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Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040 Dairy Risk Management Hedging with Options.

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Presentation on theme: "Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040 Dairy Risk Management Hedging with Options."— Presentation transcript:

1 Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040 Dairy Risk Management Hedging with Options

2 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. ProducersProcessors

3 Risk-Reward Diagram: Unhedged Production

4 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.

5 Put Option Contract StrikePremium $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.

6 Risk-Reward Diagram: Put Option

7 Put Premium Paid: $0.68 Put Strike Price: $15.00 Breakeven Point: Strike – Premium = $14.32

8 Trade-off: Strike vs. Premium

9 Hedging with Options

10 Comparing Futures, Options, and Luck

11 Put Option Contract Strike price + Expected Basis ̶ Option Premium _________________ Expected Minimum Net Selling Price Futures + Expected Basis _______________ Expected Net Selling Price Using FuturesUsing Put Options

12 Put Option Contract StrikePremiumExpected 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

13 2009 Hedging Example (Minnesota) October 13, 2008February 27, 2009  Buy 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/cwt  Realized 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 price expected basis premium expected price floor $11.82 + $5.01 $16.83 cash sale net put profit = Max($15.00- $9.31,0)-$0.68 realized price

14 2009 Hedging Example (New York) October 13, 2008February 27, 2009  Buy 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 sale net put profit = Max($15.00- $9.31,0)-$0.68 realized price

15 Hedging August 2011 NY Mailbox Milk Price April 1, 2011September 2, 2011  Sell Jul’11 Class III milk contract @ $ 17.32/cwt  July Class III milk contract @ $ 21.39/cwt  Expected Mailbox Milk Price $20.56/ cwt  Expected Basis over Class III Milk: $3.24/cwt  Aug Milk Check @ $ 21.92/cwt  Realized basis is + $ 0.53/cwt  Realized net price in August: $ 21.92 - $ 4.07 $ 17.85 cash sale futures change (sold at $ 17.32, bought at $ 21.39) realized price

16 2011 Hedging with Puts (NY) April 1, 2011September 2, 2011  Buy Jul’11 Class III milk put with $17.00 strike for $0.87  July Class III milk contract @ $ 21.39/cwt  Aug Milk Check @ $ 21.92/cwt  Realized net price in August: $ 21.92 - $ 0.87 $ 21.05 cash sale Put expired worthless, total cost equal to premium paid realized price

17 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: StrikeCall 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

18 Profit from a long futures position

19 Profit from a long call position

20 Protecting the milk purchase price

21 Reducing Costs of Option Strategies PutsCalls $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: 10/13/2008 Feb ’09 Futures: $15.31 Buy $14.00 put for $0.31 Sell $17.00 call for $0.28

22 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

23 Short Call Option Position

24 Reducing Costs of Option Strategies

25

26 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 now E.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.

27 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 futures 5 months 1.08 below futures 7 months 1.44 below futures 9 months 1.74 below futures 11 months 2.08 below futures

28 Hedging with Puts: 3-Months Out

29 Hedging with Puts: 7-Months Out

30 Hedging with Puts: 11-Months Out

31 A Simple Hedging Program with Puts Hedging Horizon Number of Profitable Trades Net Profit/Loss 2007-2012 Return on Investment 2007-2012 1 month 16/74-0.14-41% 3 months 21/740.0613% 5 months 19/740.2146% 7 months 15/740.2452% 9 months 09/740.2657% 11 months 10/740.3373%

32 Why Does this Work?

33

34

35 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.


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