Price Risk Management
and
the Futures Market
Hedging
1
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
2
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
3
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
Futures Markets
• Futures Exchanges : CBOT, CME,
KCBT etc.,
• Futures price is today’s price for
products to be delivered in the future.
– Contract specifications
– Order execution process (open outcry)
– Margin requirements
6
Date
17-Jan
18-Jan
19-Jan
Price per Bushel
Action
Initial margin = $500
Maintenance margin = $350
Margin Action
Account Balance
$2.50
$2.52
$2.54
Sell July corn
Deposit $500
$500
$400
$300
$500
$550
$200
$500
$650
$750
$950
$500
$600
$800
Margin Call $200
20-Jan
21-Jan
$2.53
$2.60
Margin Call $300
24-Jan
25-Jan
26-Jan
$2.57
$2.55
$2.51
Withdraw $450
27-Jan
28-Jan
$2.49
$2.44
Buy July corn
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
9
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
Hedging Guidelines
• Decide on a definite hedging objective •
•
•
•
•
reasons, month
Discuss hedging plan with those involved; e.g.
bankers
Know how to calculate your productions costs FC, VC, BEP
Follow basis patterns
Hedge reasonable amounts of commodity
Keep adequate records
12
Production and Marketing
Periods
Spring
Planting
Fall
Harvest
Pre-Harvest Period
Risk: Plant without
knowing Fall Price
Spring/
Summer
Storage Period
Risk: Store without
knowing Spring Price
13
The Perfect Hedge
(Falling Price Period)
Cash
Price
Futures
Price
Basis
Nov. 1
Buy @ $2.00
Sell @ $2.50
$.50
Dec. 1
Sell @ $1.90
Buy @ $2.40
$.50
Cash sale = $1.90
+ Futures Gain = .10
Return to Hedge = $2.00
10 cent gain
14
Perfect Hedge Returns
For a Perfect Hedge (Basis = Constant), The
Return To The Hedge (Cash Price + Futures)
Will Always Be the Same.
15
The Perfect Hedge
(Rising Price Period)
Cash
Price
Futures
Price
Basis
Nov. 1
Buy @ $2.00
Sell @ $2.50
$.50
Dec. 1
Sell @ $2.10
Buy @ $2.60
$.50
Cash sale = $2.10
- Futures Loss = .10
Return to Hedge = $2.00
10 cent loss
16
The Slightly Imperfect
Hedge
Cash
Price
Futures
Price
Basis
Nov. 1
Buy @ $2.00
Sell @ $2.50
$.50
Dec. 1
Sell @ $1.90
Buy @ $2.45
$.55
Cash sale = $1.90
+ Futures Gain = .05
Return to Hedge = $1.95
$1.95 is better
than $1.90…
17
But not $2.00
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, Sell on Cash Market
Loss on One Market = Gain on Other Market
Transfer of Risk from Hedgers to Speculators
No Tears, No Regrets
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Types of Hedges
• Short Hedge (Protects Against Falling Prices)
– Long Cash, Short Futures
– Sell Cash, Buy Back Futures
• Long Hedge (Protects Against Rising Prices)
– Short Cash, Long Futures
– Buy Cash, Sell Futures
• Texas “Hedge” (Not a True Hedge)
– Same Position on Cash and Futures Markets
– Doubles the Risk
19
Three Farmer Hedges
• Perfect Hedge
– Useful for Learning; Rare in Practice
• Storage Hedge
– Set During Storage; Oct. to May
– Protects Against Falling Prices
– Helps Earn Storage Returns
• Pre-Harvest Hedge
– Set in Spring
– Protects Fall Harvest Price
20
Storage Hedges
•
•
•
•
Harvest-to-Sale Period (Storage Season)
Risk of Price Decline, 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
The Storage Hedge
Cash
Price
Futures
Price
Basis
Nov. 1 Buy/Store @ $2.00 Sell @ $2.50 $.50
June 1
Sell @ $2.30
Buy @ $2.40 $.10
Cash sale = $2.30
+ Futures Gain = .10
=Return to Hedge = $2.40
- Original Cost = $2.00
= Storage Return = $.40
- $.40
22
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
Corn Storage Hedge
Date
October
Cash Market
Futures
Market
Harvest Price = $3.00 Sell July Fut. = $3.50
Est. June Basis = $.10
Storage Cost = $.30
Forward Price = $3.50-.10= $3.40
Storage Profit= $3.40 -3.00 - .30= $.10
June
Cash Sale @ $3.30
Return to Hedge:
Buy Back Fut. @ $3.40
25
$3.30 + $.10 = $ 3.40
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
The PreHarvest Hedge
Cash
Price
Futures
Price
Basis
May 1
Planting
Plant at Target
Price:
$3.00-.40=$2.60
Sell @ $3.00
Nov. 1
Harvest
Sell @ $2.40
Buy @ $2.80 Expected
$.40
Cash Sale = $2.40
+ Futures Gain = .20
Return to Hedge = $2.60 = Spring Target 27
Corn Pre-Harvest Hedge
Date
Cash Market
May
Futures
Market
Sell Dec Fut. = $2.80
Cost of Production = $2.10
Expected basis = $.30
Forward Price = $2.80-.30 basis= $2.50
Expected Profit= $2.50 -2.10 = $.40
Oct.
Cash Sale @ $2.40
Buy Back Fut. @ $2.70
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Net Return to Hedge:
$2.40 + $.10- $2.10 = $ .40
Calculating the Return
To a Hedge
Today:
Current Futures Price……...$4.00
Less: Expected Basis at Sale Time ….. .50
Equals: Lock-In Forward Price……..$3.50
Cash Price…………………..$3.00
Plus/Minus Futures Transaction……… $.50
Future Sale:
Equals: Total Return to Hedge…..…. $3.50
Less: Costs (Prodn. Or Storage)….…$3.20
Equals: Net Return To Hedge……….…..$.30
29
Combination Pre-Harvest
and Storage Hedge
Cash
Market
May 1998
May 1999
Target
$3.40-.20
= $3.20
$2.30
Dec. 98
Futures
June 99
Futures
$3.00
Sell@$3.40
Est. Spr.
basis=$.20
xxxx
Buy@$2.50
Return to Hedge: $2.30 + .90 =$3.20
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Why Don’t More Farmers
Hedge?
•
•
•
•
Lack of Understanding of Hedging
Mistrust of Futures Market
Prefer Ease of Forward Contracts
Like Risk; Prefer to Speculate on Cash
Market
• Dislike Margin Calls
• Other????
31
Summary: Risk Management
Tools
• Hedging
• Options
• Forward Cash Contracts
• Basis Contracts
• Minimum Price Contracts
32