Econ 339X, Spring 2010 ECON 339X: Agricultural Marketing Chad Hart Assistant Professor/Grain Markets Specialist

Econ 339X, Spring 2010 Today’s Topic Risk Management Tools Price Risk Futures, Options

Econ 339X, Spring 2010 Iowa Corn Yields Source: USDA, NASS

Econ 339X, Spring 2010 Iowa Corn Prices Source: USDA, NASS

Econ 339X, Spring 2010 Iowa Corn Revenues Source: USDA, NASS

Econ 339X, Spring 2010 Corn Futures Prices Source: CME Group Corn users are worried about this Corn suppliers are worried about this

Econ 339X, Spring 2010 Crop Price Variability Price distributions for corn based on March prices for the following July futures

Econ 339X, Spring 2010 Futures and Options  Market tools to help manage (share) price risks  Mechanisms to establish commodity trades among participants at a future time  Available from commodity exchanges / futures markets

Econ 339X, Spring 2010 Futures Markets  Chicago: Corn, soybeans, wheat (soft red), oats, rice  Along with the livestock complex  Kansas City: Wheat (hard red winter)  Minneapolis: Wheat (hard red spring)  Tokyo: Corn, soybeans, coffee, sugar  Has a market for Non-GMO soybeans  Other markets in Argentina, Brazil, China, and Europe A market where contracts for physical commodities are traded, the contracts set the terms of quantity, quality, and delivery

Econ 339X, Spring 2010 Agricultural Futures Markets  Has some unique features due to the nature of the grain business  Supply comes online once (or twice) a year  So at harvest, supply spikes, then diminishes until the next harvest  Production decisions are based price forecasts  Planting decisions can be made a full year (or more) before the crop price is realized  Users provide year-round demand  Livestock feeding, biofuel production, food demand

Econ 339X, Spring 2010 Futures Market Exchanges  Competitive markets  Open out-cry and electronic trading  Centralized pricing  Buyers and sellers are both in the market  Relevant information is conveyed through the bids and offers for the trades  Bid = the price at which a trader would buy the commodity  Offer = the price at which a trader would sell the commodity

Econ 339X, Spring 2010 The View from the Corn Pit Source: M. Spencer Green, AP Photo

Econ 339X, Spring 2010 Options  What are options?  An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period.  Options on futures are the right to buy or sell a specific futures contract.  Option buyers pay a price (premium) for the rights contained in the option.

Econ 339X, Spring 2010 Option Types  Two types of options: Puts and Calls  A put option contains the right to sell a futures contract.  A call option contains the right to buy a futures contract.  Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets.

Econ 339X, Spring 2010 Put Option  The Buyer pays the premium and has the right, but not the obligation, to sell a futures contract at the strike price.  The Seller receives the premium and is obligated to buy a futures contract at the strike price if the Buyer uses their right.

Econ 339X, Spring 2010 Call Option  The Buyer pays a premium and has the right, but not the obligation, to buy a futures contract at the strike price.  The Seller receives the premium but is obligated to sell a futures contract at the strike price if the Buyer uses their right.

Econ 339X, Spring 2010 Options as Price Insurance  The person wanting price protection (the buyer) pays the option premium.  If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages.  The seller keeps the premium, but must pay for damages.

Econ 339X, Spring 2010 Options as Price Insurance  The option buyer has unlimited upside and limited downside risk.  If prices moves in their favor, the option buyer can take full advantage.  If prices moves against them, the option seller compensates them.  The option seller has limited upside and unlimited downside risk.  The seller gets the option premium.

Econ 339X, Spring 2010 Option Issues and Choices  The option may or may not have value at the end  The right to buy at $4.00 has no value if the market is below $4.00.  The buyer can choose to offset, exercise, or let the option expire.  The seller can only offset the option or wait for the buyer to choose.

Econ 339X, Spring 2010 Strike Prices  The predetermined prices for the trade of the futures in the options  They set the level of price insurance  Range of strike prices determined by the futures exchange

Econ 339X, Spring 2010 Options Premiums  Determined by trading in the marketplace  Different premiums  For puts and calls  For each contract month  For each strike price  Depends on five variables  Strike price  Price of underlying futures contract  Volatility of underlying futures  Time to maturity  Interest rate

Econ 339X, Spring 2010 Option References  In-the-money  If the option expired today, it would have value  Put: futures price below strike price  Call: futures price above strike price  At-the-money  Options with strike prices nearest the future price  Out-of-the-money  If the option expired today, it would have no value  Put: futures price above strike price  Call: futures price below strike price

Econ 339X, Spring 2010 Options Premiums Dec Corn Futures $3.85 per bushel Source: CME Group, 3/26/10 In-the-money Out-of-the-money

Econ 339X, Spring 2010 Options Premiums Dec Corn Futures $3.85 per bushel In-the-money Out-of-the-money Source: CME Group, 3/26/10

Econ 339X, Spring 2010 Setting a Floor Price  Short hedger  Buy put option  Floor Price = Strike Price + Basis – Premium – Commission  At maturity  If futures < strike, then Net Price = Floor Price  If futures > strike, then Net Price = Cash – Premium – Commission

Econ 339X, Spring 2010 Put Option Graph Put Option Dec $3.90 Premium = $0.43

Econ 339X, Spring 2010 Out-of-the-Money Put Put Option Dec $3.00 Premium = $0.07

Econ 339X, Spring 2010 In-the-Money Put Put Option Dec $5.00 Premium = $1.26

Econ 339X, Spring 2010 Setting a Ceiling Price  Long hedger  Buy call option  Ceiling Price = Strike Price + Basis + Premium + Commission  At maturity  If futures < strike, then Net Price = Cash + Premium + Commission  If futures > strike, then Net Price = Ceiling Price

Econ 339X, Spring 2010 Call Option Graph Call Option Dec $3.90 Premium = $0.38

Econ 339X, Spring 2010 Combination Strategies  Option fence  Buy put and sell call  Higher floor, but you now have a ceiling  Put spread  Buy At-the-money put and sell Out-of-the- money put  Higher middle and higher prices, but no floor below Out-of-the-money strike price

Econ 339X, Spring 2010 Fence Buy Put Option Dec $3.40 Premium = $0.18 Sell Call Option Dec $4.40 Premium = $0.23

Econ 339X, Spring 2010 Summary on Options  Buyer  Pays premium, has limited risk and unlimited potential  Seller  Receives premium, has limited potential and unlimited risk  Buying puts  Establish minimum prices  Buying calls  Establish maximum prices

Econ 339X, Spring 2010 Class web site: lawrence/ lawrence/