Econ 339X, Spring 2011 ECON 339X: Agricultural Marketing Chad Hart Assistant Professor John Lawrence Professor

Econ 339X, Spring 2011 The Cash and Futures Markets Are Related Basis = Cash price – Futures price Rearranging terms: Cash price = Futures price + Basis So national (and international) events can affect local prices

Econ 339X, Spring 2011 Futures Contracts  A legally binding contract to make or take delivery of the commodity  Trading the promise to do something in the future  You can “offset” your promise  Standardized contract  Form (weight, grade, specifications)  Time (delivery date)  Place (delivery location)

Econ 339X, Spring 2011 Market Participants  Hedgers are willing to make or take physical delivery because they are producers or users of the commodity  Use futures to protect against a price movement  Cash and futures prices are highly correlated  Hold counterbalancing positions in the two markets to manage the risk of price movement

Econ 339X, Spring 2011 Market Participants  Speculators have no use for the physical commodity  They buy or sell in an attempt to profit from price movements  Add liquidity to the market  May be part of the general public, professional traders or investment managers  Short-term – “day traders”  Long-term – buy or sell and hold

Econ 339X, Spring 2011 Market Participants  Brokers exercise trade for traders and are paid a flat fee called a commission  Futures are a “zero sum game”  Losers pay winners  Brokers always get paid commission

Econ 339X, Spring 2011 Hedging  Holding equal and opposite positions in the cash and futures markets  The substitution of a futures contract for a later cash-market transaction  Who can hedge?  Farmers, merchandisers, elevators, processors, exporter/importers

Econ 339X, Spring 2011 Short Hedgers  Producers with a commodity to sell at some point in the future  Are hurt by a price decline  Sell the futures contract initially  Buy the futures contract (offset) when they sell the physical commodity

Econ 339X, Spring 2011 Short Hedge Expected Price  In my example: ($ per bushel) Nov soybean futures12.73 Historical basis for Nov Commission on trade Expected local hedged price12.47  Expected price = Futures prices when I place the hedge + Expected basis at delivery – Broker commission

Econ 339X, Spring 2011 Long Hedgers  Processors or feeders that plan to buy a commodity in the future  Are hurt by a price increase  Buy the futures initially  Sell the futures contract (offset) when they buy the physical commodity

Econ 339X, Spring 2011 Long Hedge Example  In my example: ($ per bushel) Dec corn futures 5.48 Historical basis for Dec Commission on trade+0.01 Expected local net price 5.24  Expected price = Futures prices when I place the hedge + Expected basis at delivery + Broker commission

Econ 339X, Spring 2011 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 2011 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 2011 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 2011 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 2011 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 2011 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 futures 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 2011 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 2011 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 2011 Class web site: Spring2011/ Have a great weekend!