Managing Commodity Price Risk with Futures & Options

Derivatives Derivatives: contracts that convey the right to buy or sell a commodity on a future date e.g. Futures contracts (futures) Option contracts (options) Derivatives may be traded on an exchange (ETD) or over the counter (OTC) ETDs: freely tradeable between market participants

Derivatives The price/value of a derivative derives from the price/value of the underlying commodity e.g. The price of a wheat future derives from the price of physical wheat e.g. The price of a corn option derives from the price of physical corn

Managing Price Risk Price risk: the danger that the price of a commodity (e.g. wheat) will move in an adverse direction How can price risk be managed? 1.Do nothing! 2.Trade futures 3.Trade options

Managing Price Risk 1: Do Nothing! Price risk is a fact of life Oil, interest rates, wheat, etc. To do nothing is to take a view …in reality, to speculate It all averages out in the long run… But does it?

Milling Wheat Price

Managing Price Risk Price risk…the danger that the price of wheat will move in an adverse direction How can price risk be managed? 1.Do nothing! 2.Trade futures 3.Trade options

Managing Price Risk 2: Trade Futures Futures contracts (futures) traded on exchanges Agreements to buy/sell a commodity on a future date...with the price agreed in the present They are contracts…paper trading Consider NYSE Liffe Milling Wheat Futures

Managing Price Risk 2: Trade Forward 1 NYSE Liffe Milling Wheat Future represents 50 tonnes of Milling Wheat of EU origin Price is quoted in and cents per tonne Various delivery months are available for trading: Jan, March, May, (Aug), Nov (8 months) /liffe

Managing Price Risk 2: Trade Forward Consider a grower who will be long 500 tonnes of wheat at harvest in November 2012 (equivalent to 10 NYSE Liffe Milling Wheat Futures) The grower would like wheat prices to rise The grower is exposed to wheat prices falling Open ended risk is unacceptable! Correct futures hedge?

11 Hedging Example Assume: Current date is January 1 st, 2012 November 2012 Milling Wheat Futures price is 200 Grower wishes to sell (to regular buyer) 500t of wheat with price to be fixed at time of delivery in Oct 2012 Action: Seller agrees to deliver 500t in Oct 2012 (price to be fixed at time of delivery) and sells (goes short) 10 lots (500t) Nov

12 Hedging Example Wheat price falls between Jan 1 st and Oct 2012 In October 2012 (i.e. time of delivery): Nov 12 Milling Wheat Futures are 175 Action: Grower fixes physical 175 per tonne (i.e. prevailing market price) and buys back 10 lots of Nov Milling Wheat 175

13 Hedging Example Outcome: Price of physical wheat has fallen by 25 per tonne since January1 st i.e. a loss to the grower of 12,500 but… Futures hedge profit = 12,500 i.e. sold 10 Nov Futures on Jan1 200 and bought them back in 175 (10 Futures x 50t x 25 = 12,500)

14 Hedging Example N.B. The futures market was not used to secure physical delivery… …it was used to secure price Physical delivery took place through normal channels Futures markets can be used for physical delivery, but this is a rare occurrence The future is used simply to hedge price risk

Managing Price Risk 2: Trade Forward In our example, the loss on the price of wheat falling is offset by a profit on the futures hedge Price risk is removed... but so is profit potential The growers price is locked in: a problem?

Managing Price Risk 2: Trade Forward Futures/forwards may be used to remove price risk......but profit potential is simultaneously removed Potential problems? Opportunity cost (trading backwards) Competitive advantage/disadvantage Cash flows (margin)

Managing Price Risk Price risk…the danger that the price of wheat will move in an adverse direction How can price risk be managed? 1.Do nothing! 2.Trade forwards (futures)...if locking in is no problem 3.Trade options...if locking in is a problem

Managing Price Risk 3: Trade Options Options convey the right but not the obligation to buy (call) or sell (put) futures at a specific price e.g. The buyer of an NYSE Liffe Milling Wheat Put has the right but not obligation to sell a NYSE Liffe Milling Wheat future at a given price

Managing Price Risk 3: Trade Options Buying options allows market participants to buy or sell the related futures if they need to...if they want to Options protect against adverse price movement yet allow profit from beneficial price movement to be retained Hence options command a price (premium) Key question: is the option price correct?

Managing Price Risk: Summary Price risk is a fact of life We can: 1.Do nothing: take a market view 2.Trade futures: lock in the current price 3.Trade options: be hedged and retain profit potential

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