Chapter 10

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

2. 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

3. Purposes of aFutures 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

4. 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

5. Futures Market Terminology

6. 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.

7. Cattle Futures Price Quotes— Chicago Mercantile Exchange, July 2005

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

9. 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

10. 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

11. 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

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

13. 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

14. Information andFutures Price Movements • Information and its interpretation by buyers and sellers is basis of futures market movements • Fundamental analysis: • Symmetric information • Asymmetric information • Technical analysis

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

16. Basis Terminology andMovement

17. Direction and Impact of BasisMovement for Short and Long Hedger

18. Historical and SeasonalBasis 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

19. 5- and 10-year AveragesSoybean Basis (Kansas City, KS)

20. Feeder Cattle Basis for VariousWeight Categories (Dodge City, KS)

21. Using Basis to Predicta 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]

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

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

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

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

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

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

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

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

30. 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