Chapter 10Chapter 10

Understanding and Understanding and Applying Hedging:Applying Hedging:

Using Futures, Options, Using Futures, Options, and Basisand Basis

Commodity Futures ExchangeCommodity Futures Exchange

A marketplace for persons interested in A marketplace for persons interested in buying or selling commodities—based on buying or selling commodities—based on today’s information and the perception of today’s information and the perception of where prices will be in the future.where prices will be in the future.

Grew out of:Grew out of:– The need for certain parties to guard against The need for certain parties to guard against

undesired price movements over timeundesired price movements over time– The desire by certain parties to assume the The desire by certain parties to assume the

risk of price movements in return for profitrisk of price movements in return for profit

Purposes of aPurposes of aFutures ExchangeFutures Exchange

A place of price discoveryA place of price discovery A mechanism for people to transfer cash A mechanism for people to transfer cash

price risk and uncertaintyprice risk and uncertainty A place for public access to information A place for public access to information

for decision makingfor decision making

Locations of Agricultural Locations of Agricultural Commodity Futures MarketsCommodity Futures Markets

Chicago Board of TradeChicago Board of Trade Chicago Mercantile ExchangeChicago Mercantile Exchange New York Board of TradeNew York Board of Trade Kansas City Board of TradeKansas City Board of Trade Minneapolis Grain ExchangeMinneapolis Grain Exchange Also Tokyo, China, BrazilAlso Tokyo, China, Brazil

Futures Market TerminologyFutures Market Terminology

Futures Contract TerminologyFutures Contract Terminology

Futures contract: Futures contract: – A regulated market mechanism in which sellers and A regulated market mechanism in which sellers and

buyers agree to sell/buy a commodity at an explicit price buyers agree to sell/buy a commodity at an explicit price and date in the future.and date in the future.

Arbitrage: Arbitrage: – Process whereby a commodity is simultaneously bought Process whereby a commodity is simultaneously bought

and sold in two different markets to take advantage of a and sold in two different markets to take advantage of a price discrepancy.price discrepancy.

Hedging:Hedging:– Process whereby a person who owns a commodity uses Process whereby a person who owns a commodity uses

the futures markets to transfer the price risk or to the futures markets to transfer the price risk or to establish a price.establish a price.

Cattle Futures Price Quotes— Cattle Futures Price Quotes— Chicago Mercantile Exchange, July 2005Chicago Mercantile Exchange, July 2005

Corn Futures Price Quotes—Corn Futures Price Quotes—Chicago Board of Trade, July 2005Chicago Board of Trade, July 2005

Options ContractsOptions Contracts

Put option: Put option: – Gives an individual the right but not the Gives an individual the right but not the

obligation to obligation to sell sell a futures contract at a a futures contract at a specified price during a specific time periodspecified price during a specific time period

Call option:Call option:– Gives an individual the right but not the Gives an individual the right but not the

obligation to obligation to buybuy a futures contract at a a futures contract at a specified price during a specific time periodspecified price during a specific time period

Strike price:Strike price:– The price at which the futures market can be The price at which the futures market can be

entered under an optionentered under an option

Strike PricesStrike Prices

Option contracts offer a range of strike prices Option contracts offer a range of strike prices so purchasers can choose the level at which so purchasers can choose the level at which they may eventually want to take a futures they may eventually want to take a futures positionposition

Terms describe where the strike price is Terms describe where the strike price is relative to the underlying futures contract relative to the underlying futures contract price:price:– In-the-moneyIn-the-money– At-the-moneyAt-the-money– Out-of-the-moneyOut-of-the-money

Value of the OptionValue of the Option

Intrinsic value: value relative to the Intrinsic value: value relative to the underlying futures priceunderlying futures price

Time value: reflects time between the Time value: reflects time between the option premium quote and contract option premium quote and contract expirationexpiration

Option premium: value that a hedger or Option premium: value that a hedger or speculator pays for the right to take a speculator pays for the right to take a futures position laterfutures position later

Options Price QuotesOptions Price Quotes(Dec. 2005 futures contract for July 15, 2005)(Dec. 2005 futures contract for July 15, 2005)

HedgingHedging

When to hedge: farmer needs to When to hedge: farmer needs to determine what prices he might consider determine what prices he might consider forward pricing, based on enterprise cost forward pricing, based on enterprise cost of productionof production

Placing a hedge: done by placing an order Placing a hedge: done by placing an order through a broker; traders use open out-through a broker; traders use open out-callscalls

Hedging costs: commission, initial margin, Hedging costs: commission, initial margin, maintenance margin, margin callmaintenance margin, margin call

Information andInformation andFutures Price MovementsFutures Price Movements

Information and its interpretation by Information and its interpretation by buyers and sellers is basis of futures buyers and sellers is basis of futures market movementsmarket movements

Fundamental analysis:Fundamental analysis:– Symmetric informationSymmetric information– Asymmetric informationAsymmetric information

Technical analysisTechnical analysis

Commodity BasisCommodity Basis

Difference between a local cash price Difference between a local cash price and the relevant futures contract price and the relevant futures contract price for a specific time periodfor a specific time period

Basis = Cash price Basis = Cash price – Futures price– Futures price

Basis Terminology andBasis Terminology andMovementMovement

Direction and Impact of BasisDirection and Impact of BasisMovement for Short and Long HedgerMovement for Short and Long Hedger

Historical and SeasonalHistorical and SeasonalBasis PatternsBasis Patterns

Basis tends to vary within marketing year Basis tends to vary within marketing year for grains, oilseed crops, and livestockfor grains, oilseed crops, and livestock

Understanding seasonal patterns/historical Understanding seasonal patterns/historical trends helps producers and agribusiness trends helps producers and agribusiness personnel make good forward contracting, personnel make good forward contracting, hedging, and production decisionshedging, and production decisions

Basis trends tend to be consistent over Basis trends tend to be consistent over timetime

5- and 10-year Averages5- and 10-year AveragesSoybean Basis Soybean Basis (Kansas City, KS)(Kansas City, KS)

Feeder Cattle Basis for VariousFeeder Cattle Basis for VariousWeight Categories Weight Categories (Dodge City, KS)(Dodge City, KS)

Using Basis to PredictUsing Basis to Predicta Local Cash Pricea Local Cash Price

An expected price, where E denotes an An expected price, where E denotes an expectation and expectation and tt is the futures contract of is the futures contract of interest, is given by:interest, is given by:

E E [Cash price][Cash price] = = [Futures price][Futures price]t t

+ E+ E [Basis] [Basis]

Hedging: Futures ContractsHedging: Futures Contracts Example: short hedge using live cattle futures Example: short hedge using live cattle futures

with cash price decreasing faster than futures with cash price decreasing faster than futures (basis weakens).(basis weakens).

Hedging: Futures ContractsHedging: Futures Contracts Example: short hedge using live cattle futures Example: short hedge using live cattle futures

with cash price increasing faster than futures with cash price increasing faster than futures (basis strengthens).(basis strengthens).

Hedging: Futures ContractsHedging: Futures Contracts Example: Long hedge using corn futures with Example: Long hedge using corn futures with

cash price increasing faster than futures (basis cash price increasing faster than futures (basis strengthens).strengthens).

Hedging: Futures ContractsHedging: Futures Contracts Example: Long hedge using corn futures with Example: Long hedge using corn futures with

cash price decreasing faster than futures (basis cash price decreasing faster than futures (basis weakens).weakens).

Hedging: Options ContractsHedging: Options Contracts

Short-hedge example using corn options: Short-hedge example using corn options:

Put: Cash and future prices decreasePut: Cash and future prices decrease

Hedging: Options ContractsHedging: Options Contracts

Short-hedge example using corn options: Short-hedge example using corn options: Put: Cash and futures prices increase.Put: Cash and futures prices increase.

Hedging: Options ContractsHedging: Options Contracts

Long-hedge example using corn options: Long-hedge example using corn options:

Call: Cash and futures prices increase.Call: Cash and futures prices increase.

Hedging: Options ContractsHedging: Options Contracts

Long-hedge example using corn options: Long-hedge example using corn options: Call: Cash and futures prices decrease.Call: Cash and futures prices decrease.

Class ExerciseClass Exercise

Find out whether there is a contract for Find out whether there is a contract for your assigned agricultural commodity. your assigned agricultural commodity. Investigate whether contracts are available Investigate whether contracts are available in markets around the globe. Discussin markets around the globe. Discuss– Why contracts do or do not existWhy contracts do or do not exist– Contract specifications and delivery pointsContract specifications and delivery points