Marin Bozic - University of Minnesota MFM Seminar, Minneapolis, September 28, 2012
Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040
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Transcript of Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040
Marin BozicUniversity of Minnesota – Twin Cities
Guest Lectures for Cornell University - AEM3040
Dairy Risk ManagementHedging with Options
Volatility vs Risk
Will want to buy the commodity at some point in future
Do not like when price goes up.
Upside risk. Downside potential.
Long futures position.
Have (or will have) a commodity to sell
Do not like when price goes down.
Downside risk Upside potential
Short futures position.
Producers Processors
Risk-Reward Diagram: Unhedged Production
Put Option Contract
Put option gives option contract holder a right, but not the obligation to sell the underlying asset at a pre-negotiated price.
Underlying asset in a case of agricultural commodities is just a futures contract.
Pre-negotiated price is called the strike price.
Like with any insurance contract, policyholder must pay up-front for the privilege of having the insurance policy. That fee is called option premium.
Put Option Contract
Strike Premium$13.00 $0.11$13.50 $0.19$14.00 $0.31$14.50 $0.47$15.00 $0.68$15.50 $0.94$16.00 $1.24$16.50 $1.58
On October 13, 2008, February 2009 Class III Milk Futures Price was $15.31.
Risk-Reward Diagram: Put Option
9.0010.00
11.0012.00
13.0014.00
15.0016.00
17.0018.00
19.0020.00
21.0022.00
23.0024.00
-$1.00
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
10/13/2008:Feb 2009 Class III Milk Futures:
$15.31
Feb '09 Class III Milk Price
Profi
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9.0010.00
11.0012.00
13.0014.00
15.0016.00
17.0018.00
19.0020.00
21.0022.00
23.0024.00
-$2.00
-$1.00
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
Feb '09 Class III Milk Price
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Put Premium Paid: $0.68
Put Strike Price: $15.00
Breakeven Point: Strike – Premium = $14.32
Trade-off: Strike vs. Premium
Hedging with Options
Comparing Futures, Options, and Luck
Put Option Contract
Strike price+ Expected Basis ̶ Option Premium_________________Expected Minimum Net Selling Price
Futures + Expected Basis
_______________ Expected Net Selling Price
Using Futures Using Put Options
Put Option Contract
Strike Premium Expected Mailbox Milk Price Floor
$13.00 $0.11 $14.25 $13.50 $0.19 $14.67 $14.00 $0.31 $15.05 $14.50 $0.47 $15.39 $15.00 $0.68 $15.68 $15.50 $0.94 $15.92 $16.00 $1.24 $16.12 $16.50 $1.58 $16.28
On October 13, 2008, February 2009 Class III Milk Futures Price was $15.31. Minnesota Expected Basis: $1.36
2009 Hedging Example (Minnesota)October 13, 2008 February 27, 2009Buy Feb ’09 Class III milk put
with $15.00/cwt strike for $0.68
Announced Class III milk Price @ $9.31/cwt
Expected milk check basis + $1.36 / cwt
Feb Milk Check @ $11.82/cwtRealized basis is +$2.51/cwt
Expected minimum net selling price in February 2009:
Realized net price in February:
$15.00 + $1.36
-$0.68
$15.68
Strike priceexpected basispremium
expected price floor
$11.82+ $5.01
$16.83
cash salenet put profit =Max($15.00-$9.31,0)-$0.68
realized price
2009 Hedging Example (New York)October 13, 2008 February 27, 2009Buy Feb ’09 Class III milk put
with $15.00/cwt strike for $0.68
Announced Class III milk Price @ $9.31/cwt
Feb Milk Check @ $11.72/cwt
Realized net price in February:
$11.72+ $5.01
$16.73
cash salenet put profit =Max($15.00-$9.31,0)-$0.68
realized price
Hedging August 2011 NY Mailbox Milk PriceApril 1, 2011 September 2, 2011Sell Jul’11 Class III milk
contract @ $17.32/cwt July Class III milk contract @
$21.39/cwtExpected Mailbox Milk Price $20.56/ cwt
Expected Basis over Class III Milk: $3.24/cwt
Aug Milk Check @ $21.92/cwtRealized basis is +$0.53/cwt Realized net price in August:
$21.92- $4.07
$17.85
cash salefutures change(sold at $17.32, bought at $21.39)
realized price
2011 Hedging with Puts (NY)April 1, 2011 September 2, 2011Buy Jul’11 Class III milk put
with $17.00 strike for $0.87 July Class III milk contract @
$21.39/cwtAug Milk Check @ $21.92/cwt
Realized net price in August:
$21.92- $0.87
$21.05
cash salePut expired worthless, total cost equal to premium paidrealized price
Call Option Contract
Call option gives option contract holder a right, but not the obligation to buy the underlying asset at a pre-negotiated price.
On Oct 31, 2013, Jan ’14 Class III Milk Futures traded at $17.40. Call premiums were:
Strike Call Premium$17.50 $0.45 $17.75 $0.36 $18.00 $0.29 $18.25 $0.23 $18.50 $0.18 $18.75 $0.14 $19.00 $0.11 $19.25 $0.09
Profit from a long futures position
Profit from a long call position
Protecting the milk purchase price
Reducing Costs of Option Strategies
Puts Calls$13.00 $0.11 $15.50 $0.94$13.50 $0.19 $16.00 $0.55$14.00 $0.31 $16.50 $0.40$14.50 $0.47 $17.00 $0.28$15.00 $0.68 $17.50 $0.20$15.50 $0.94 $18.00 $0.13$16.00 $1.24 $18.50 $0.09$16.50 $1.58 $19.00 $0.06
Date: 10/13/2008Feb ’09 Futures: $15.31
Buy $14.00 put for $0.31Sell $17.00 call for $0.28
Call options: buyers vs sellers
holding options
Pays premium up-front
No margin required.
Can buy a futures contract at the strike price if he so chooses, but he does not have to do it.
selling = writing options
Receives premium up-front
Has to maintain a margin account
Must sell a futures contract at strike price if option holder demands so.
Call option sellerCall option buyer
Short Call Option Position
Reducing Costs of Option Strategies
Reducing Costs of Option Strategies
When Should I Hedge?
Consider this simple risk management program:
• Buy Class III Milk puts consistently, do not try to guess what the price will do next
• Never spend more than 50 cents on a put
Let us evaluate three strategies:1) Always buy puts for milk produced THREE months from now
E.g. in January 2013 hedge April milk, in February hedge May milk, etc.
2) Always buy puts for milk produced SEVEN months from nowE.g. in January 2013 hedge August milk, in February hedge
September milk, etc.3) Always buy puts for milk produced ELEVEN months from now
E.g. in January 2013 hedge November milk, in February hedge December milk, etc.
When Should I Hedge?
Hedging Horizon
What Can You Buy for 50 cents? (Option Strike)
1 month 5 cents below futures 3 months 64 cents below futures5 months 1.08 below futures7 months 1.44 below futures9 months 1.74 below futures
11 months 2.08 below futures
Hedging with Puts: 3-Months Out
Hedging with Puts: 7-Months Out
Hedging with Puts: 11-Months Out
A Simple Hedging Program with Puts
Hedging Horizon
Number of Profitable
TradesNet Profit/Loss
2007-2012Return on
Investment2007-2012
1 month 16/74 -0.14 -41%3 months 21/74 0.06 13%5 months 19/74 0.21 46%7 months 15/74 0.24 52%9 months 09/74 0.26 57%
11 months 10/74 0.33 73%
Why Does this Work?
Why Does this Work?
Why Does this Work?
Lessons Learned?
• Either hedge consistently or not at all.
• Plan for hedging far ahead. When prices decline, they tend to stay low for a while. If you wait for too long, the opportunity to lock in good prices may be gone.
• You are likely to lose money on most of your trades. That’s OK. That does not mean that the market is full of crooks. It means that bad times come around infrequently, but when they do come, you will get back plentifully.