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 4 .

Farmer Tools For Managing Price Risk ‡ Cash Sale (at Harvest or From Storage) ‡ Forward Pricing: ± Forward Contracts: Cash and Basis contracts ± Hedging using Futures ± Options ‡ Minimum Price Contract 5 .

KCBT etc. ‡ Futures price is today¶s price for products to be delivered in the future.Futures Markets ‡ Futures Exchanges : CBOT. CME. ± Contract specifications ± Order execution process (open outcry) ± Margin requirements 6 ..

55 $2.53 $2.60 Deposit $500 Margin Call $200 Margin Call $300 $2.57 $2.50 $2.54 $2.Date Price per Bushel Action Initial margin = $500 Maintenance margin = $350 Sell July corn Margin Action Account Balance 17-Jan 18-Jan 19-Jan 20-Jan 21-Jan 24-Jan 25-Jan 26-Jan 27-Jan 28-Jan $2.44 Buy July corn $500 $400 $300 $500 $550 $200 $500 $650 $750 $950 $500 $600 $800 .49 $2.52 $2.51 Withdraw $450 $2.

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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 .

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 10 .

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? 11 .

g. e. month Discuss hedging plan with those involved. BEP Follow basis patterns Hedge reasonable amounts of commodity Keep adequate records 12 . VC. bankers Know how to calculate your productions costs FC.Hedging Guidelines ‡ Decide on a definite hedging objective ‡ ‡ ‡ ‡ ‡ reasons.

Production and Marketing Periods Spring Planting Fall Harvest Spring/ Summer Pre-Harvest Period Risk: Plant without knowing Fall Price Storage Period Risk: Store without knowing Spring Price 13 .

50 $. 1 Buy @ $2.50 Buy @ $2.10 Return to Hedge = $2.00 Sell @ $1.40 Basis $. 1 Dec.50 10 cent gain 14 Cash sale = $1.The Perfect Hedge (Falling Price Period) Cash Price Nov.00 .90 Futures Price Sell @ $2.90 + Futures Gain = .

Perfect Hedge Returns For a Perfect Hedge (Basis = Constant). 15 . The Return To The Hedge (Cash Price + Futures) Will Always Be the Same.

00 .Futures Loss = .10 .The Perfect Hedge (Rising Price Period) Cash Price Nov.10 Futures Price Sell @ $2.10 Return to Hedge = $2.50 Buy @ $2.50 10 cent loss 16 Cash sale = $2.50 $. 1 Buy @ $2.60 Basis $.00 Sell @ $2. 1 Dec.

90« 17 But not $2. 1 Dec.The Slightly Imperfect Hedge Cash Price Nov.50 Buy @ $2.50 $.00 .55 Cash sale = $1.45 Basis $. 1 Buy @ $2.95 is better than $1.95 $1.00 Sell @ $1.90 Futures Price Sell @ $2.90 + Futures Gain = .05 Return to Hedge = $1.

No Regrets 18 . Sell on Cash Market Loss on One Market = Gain on Other Market Transfer of Risk from Hedgers to Speculators No Tears.Characteristics of a Successful Hedge ‡ Equal and Opposite Positions on Cash and ‡ ‡ ‡ ‡ ‡ ‡ Futures Markets Cash and Futures Markets Move In Same Direction Predictable Basis Pattern Nullify Futures Position.

Buy Back Futures ‡ Long Hedge (Protects Against Rising Prices) ± Short Cash.Types of Hedges ‡ Short Hedge (Protects Against Falling Prices) ± Long Cash. Long Futures ± Buy Cash. Sell Futures ‡ Texas ³Hedge´ (Not a True Hedge) ± Same Position on Cash and Futures Markets ± Doubles the Risk 19 . Short Futures ± Sell Cash.

Oct.Three Farmer Hedges ‡ Perfect Hedge ± Useful for Learning. Rare in Practice ‡ Storage Hedge ± Set During Storage. to May ± Protects Against Falling Prices ± Helps Earn Storage Returns ‡ Pre-Harvest Hedge ± Set in Spring ± Protects Fall Harvest Price 20 .

Inventory Loss Will Price Rise Cover Storage Costs? Carrying Charges: ± Storage Costs ± Handling Charges ± Insurance and Interest Costs ‡ Key to Success: Narrowing Basis Pattern 21 .Storage Hedges ‡ ‡ ‡ ‡ Harvest-to-Sale Period (Storage Season) Risk of Price Decline.

$. 1 Buy/Store @ $2.The Storage Hedge Cash Price Futures Price Basis Nov.Original Cost = $2.00 = Storage Return = $.40 .50 $.00 Sell @ $2.40 Cash sale = $2.40 22 .10 .40 $.30 + Futures Gain = .30 Buy @ $2.10 =Return to Hedge = $2.50 June 1 Sell @ $2.

Storage Hedge Rule The Storage Hedger¶s Carrying Charge (Return to Storage) Will Always Equal The Change in Basis Over the Storage Period The Storage Hedge Transfers the Basis Change From the Speculators to Hedgers 23 .

Hedging Principle The Basis Determines the Success of A Hedge 24 .

40 .30 Return to Hedge: Buy Back Fut.10 Storage Cost = $.Corn Storage Hedge Date Cash Market Futures Market October Harvest Price = $3.10 = $ 3..10= $3.00 Sell July Fut.00 . = $3.30= $.30 Forward Price = $3.30 + $.40 25 June $3.40 -3.10 Cash Sale @ $3. June Basis = $.40 Storage Profit= $3. @ $3.50-.50 Est.

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 26 .

40 Futures Price Sell @ $3.60 Sell @ $2.40 + Futures Gain = .00 Basis Buy @ $2.60 = Spring Target 27 .00-.The PreHarvest Hedge Cash Price May 1 Planting Nov. 1 Harvest Plant at Target Price: $3.80 Expected $.20 Return to Hedge = $2.40=$2.40 Cash Sale = $2.

10 Expected basis = $. = $2.50 Expected Profit= $2.Corn Pre-Harvest Hedge Date May Cash Market Futures Market Sell Dec Fut.10 = $ . Cash Sale @ $2.80 Cost of Production = $2.10.70 28 Net Return to Hedge: $2.$2.40 + $.30 Forward Price = $2. @ $2.40 Buy Back Fut.50 -2.30 basis= $2.80-.10 = $.40 .40 Oct.

.Calculating the Return To a Hedge Today: Current Futures Price««.50 Less: Costs (Prodn.50 Equals: Total Return to Hedge«.$4..$3.30 .$.«.00 Plus/Minus Futures Transaction««« $.$3.«.....50 Future Sale: Cash Price«««««««.«$3.20 29 Equals: Net Return To Hedge«««.50 Equals: Lock-In Forward Price««.00 Less: Expected Basis at Sale Time «. . $3. Or Storage)«..

20 .20 Buy@$2.40 Est.00 June 99 Futures Sell@$3.20 $2.20 = $3. 98 Futures $3. Spr.90 =$3.30 + . basis=$.40-.Combination Pre-Harvest and Storage Hedge Cash Market May 1998 Target $3.50 30 May 1999 xxxx Return to Hedge: $2.30 Dec.

Prefer to Speculate on Cash Market ‡ Dislike Margin Calls ‡ Other???? 31 .Why Don¶t More Farmers Hedge? ‡ ‡ ‡ ‡ Lack of Understanding of Hedging Mistrust of Futures Market Prefer Ease of Forward Contracts Like Risk.

Summary: Risk Management Tools ‡ Hedging ‡ Options ‡ Forward Cash Contracts ‡ Basis Contracts ‡ Minimum Price Contracts 32 .

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