HEDGING OF MARKET RISKS FACTORS TO WATCH AND HOW TO DEVELOP AN EFFECTIVE STRATEGY

Matt Ammermann

Commodity Risk Manager- Vice President Eastern Europe/Black Sea Region

INTL FCStone Financial Inc- FCM Division

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Source:Google

Commodity Risk Management

Source: USDA

560.000

580.000

600.000

620.000

640.000

660.000

680.000

700.000

720.000

740.000

760.000

780.000

800.000

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Combined World Wheat, Coarse Grain, and Oilseed Area Harvested (Source: USDA)

Growth Curve Flattened Out With Stable, But Low Commodity

Prices

Growth is Non-US South America 46%

Africa 23% FSU 22%

US 9% (CRP)

US Renewable Fuel Standard

Program

PRICE IS THE CATALYST!

Growth in US, Canada, & EU

9

10

11

VOLATILITY

Uncertainty

Sleepless nights

• Risk is directly related to the cost of capital as well as expected returns/profits

• As such, increased risk typically reveals itself in increased

profits but also in increased capital costs • Therefore: increased volatility in costs and revenues via

input and output prices, increases risk which can increase financing costs because of perceived or actual increase in firm’s risk

VOLATILITY &

RISK

HEDGING

&

Industry

Intelligence

Industry

Intelligence

Supply

Demand

Weather Treaties

Trade Agreements

Tariffs

Quotas

Monetary Policy

Fiscal Policy

Politics

Interest rates

Currency exchange

War

Terrorist Activities

Bio-Security

New Products

New Technology

Industry Consolidation

Hedge / Index Funds

Technical Analysis

Basis Analysis

Market Perceptions

Local Issues

Transportation

Legislation

Issues that affect the price of a commodity…

Back

Cross Commodity

Relationships

• What is Hedging? – The use of exchange futures or option contracts to reduce price risk, the use of opposite

exposures to reduce balance sheet risk

• Long Physical- Short Hedge

• Short Physical- Long Hedge

– Hedgers have an interest in the underlying commodity

– A cross-hedger uses futures or option contracts to manage the price risk of a commodity that is similar to the underlying commodity (ex. CME Soyoil to Hedge FOB Black Sea Sunoil Prices)

• What makes a “Good Hedge” – Protects from or offsets losses from adverse price movements in the physical good or cash

market exposure, Basis levels

– Has a high degree of correlation to the physical good being hedged. (75% or Higher)

– Can be initiated and liquidated with relative ease and without affecting the market value of the position (liquidity)

– Effective, transparent, and liquid forward market exists (1-2 years)

– Option market exists and is liquid (not necessary but an advantage)

Exchanges & Markets for Hedging

CME

• Chicago, USA

• Est. 1848

• #2 Yellow Soybeans, Meal, Oil, Corn, Wheat

• Options Available

• Physical Delivery Settlement

LIFFE MATIF

• Paris, France

• Est. 1986

• Rapeseed, Corn,Wheat

• Options available (illiquid)

• Physical Delivery Settlement

OTC*

• Global Network

• Began in mid 1970s

• Thousands of Commodity contracts and options

• Typically financial settlement

* Over-the-Counter (“OTC”) Products or “Swaps” are only available to individuals or firms who qualify under CFTC rules as an Eligible Contract Participant (“ECP”) and who have been accepted as customers of IFM.

Why Cross Hedging?

• Tradable market may not exist for the physical commodity that is being hedged

• Though a futures/options market may exist for the physical commodity, it may be very illiquid

• Futures/options for physical commodity may not trade for future time periods

• Very large producers or users of the commodity require high volume markets. (a hedger does not want to represent a high percentage of the market open interest)

• Options may not exist on the physical commodity but may exist on a commodity that can be used as a cross hedge

Cross Hedging – Black Sea

Black Sea Commodity Exchange Traded Commodity

Sunflower oil CME Soybean Oil

Sunseeds CME Soybeans

Corn CME / LIFFE

Wheat CME / MGEX / LIFFE

Components of a Crop’s Price and Risk

Basis Component Reflects local supply/demand factors, transportation and quality differentials, etc.

80%

20%

Futures Component Reflects Macro environment factors such as supply/demand and economic conditions

*Assuming 0.80 R^2 between futures and crop price

$160

$40

$200/MT Total

BASIS (difference) = CASH PRICE – FUTURES PRICE

$$$=FUTURES +/- BASIS

FUTURES MARKET (Think 80%)

Hedger

Speculator

Flat Price Risk (Standardized)

Futures Price Risk (standardized)

Basis Risk (think 20%)

Hedging is the exchange of flat price risk for basis risk…

Basis is all about TODAY, it consists of Location, Time, Form, and Regional Supply/Demand differences

IRMP Process

Risk Management Policy/Plan

Goals & Objectives

- Risk Tolerance

- Knowledge

- Financial Situation

- Physical Assets

Data Analysis /Modeling

Industry Intelligence

- Supply, Demand, Weather, Politics

- Customer receives Daily, weekly, monthly, and special reports

- Webinars

Execution & Hedging

• Futures • Options • OTC’s • Cash • Wait

Year End Analysis

Month End Report

Training

Specific Black Sea Commodity Risk Management

• Selling/Buying on Premium vs CME Wheat or Matif Wheat – Full risk remains on exchange traded market- Ex. Selling Russian Wheat -

8euro/mt.

• Maximum Price Contract – Physical buyer buys on spot, but still has opportunities to participate in a further

market decline

• Various Option strategies to manage correlation risk

CME Corn

Long Futures

Example does not include commissions and fees

Short Cash – Basic Futures / Swap Hedge

P/L

0 Settlement

Price

Hedge

Short Cash

Long Futures

Buy Call

Example does not include commissions and fees

Buy Call

Buy Collar (buy call/sell put)

Example does not include commissions and fees

Buy Collar (buy put/sell call)

3 way (buy call/sell call/sell put)

Example does not include commissions and fees

3 way (buy put/sell put/sell call)

Market Outcome:

Strategic Approach

• Ideal situation is the physical market always goes in your favor, so a forward contract or selling/buying on spot remains ideal, but if outlook is wrong, there may be a high level of unacceptable risk

– Favorable Physical Price Move- Options • Option Cost

– Unfavorable Physical Price Move- Futures • Best Protection on physical product

– Uncertain Physical Price Move- Collar • This strategy can be constructed such that it is somewhat neutral to the price

MATIF Weekly

THANK YOU

Спасибо! Дякую!

Teşekkürler

42

Matt Ammermann INTL FCStone Financial Inc. FCM Division

+1.952.852.2905 Office

+1.612.759.8360 Mobile

Yahoo I.M: m_ammermann

Skype: matt.ammermann

Matt.ammermann@intlfcstone.com