice that n both cases the gains and losses on tho. ‘wo market postions cancel out each other. That is, wen there fsa gain on one market positon, thre i. 1 comparable loss on the other. This explains why hedging soften said fo lock ra price level. set out to achieve: W established a song price of {57.00 a bushel for soybeans to be delivered in ‘November. By hedging, you give up the opportunity 0, Deneft trom a price inerease to obtain protection ‘agains a price decrease.‘This particular type of hedge is known as a short hedge because ituses a short futures poston. On the ether hand, vestock feeders, grain exporirs, food manufacturers, and other buyers of agrcdturel Products offen need protection against rising prices fd might instead use along hedge Involving along futures poston For examplo, assume that tis July and you ae plan- ning to buy com in Docomber. Th cash market peo ‘in July i $2.50 per bushel, but you are concerned ‘hay the time ou make th purchase he a ‘may be much higher. To protect yours rom @ poss be price increase, you buy December com fats at $2.50 per bushel. What would be the outoome iteom Prices increase $0.50 per bushel by Decomber? ‘Cash market Futures market KI easheornis ‘uy Dec corn S250mu fotures at 6250/0 Dec cash omnis sell Dec com ‘$3.00; futures at §3.00/00 change $0.50bu loss $0.50/bu gain ‘cash price when corn fs purchased $3,00fou ‘ain on futures postion 70.50u ‘et purchase price $250 In this example, the higher cast of com inthe cash ‘market was offset by a gain in the flures maiket Conversely, if corn prices decreased by $0.50 per ‘bushel In Becamber, the lower east of corn inthe ‘cash markot would be offset by a loss In the fares ‘market, The net purchase price would stil be $250 per bushel Futures market (Gash market a Te eash com is ‘buy Dec com S250b0 futures at $250%s Dec cash cam is at! Dac com S200 futures et $2.00%0 change $0.50 gain $0.50/bu loss cash price when com is purchased $2.00/%0 loss on futures postion $4050 not purchase price '$250u Bea in mind that whethor you have a shot hedge or ‘along hedge, any losses on you futures position may Tesuitin a margin call rom your broker, requng you 1 deost atonal nds your marin amt Previously discussed, adequate funds must be mal. {alnod in the aocount io cover day-to-day losses, Basis: The Link Between Cash and Futures Prices ‘Allof the examples just presented assured Kontcal cash and fuures prices. But, ityou are in a business that involves buying or seling gran, you know thatthe ‘ash price In your area difrs from prices quotod In the futures market, Tis diference may be Sight or ft may be substantial, and the two prices may not always vary by the same amount. The differance betwen the cash market price in the community hare you sell your crop and the price for a given futures contract is known as the basis. Basis rollocts transporiation costs between your focal market and the dolivery point specifed by the fulires contract, as wall as storage and handling costs untl tho delivery ‘month ofthe futures contract. Basis also depends on local supply and demand factors. Ils calculated by ‘subtracting the futures price trom the eash pica, and ‘can be postive oF negative dapencing on whothor the cash price Is over or Unda the futures price, ‘A primary consideration in evaluating the basis i its strength or weaknoss. The more postive (or less nog ave) the basi, the stronger its. In contrast, the ‘more negative (r less positive) the bass, the woakor ts. For example, a basis change trom 10 under (a cash ‘rice $0.10 las than the futures price) toa basis of 5 ‘cash price $0.05 less than the futures pres) Indicates a strengthening basis, even though the basis is sil negative. On the other hand, a basis change trom 20 over (a cash prica $0.20 more than the futures price) to a basis of 15 over (a cash price {$0.15 more than the fulures price) Indicates a woak ‘ning basis, despite the fact thatthe bass ssl post tre, Basis i important tothe hodger bocause it can affect the final outcome of his hedge. For axampla, suppose it's March and you plan to sell wheat to yout local etevat in Jy, The July wheat utures pce is $3.60 ‘per bushel, and the cash price In your area in July is normaly about $0.35 under the July futures price. The ‘approximate price you can establish by hedaina Is S215 per bushel (83.50 minus $0.35). Hero f how tha hedge would work the futures price had decined to $9.00 by July and the basis was $0.35 under.‘Gash market Futures market Basie War expected cash sellJulwheat — -35 wheat pre is fuures at $3.50/bu Satu Jul solleash wheat buy Julwhest 35 ats2estu futures at $3.00%u change $0.50buloss — $0.50bugain 00 cash price when wheat sold $2.65/bu ‘gain on futures postion 30.500u_ et soling rice sas ‘Suppose, instead, that the basis in July had turned cut fo be $0.40 under rather than the expected $0.25 Under. Then the net seling price would have been ‘$5.10 rather man $3.15 ‘Gash market Futures market Mar expoctod cash soll Jul wheat ‘wheat price is futures at $3.50/bu $3180 Jul sollcash wheat buy Julwheat 40 at$260bu futures at $8.00/bu change $05Sbuloss — $0.50bugain 05 ‘cash price when wheats sold —$2.60/bu ‘in on futures postion 30.500 net seling price $8:10u ‘This example lustrates how a woaker-than-oxpect ed basis reduces the sffeciveness of a shor hedge. ‘And, as you might imagine, a short hedge becomes ‘more etfecve wth a stronger-than-expected basis. {oak atte folowing exampe. Futures market ‘sell Jul wheat futures at $3.50%e0 a buy Jot wheat futures at $3.00/b0 change $040Pouloss $0.60 gain ‘cash price when wheats sold fin on futures postion et soling price 25 +10 $2750 $30.50 S250 How does basis affect the perfarmance of a long ‘Cash market Fulures market Basle of ‘buy May soybean +20 Soybean meal maa fiaures at rice is $1801on $1700 May buy soybean sell May soybean +20 ‘meal at $220%e teal ures at Seon change $30nonloss —_—$30Vtongain ° cash pte when meals puchasad_$220R0n ‘ain on futures postion net purchase price Hiten ‘What tthe basis had become stronger—in this case, more postive and instead of he expected Soa ‘ver, wae actualy $40non over nay? Then the het purchase price would alo have been $20 higher, or S210Ren. ‘Cash market ‘Gal expecied soybean meal pices $180rIon §170R0 May buy soybean sol May soybean +40 meal at $2407en meal tures at Se0ar0% change $50ton loss $80nongain 420, cash price when mealis purchased $240/ton {ain on futures positon soon net purchase price Bet0non CConversoly if the bass had weakened trom $20 over to $10-over, tho not purchase price would have boon '$180/0n ($210 minus $80Ron gai) rater than $210 per ton.Gash market Futures market Bask ‘Ga expected buy May soybean +20 Sajpean meal meal tures at roe ls s120ten St70Ren soybean sol May soybean +10 Mey usaf Stoned uhees at $2o0non change $20nonloss — $90Hongain +10 cash price when meal's purchased $210hon {jan on ures poston =20fon et purchase pee S190non Notice the opposite effects of a basis change on ‘short and fong hedgers. A stronger-hen: basis makes short edges more effective and long ecg ios ofecine,Gonvrely «weak than ‘tectely and shor hedges xs elocivay, ‘Basis Change stronger weaker fess moro ‘Summary Hecaing wih tutes ofr he opporunty oes 1h an tpproxinae pros mortem aon of ctu! slg or purcabo and protec th hada kom Uravrabe pice change. hi sponsible bactuse {aah and fares pice tnd fo move Inthe same SGrecion and by emfar amounts so fasts in one mart can be oft win gal Ine oer. Although {he tures hooper abl to Dene tom forte ‘rca changes he Is protected om untaverabie mar. Ectmoves igh Basie risk Is considerably less than price risk, but basis behavior can have a significant Impact on the mance of a hedge. A stronger tharvexpected sis wil bef a short hodger, wile a weakorthan- oxpocted basis works to the advantage ofa long edger Quiz2 1. Atarmer's crop stil in tho fed. His cash market poston i: (a)iong (b) shor (c) neither, since the erop hasnt been harvested ‘because he has no postion inthe ‘market miso that makes hedging possba i that ‘cash and futures prices {2) move in opposite directions (©) move upward and downward by identical ‘amounts (€ generally change in tho same direction by ‘pout ne same amount (€)are regulated by the exchange 8.To hedge against an increase in pric ‘woul (6) purchase futures contracts 4“ (0) st tres contracts ‘Used in connection wih tures tadng, he term tas ha ooo wih {2} he aiterence between cash mart prices in tere ocabore (2) the citerence between pies fr tleent doivery monte (€) te erence between he lcalcash prices no atures pies (6) eter relevant only o speciation Sf yu estate the basis wil be $0.18 under at ttn ou der you carn dye pon tate sling pres you can Tock 2 {tures contact $850 ya ones, ()se00 8200 (98205 (6) none o the above6 you estinate your local cash pce wil be $0.5 ‘under te futures price a the time you dalver {your com, tho approximate nt seting pice yes Ean tock in by seing a hues contract at $250 « (@) $205 (1) s260 (8235 {6} none othe above “Assuming your 0 gorealy gut i unt de COT laure pce Se edad tanaporatl costs n your afea woud be expec {edionave what elect onthe bass (@) woakantne basis (© svonathen the basis (€) no efecton te bess 2. you havea long cash market postion and co ‘not hedge you ae: (2) aspecutor (©) na postion o pot rom an increase in price {@ subject asst pes decine {@alottheatove ‘.Again assuming your local cash market price lk Genoraly quoted tndor tho GBOT hates pre, You have hedged by sclng a tues contac 3 Sed eee te op and oboe fea (a) once you have hedged, it makes no ditrence (©) when the basis is rlatvely woak (€) when the bass is relatively strong (6) whenever the cash market price i highest 10.Basis risk invives: (a) the fact that basis cannot be exactly procictod (©) the absoute level of futures prices (6) the inherent voit of futures prices Answer Guide: Quiz 2 1. (@) He is in the same positon, in terms of market ‘exposure, as someone who has purchased gran and i storrg the benefis f prices Increase and loses tf prices decrease 2 (€) Cash prices and futures prices generally move 40 ‘Upward and downward ogether bu not necessar- iy penny Yor penny. Even so, the changes are cosa enough fo make hedging possible by taking, ‘opposite postions inthe cash and futures mar= ie. 3. (@) Protection against rising prices is accom- Dlshad by taking a long futures pastion—~ie., by purchasing futures contracts. Protocton against ocilning prices would have boon achieved by selng futures contracts, {6) The basis isthe amount by which the local ash price is below (or above) a particular futures torent detvery monte ie known es he cary: ingotargee (6) Croc yourset a bonus point your sharp eye aught te quan. The gueson ase ‘wha seling price Jou can lock Is by Buying & tocked in by (6) The approximato net sling price you can lock In by seling a futures contact isthe price of the futures contrac that you sold less te local basis, $0.15, (@) Transportation costs duet locaton etferences ‘are one of the componanis of the basis (along wnth storage and handing expenses; thus higher Transportation costs woul, al else remaining the ‘same, weakon the basis. (@) An unhedged fong cash marke: poston is 2 Speculative posiion—you will reclize a gain it ices increase, ora loss If pices decrease, {c) When the basis is relatively stronger, For ‘example, assume you intialy hedged by seling a Soybean futures correct at $7.00. at harvest, the cash market price is $6.00 ard the Tutures price is $6.20 (a bass of $0.20 urder, your net Selling price when you lit the hedge is $6.80, ($6.00 cash price plus $0.80 gain on futures. (On the othor hand, lot's say the cash price was ‘$6.10 andthe futures was $6.40 (a basis of $0.30 ‘under. Your net seling price would be ony $6.70 (cash price of $6.10 pus futures gan of $0.60), (a) I you could precict the basis exact, you's Know to the penny what nat price ¢ ven hedge would produce, To the extent basis Is subject to fluctuation, there is a basis risk"