Chap 15 - Hedging and Risk
Farming & Risk (quantity, quality, price)
Hedging
weather & pests
> crop insurance
price
> forward or futures contract
transfer of risk to a counterparty (incomplete)
similar to insurance
cost - margin account, brokerage fees
Example: Perfect Short Hedge
Simplifying Assumptions:
October - post harvest;
crop in storage
(long physical corn)
Return to storage = f(spot sale in May)
Target return to storage = $0.25/bu
Current spot price
= $3.50
Current May futures
= $3.75
Return to storage
= $0.25
(October to May)
spot market = delivery point
(expected)
The Short Hedge
October:
SELL May contract @ $3.75
May: May Futures and May Spot price (rises) = $3.75
SELL (deliver)
Physical corn @ $3.75
Futures contract satisfied
Return to storage
= $0.25 = Target return
Spot and Futures Convergence at contract expiry
Arbitrage between spot and futures
Spot & Futures Convergence
March Contract
Futures
Price
Basis
Spot
Oct
March
The Hedge: Prices Change
Assume:
Unexpected large crop in Argentina
Lower cash price in May
= $3.60
Farmer still protected (October cash price = $3.50)
October:
SELL May contract @ $3.75
May:
BUY May contract @ $3.60
NET = $ 0.15
SELL physical corn @ $3.60
NET = $ 0.10
Return to storage
= $ 0.25
The Result:
The same regardless of price increase or decrease
Hedging & the Basis
Basis:
Price difference between two locations in
Space OR Time OR Both
Space:
Time:
Local Spot Price ≠ Delivery Point Spot Price
Current local Price ≠ Current May Futures Price
Basis = cost of transfer (transport + storage + insurance etc.)
Bt = Ft - Pt
Current May Futures - Current Local Spot Price
Successful Hedge <= Basis now vs Basis in May (time of delivery)
Perfect Hedge
<= Basis now = Basis in May
Ontario Basis
December 2011
Hedging, the Basis & the Return to Storage
Generally:
The basis is not stable over time
Result:
Actual return to storage > or < anticipated return
Cash Market (physical)
Futures Market
NOW: BUY/OWN Corn @ P1
SELL May Futures @ F1
MAY:
BUY May Futures @ F2
SELL Corn @ P2
Hedging, the Basis & the Return to Storage
Return to storage = (P2 - P1) + (F1 - F2)
Buy LOW and Sell HIGH in both markets
Return = (F1 - P1) - (F2 - P2) = B1 - B2
B1 > B2
=>
Positive Return
B1 < B2
=>
Negative Return
Hedging: Using Futures to Target Price
Problem:
Pre-planting, farmers need to “price” the future crop
Futures provide “price discovery”
Banks want insurance against loan to farmer
Locked in Price => less bank risk
Solution:
Use futures to “price” the crop & profitability
Planting Decision: Hedged or not – it is a commitment to sell
Not using futures/forward = Speculation
Futures & the Pre-Plant Decision
Profit =
Returns in Cash and Futures Markets
Cash return:
(P2 - C1)
C1 = Cost of production
Futures return:
(F1– F2)
Sell - Buy
Total Return
=
(P2 - C1) + (F1 – F2)
=
F1 – ((C1 + (F2 – P2))
=
(F1 – C1) - B2
Anticipated Return – Basis @ delivery + BUY offset
Complication – Anticipated yield ≠ Actual yield (uncertain)
Futures & the Pre-Plant Decision
Profit =
Cash Return + Futures Return
Rising Futures & Spot Price
Cash return:
(P2 - C1) = ($5.25 - $4.00) = $1.25
Futures return:
(F1– F2) = ($5.00 - $5.25) = - $0.25
Total Return
= $1.00 above cost of production
$5.00/bu
Futures & the Pre-Plant Decision
Profit =
Cash Return + Futures Return
Falling Futures & Spot Price
Cash return:
(P2 - C1) = ($4.25 - $4.00) = $0.25
Futures return:
(F1– F2) = ($5.00 - $4.25) = $0.75
Total Return
= $1.00 above cost of production
Speculative Spread
Across Delivery Months
May too LOW & Sept too HIGH ? => Basis too big ?
Spread
=> Trade commodity across different delivery months
Arbitrage the price spread
Principal
=> Buy LOW, sell HIGH
NOW:
BUY May
SELL Sept
B1
LATER:
SELL May
BUY Sept
B2
RETURN:
Profit (loss) on MAY & SEPT Contracts
π = B1 - B2
Speculative Straddle
Across Commodities
Principal: Act on abnormal price relationship between commodities
Wheat vs corn
Wheat too LOW relative to Corn? => Basis too small ?
NOW:
BUY wheat & SELL corn
B1
LATER:
SELL wheat & BUY corn
B2
RETURN:
Profit (loss) on wheat & corn contracts
π = B2 - B1