Agro Products: Spread Strategies & Basis Pricing

L o g o 1 Contents I. Agro Products: Spread Strategies II. Agro Products: Basis Pricing

L o g o I. Agro Products: Spread Strategies 2

L o g o Spread trading:  Spread trading means to buy or sell a futures contract (commodity) and sell or buy another related futures contract (commodity) at the same time, and then close positions for both contracts (commodities) simultaneously at sometime in the future.  Spread trading utilizes the unreasonable spread between different markets or different commodities to gain profit at low risk levels.  Spread trading utilizes unreasonable spread and turns it reasonable through the trading. 4

L o g o 4 Types of spread trading:  Calendar spread  Inter-commodity spread  Inter-exchange spread  Arbitrage

L o g o 4 Calendar spread: to buy in or sell out futures contracts of the same commodity or in the same exchange but with different delivery months, and gain profit from the changing spread between the contracts.  Holding cost strategy: the spread between contracts of the same commodity but different delivery months exceeds the holding cost This strategy is affected by delivery system (generation and cancellation of warehouse receipts), capital interest and warehouse cost. Warehouse receipt financing offered by exchanges lowers the market threshold, such as the rape oil contracts to be delivered in September 2014 and January  Bull spread: typically in a bull market, the price markup of near month (dominant) contracts is higher than that of far month contracts, so we long near month contracts and short far month contracts. The timing is determined by analyzing the S&D trends and cost structures of the two contracts. An example is the long near and short far trading of soymeal contracts in recent years.  Bear spread: typically in a bear market, the price drop of near month (dominant) contracts is higher than that of far month contracts, so we short near month contracts and long far month contracts. The timing is still determined by analyzing the S&D trends of the two contracts, with a focus on near month contract. Soymeal contracts to be delivered in May and September 2014 are good examples.

L o g o 4 Inter-commodity spread: to utilize the strong correlation commodities e.g. the complementarity or substitutability between some certain to gain profit through reverse operations between these commodities.  Substitutability-based inter-commodity spread: price correlation occurs when different commodities have substitutability or competition coorelation in terms of functionality or acreage. We can utilize the excessive deviation of the relative price and spread between these commodities. For example, soymeal and rapeseed meal are substitutable to each other, different vegetable oils are substitutable to each other, soybean and corn compete with each other for acreage, etc.  Industry chain spread: correlation exists between commodities in the same industry chain due to the effect of cost and profit. Crush spread between domestic and international markets, a type of spread trading combining inter-commodity and inter-exchange features.

L o g o 4 Inter-exchange spread: to buy in (or sell out) a commodity contract in an exchange and sell out (or buy in) the same contract in another exchange.  Import spread: the spread between domestic and international markets utilizing the changing import profits of soy oil, palm oil, etc.  Others: spread between different wheat varieties traded in three American exchanges, the underlying logic is based on the S&D of these varieties.

L o g o 4 Arbitrage: to gain profit from the unreasonable spread between futures and spot of the same commodity.  Forward arbitrage: when the premium between futures and spot exceeds the holding cost. Examples: palm oil and soy oil traded in domestic exchanges.  Arbitrage incorporating presales:

L o g o 4 Risks related to spread trading  Risk in capital management “The market irrationality may last much longer than your capital adequacy.” - Keynes  Changes in spread range Changes in fundamentals or macroeconomic situation usually triggers changes in spread range. Analyzing the fundamentals is necessary for spread trading based on historical statistics.

L o g o II. Agro Products: Basis Pricing 2

L o g o Hedging: profit locking and basis speculation  Futures price reflects forward price expected by investors;  Delivery system ensures the final convergence of futures price and spot price;  Function of futures hedging – the buyer locks his cost by buying in advance, and the seller locks his price by selling in advance;  Let’s take the seller as an example: can he really sell his contract at the locked price?  Futures price ≈ spot price, but it only realizes when the futures contract is to be or being delivered;  What’s the actual price you’ll get when you can’t hold positions till delivery? Can you still lock your profit?

L o g o Futures price Local spot price Maturity Price Logistics and delivery cost Final convergence of futures and spot with a dynamic process Convergence insured by delivery system Problem: before maturity Futures price ≠ spot price Let’s take the seller as an example: can he really sell his contract at the locked price? Futures price ≈ spot price, but it only realizes when the futures contract is to be or being delivered; What’s the actual price you’ll get when you can’t hold positions till delivery? Can you still lock your profit?

L o g o Profit locking and basis speculation  Concept 1: hedging means profit locking;  Concept 2: hedging is essentially a basis speculation; Seem to be different; how to align these two concepts?  Formally aligned: hedging profit is basically the spread between futures price and spot price, and the basis between futures and spot is the ultimate form, the only question is positive or negative.  Substantially aligned: hedging provides an access mode for basis speculators with the safest margin. When the profit is locked, a basis speculator is able to realize part or all of his locked profit even if he is exposed to relevant risks. On the other hand, if loss is locked, a basis speculator must be careful with the direction of his speculation, otherwise all he will get upon delivery is loss when exposed to relevant risks.  Difference: hedging aimed to lock profit is a basis speculation with certainty; while hedging without locking profit is a basis speculation with uncertainty (also known as trend hedging).

L o g o Why spot traders need basis speculation 15  Premium/ basis Basis = local spot price – futures price Futures: macro supply & demand with higher volatility - Floor pit Basis: micro market with lower volatility - Local market  Basis reflects local supply and demand in spot market. Basis trend analysis: seasonal analysis + characteristics of natural convergence + spot forecast  Factors affecting basis: freight cost, logistic conditions, local spot S&D (market competition, policies, weather, harvest progress, farmer sales, local stock), product quality, warehouse cost and availability, S&D of substitute product, price expectation, etc.