Derivatives • “Derivatives”: contracts that convey the right to buy or sell a commodity on a future date • e.g. Futures contracts (“futures”) Option contracts (“options”) • Derivatives may be traded on an exchange (ETD) or “over the counter” (OTC) • ETDs: freely tradeable between market participants
Derivatives • The price/value of a derivative derives from the price/value of the underlying commodity • e.g. The price of a wheat future derives from the price of physical wheat • e.g. The price of a corn option derives from the price of physical corn
Managing Price Risk • “Price risk”: the danger that the price of a commodity (e.g. wheat) will move in an adverse direction • How can price risk be managed? • Do nothing! • Trade futures • Trade options
Managing Price Risk 1: Do Nothing! • Price risk is a fact of life • Oil, interest rates, wheat, etc. • To do nothing is to take a view …in reality, to speculate • “It all averages out in the long run…” But does it?
Milling Wheat Price 2000 - 2011 €280 €200 €120
Managing Price Risk • “Price risk”…the danger that the price of wheat will move in an adverse direction • How can price risk be managed? • Do nothing! • Trade futures • Trade options
Managing Price Risk 2: Trade Futures • Futures contracts (“futures”) traded on exchanges • Agreements to buy/sell a commodity on a future date ...with the price agreed in the present • They are contracts…“paper” trading • Consider NYSE Liffe Milling Wheat Futures
Managing Price Risk 2: Trade Forward • 1 NYSE Liffe Milling Wheat Future represents 50 tonnes of Milling Wheat of EU origin • Price is quoted in € and € cents per tonne • Various delivery months are available for trading: Jan, March, May, (Aug), Nov (8 months) • www.nyx.com /liffe
Managing Price Risk 2: Trade Forward • Consider a grower who will be “long” 500 tonnes of wheat at harvest in November 2012 (equivalent to 10 NYSE Liffe Milling Wheat Futures) • The grower would like wheat prices to rise • The grower is exposed to wheat prices falling • Open ended risk is unacceptable! • Correct futures hedge?
Hedging Example • Assume: • Current date is January 1st, 2012 • November 2012 Milling Wheat Futures price is €200 • Grower wishes to sell (to regular buyer) 500t of wheat with price to be fixed at time of delivery in Oct 2012 • Action: Seller agrees to deliver 500t in Oct 2012 (price to be fixed at time of delivery) and sells (goes short) 10 lots (500t) Nov ‘12 Futures @ €200
Hedging Example • Wheat price falls between Jan 1st and Oct 2012 • In October 2012 (i.e. time of delivery): • Nov ‘12 Milling Wheat Futures are priced @ €175 • Action: Grower fixes physical contract @ €175 per tonne (i.e. prevailing market price) and buys back 10 lots of Nov Milling Wheat Futures @ €175
Hedging Example • Outcome: • Price of physical wheat has fallen by €25 per tonne since January1st • i.e. a loss to the grower of €12,500 but… • Futures hedge profit = €12,500 • i.e. sold 10 Nov Futures on Jan1st @ €200 and bought them back in October @ €175 (10 Futures x 50t x €25 = €12,500)
Hedging Example • N.B. The futures market was not used to secure physical delivery… …it was used to secure price • Physical delivery took place through normal channels • Futures markets can be used for physical delivery, but this is a rare occurrence • The future is used simply to hedge price risk
Managing Price Risk 2: Trade Forward • In our example, the loss on the price of wheat falling is offset by a profit on the futures hedge • Price risk is removed... but so is profit potential • The grower’s price is “locked in”: a problem?
Managing Price Risk 2: Trade Forward • Futures/forwards may be used to remove price risk... ...but profit potential is simultaneously removed • Potential problems? • Opportunity cost (“trading backwards”) • Competitive advantage/disadvantage • Cash flows (margin)
Managing Price Risk • “Price risk”…the danger that the price of wheat will move in an adverse direction • How can price risk be managed? • Do nothing! • Trade forwards (futures)...if “locking in” is no problem • Trade options...if “locking in” is a problem
Managing Price Risk 3: Trade Options • Options convey the right but not the obligation to buy (call) or sell (put) futures at a specific price • e.g. The buyer of an NYSE Liffe Milling Wheat Put has the right but not obligation to sell a NYSE Liffe Milling Wheat future at a given price
Managing Price Risk 3: Trade Options • Buying options allows market participants to buy or sell the related futures if they need to...if they want to • Options protect against adverse price movement yet allow profit from beneficial price movement to be retained • Hence options command a price (“premium”) • Key question: is the option price correct?
Managing Price Risk: Summary • Price risk is a fact of life • We can: • Do nothing: take a market view • Trade futures: lock in the current price • Trade options: be hedged and retain profit potential
Resources • www.nyx.com/liffe : market information & education • Specialist futures & options brokers • A wide range of books & websites