Using Options to Enhance Marketing Charlie Sernatinger Rongfang Ding ED&F Man Capital Markets

What are some of the ways options can add to what you offer your customers? Contracts can be constructed to offer buyers of your product a maximum price that he would pay over a period of time A seller of grain or soy products can set up a contract guaranteeing a minimum price Buyers or sellers can set up contracts that protect for certain ranges of price movements. For customers that do not understand options, it is often easier to construct contracts that contain the cost of using an option into the basis offered.

Maximum Price Guaranty What is it, and when do you use it? A maximum price guarantee is a contract that uses options to hedge a limit on the upside move of price for a consumer. In it’s simplest form, it is a simple call option added on to the value of the basis levels quoted. The end user is quoted a basis for the delivered material, and a price that the landed material will not exceed. The customer is also given the option of being able to price out the contract at a lower price, should the market move lower.

How does it work? Let’s use a seller of soybean meal as example First we determine what basis we want to sell the meal at Then we choose a call option with a strike price that is close to the money After determining the price of the call, you add that value to the basis to give an “enhanced basis” You can quote a regular basis to the customer, then you can offer him a maximum price on his contract if he pays the “enhanced basis”

Let’s look at an example… 1) On November 15th, the price of July soybean meal is $320.20 2) The basis to deliver meal to a hog feeder is +$20.00 over the July futures 3) at this time, the price of the July 320 meal call option is $15.00 4) you offer to sell the hog producer the meal at +20.00 over July futures, with pricing before delivery in June 5) as an alternative, you offer the producer to sell him the meal at a basis of +35.00 over July, and guaranty that he will never pay more than $355.00 per ton for the contract. If the market goes down, he can price at the lower value at any time before delivery in June

What are the mechanics? If the buyer agrees to the “enhanced basis”, you immediately purchase July 320 soybean meal calls of the same tonnage as the contract, paying $15.00 a ton for the options If the market goes down, the buyer can price out at any time before delivery. If he prices at a lower price, you immediately sell out the call option for whatever time value is left in the option, and keep the money If the market goes up, the call option gives you the right to be long futures at $320.00 for the maximum price guaranty

Let’s see some numbers… the market goes down.. In early November, you put on a crush spread, buying soybeans and selling soymeal and soyoil, with the short July meal price $330.00 per ton You sell the hog producer the “enhanced basis” with guaranty at +35.00 over July, which is +20.00 basis and $15.00 for the options premium cost You pay $15.00 and buy the call option The market goes down to $292.00 in July meal, where the hog feeder asks you to price the contract. The hog feeder pays 292.00 plus 35.00 for his meal You sell out the meal call option for $3.50

What if the market goes up? In early November, you put on a crush spread, buying soybeans and selling soymeal and soyoil, with the short July meal price $330.00 per ton You sell the hog producer the “enhanced basis” with guaranty at +35.00 over July, which is +20.00 basis and $15.00 for the options premium cost You pay $15.00 and buy the call option The market goes up to $360.00 in July meal, where the hog feeder asks you to enact his maximum guaranty. The hog feeder pays 320.00 plus 35.00 for his meal You sell out the meal call option for $42.50 and buy in futures at $360.00 to price the contract

What other kinds of transactions can you market? In a similar transaction with a put option, you can give a minimum guaranty contract to a farmer that wants to sell you grain, subtracting the cost of the put from the basis that you pay the farmer. You can construct contracts that will protect a buyer from a rise in price over a certain range of values, instead of an open ended maximum price guaranty. In this case, you would buy a call spread to hedge the contract, which is less expensive than buying a call.

Example of a Minimum Price Guaranty to a Farmer You offer a basis of 20 under the July for corn purchased from the farmer for June, and tell him that he can price out his contract from the present until the third week in June. July futures are trading at 340, and it is November. The July 340 corn put is trading at 25 cents. You also offer to buy his corn at a basis of 45 under the July with a minimum price of $2.95 guaranteed, or he can price the contract at a higher level if the market rallies at any time before the third Friday in June.

How do we construct a contract that would protect a buyer over a range of prices? Some buyers may not be willing to pay a lot in a higher basis for a maximum price guaranty. You can also construct a contract that will protect them over a partial rise in price that would cost less. To do this, you would use a call spread to hedge the upside risk.

Let’s look at an example… 1) On November 15th, the price of July soybean meal is $320.20 2) The basis to deliver meal to a hog feeder is +$20.00 over the July futures 3) at this time, the price of the July 320 meal call option is $15.00, and the price of the July 360 call is $5.00 4) you offer to sell the hog producer the meal at +20.00 over July futures, with pricing before delivery in June 5) as an alternative, you offer the producer to sell him the meal at a basis of +30.00 over July, and guaranty that he will not pay more than $350.00 per ton for the contract, but he is liable for any rise in futures over $360.00. This means his maximum price guaranty runs from $350 to $390, and above that he must pay again. If the market goes down, he can price at the lower value at any time before delivery in June.

OTC and the use of options

What kind of contracts can be offered on OTC? OTC contracts can contain a myriad of elements, from options related contracts, to financed futures, to currency contracts, to average price contracts. We are going to discuss three different kinds of OTC contracts, a futures look-alike, a financed option, and an accumulator. Many other strategies are available, all of them are offered by ED&F Man Capital Markets.

Let’s look at an accumulator Let’s assume you need to purchase a certain amount of futures every day to price out a vessel. The OTC can do this for you, financing the position in the meantime. To price out your vessel, the futures can be transferred to your account via “EFR”, or “Exchange for Risk” at the average price of the accumulated contracts. You can then do an EFP expit versus cash with those futures to price out your vessel.

The Futures Look Alike on Credit This product is for companies that do not want to see daily margin calls if the market goes against them. Example: A soybean buyer puts in orders to purchase futures at specific prices which are put on the OTC handler’s books. The OTC handler agrees to finance the positions for a fee, and agrees to return the positions to the customer when they need to price out the contract. At the end of the contract, if there is a deficit, the soybean buyer pays only the deficit and fees, if there is a credit, the buyer is given the excess money.

How does it work? You give your orders to the OTC desk to buy soybeans at a price. The OTC desk executes it for its own account to hedge the contract it has made with you. On the day you want to price the soybeans, the position is transferred into your futures account as an “EFR”, or “Exchange for Risk” at the same price that you purchased them OTC. You then exchange the futures with your counter-party to price the export contract. You will be charged a fee for having financed the futures position in the meantime.

Let’s look at a financed option Let’s say you have priced a cargo of soybeans, but want to protect against its value going lower, and also do not want to put up a lot of cash for an options premium. You can enter into a “look alike” put option contract with the OTC desk. Instead of buying the put option on the exchange and putting up the cash for the premium, you can buy it from the OTC desk. The OTC desk buys the put for its own account to hedge the contract. The put can be sold out before expiration. At the end of the contract, you pay or receive either the loss or the profit on the puts, plus a fee for having financed the position.

You can also do an accumlator in options… If you sell soybean put options to hedge your soybean cargos, you can sell them over a period of time in the OTC with an accumulator. The OTC desk finances the position and sells the puts over a period of time to hedge the contract. If the market goes through the put strike, and you want the long futures, you can receive them via EFR to price out your vessel. The OTC will either charge you for losses plus interest costs or give you a credit depending upon what the market does.

There are many ways that options can help you to expand your marketing We have given you just a few examples of how you can use options along with your usual selling to create new products for your customers. OTC’s also use options to hedge their books. Options are powerful tools for risk management that open new marketing possibilities. Currency considerations can make OTC’s and their use of options attractive alternatives.

Thank you! ED&F Man Capital Markets