Chapter 10 Understanding and Applying Hedging: Using Futures, Options, and Basis Using Futures, Options, and Basis

Commodity Futures Exchange  A marketplace for persons interested in buying or selling commodities—based on today’s information and the perception of where prices will be in the future.  Grew out of: –The need for certain parties to guard against undesired price movements over time –The desire by certain parties to assume the risk of price movements in return for profit

Purposes of a Futures Exchange  A place of price discovery  A mechanism for people to transfer cash price risk and uncertainty  A place for public access to information for decision making

Locations of Agricultural Commodity Futures Markets  Chicago Board of Trade  Chicago Mercantile Exchange  New York Board of Trade  Kansas City Board of Trade  Minneapolis Grain Exchange  Also Tokyo, China, Brazil

Futures Market Terminology

Futures Contract Terminology  Futures contract: –A regulated market mechanism in which sellers and buyers agree to sell/buy a commodity at an explicit price and date in the future.  Arbitrage: –Process whereby a commodity is simultaneously bought and sold in two different markets to take advantage of a price discrepancy.  Hedging: –Process whereby a person who owns a commodity uses the futures markets to transfer the price risk or to establish a price.

Cattle Futures Price Quotes— Chicago Mercantile Exchange, July 2005

Corn Futures Price Quotes— Chicago Board of Trade, July 2005

Options Contracts  Put option: –Gives an individual the right but not the obligation to sell a futures contract at a specified price during a specific time period  Call option: –Gives an individual the right but not the obligation to buy a futures contract at a specified price during a specific time period  Strike price: –The price at which the futures market can be entered under an option

Strike Prices  Option contracts offer a range of strike prices so purchasers can choose the level at which they may eventually want to take a futures position  Terms describe where the strike price is relative to the underlying futures contract price: –In-the-money –At-the-money –Out-of-the-money

Value of the Option  Intrinsic value: value relative to the underlying futures price  Time value: reflects time between the option premium quote and contract expiration  Option premium: value that a hedger or speculator pays for the right to take a futures position later

Options Price Quotes (Dec futures contract for July 15, 2005)

Hedging  When to hedge: farmer needs to determine what prices he might consider forward pricing, based on enterprise cost of production  Placing a hedge: done by placing an order through a broker; traders use open out-calls  Hedging costs: commission, initial margin, maintenance margin, margin call

Information and Futures Price Movements  Information and its interpretation by buyers and sellers is basis of futures market movements  Fundamental analysis: –Symmetric information –Asymmetric information  Technical analysis

Commodity Basis  Difference between a local cash price and the relevant futures contract price for a specific time period  Basis = Cash price – Futures price

Basis Terminology and Movement

Direction and Impact of Basis Movement for Short and Long Hedger

Historical and Seasonal Basis Patterns  Basis tends to vary within marketing year for grains, oilseed crops, and livestock  Understanding seasonal patterns/historical trends helps producers and agribusiness personnel make good forward contracting, hedging, and production decisions  Basis trends tend to be consistent over time

5- and 10-year Averages Soybean Basis (Kansas City, KS)

Feeder Cattle Basis for Various Weight Categories (Dodge City, KS)

Using Basis to Predict a Local Cash Price  An expected price, where E denotes an expectation and t is the futures contract of interest, is given by: E [Cash price] = [Futures price] t + E [Basis]

Hedging: Futures Contracts  Example: short hedge using live cattle futures with cash price decreasing faster than futures (basis weakens).

Hedging: Futures Contracts  Example: short hedge using live cattle futures with cash price increasing faster than futures (basis strengthens).

Hedging: Futures Contracts  Example: Long hedge using corn futures with cash price increasing faster than futures (basis strengthens).

Hedging: Futures Contracts  Example: Long hedge using corn futures with cash price decreasing faster than futures (basis weakens).

Hedging: Options Contracts  Short-hedge example using corn options: Put: Cash and future prices decrease

Hedging: Options Contracts  Short-hedge example using corn options: Put: Cash and futures prices increase.

Hedging: Options Contracts  Long-hedge example using corn options: Call: Cash and futures prices increase.

Hedging: Options Contracts  Long-hedge example using corn options: Call: Cash and futures prices decrease.

Class Exercise  Find out whether there is a contract for your assigned agricultural commodity. Investigate whether contracts are available in markets around the globe. Discuss –Why contracts do or do not exist –Contract specifications and delivery points