Pricing Alternatives for Agrium Managers

1. Pricing Alternatives for Agrium Managers Agrium Regional Meetings January/ February 2003 Allan Gray and Chris Hurt Purdue University, Indiana Allan Gray and Chris Hurt, Purdue University

2. What is an Option? • Definition: An option is the right, but not the obligation to buy or sell a futures contract at a predetermined price, before expiration. • Options are derivative instruments. The option is written on an underlying asset -- the futures contract. Allan Gray and Chris Hurt, Purdue University

3. Option Terms Puts (sell) and Calls (buy) Strike Price (the price at which the buyer has the option) Premium (the price of option) Buyer (has option right) Seller (gives the right) Expiration Date (buyer has right until expiration day) Futures July Corn = $2.41 ½ Options ---$2.40 July Corn Call= $ .12 6/8 ---$2.40 July Corn Put = $ .14 2/8 Allan Gray and Chris Hurt, Purdue University

4. Puts and Calls • A put option is the right, but not the obligation, to sell an underlying futures contract at a predetermined price prior to expiration. • A call option is the right, but not the obligation, to buy the underlying futures contract at a predetermined price prior to expiration. Allan Gray and Chris Hurt, Purdue University

5. Strike Price and Premium • The predetermined price at which an underlying futures contract may be bought or sold is called the strike price or the exercise price. • The premium is the amount paid for an option. It is the price of the option and is negotiated by open outcry in the trading pit. Allan Gray and Chris Hurt, Purdue University

6. Reading Options Premiums Chicago Board of Trade: January 10, 2003 Allan Gray and Chris Hurt, Purdue University

7. Premiums • Premiums are determined in an open outcry auction. It’s important to realize that all of the options specifications are set by the exchange except for the premium. • The premium is paid up-front by the buyer, and must be paid whether the option is exercised or not. Allan Gray and Chris Hurt, Purdue University

8. Premiums Composition Option Premium= Intrinsic Value + Time Value Intrinsic Value= The immediate positive value if an option were to be exercised Time Value= The portion of the premium to cover the time until maturity For the: July Futures = 241 ½ Option Premium = Intrinsic Value + Time Value $2.40 July Corn Call 14 1/4 = 1 ½ + 12 ¾ in $2.50 July Corn Call 10 ½ = ---------+ 10½ out $2.40 July Corn Put12 ¾ = --------- + 12 ¾ out $2.50 July Corn Put 18 3/4 = 8 ½ + 10 ¼ in Allan Gray and Chris Hurt, Purdue University

9. The Option Strike in Relation to the Underlying Futures Price • In-the-money: An option is said to be in-the-money if it has positive intrinsic value. • Out-of-the-money: An option is said to be out-of-the-money if it has no (or negative) intrinsic value. • At-the-money: An option is at-the-money if its strike price is the same as its underlying futures price. Allan Gray and Chris Hurt, Purdue University

10. Pays premium when purchased plus commission Receives all the rights Does NOT have to margin position Knows the maximum costs at the beginning of the trade but the gain potential is unlimited Receives premium when sold, minus commission Gives all the rights Has to margin position Maximum gain is know at the beginning of the trade, but potential loses are unlimited and unknown Buyers and Sellers Buyer Seller or Writer Allan Gray and Chris Hurt, Purdue University

11. Buyers Alternatives • The buyer of the option may do the following prior to the option expiration: • Exercise the option and receive the underlying futures, • Offset the position (Buy a $2.40 July Corn Put is offset by selling a $2.40 July Corn Put), • or allow the option to Expire worthless. • Remember there is No Obligation with an option purchase! Allan Gray and Chris Hurt, Purdue University

12. Sellers Alternatives • Option Seller (Writer): • Receives the premium from the option buyer, • Must take the opposite position if the option is exercised. As a result, • The option seller must post margin money, • and may face margin calls • Because they take all of the risk of price change. Allan Gray and Chris Hurt, Purdue University

13. Your Turn Allan Gray and Chris Hurt, Purdue University

14. Similarities of Futures and Options Allan Gray and Chris Hurt, Purdue University

15. Obligation to buy or sell Can take a position only at current market price Must deposit margin money No extra premium charge Opportunity, but not obligated to buy or sell Can take a position at multiple price levels Buyers do not deposit margin money Buyers pay a premium, sellers receive the premium Differences of Futures and Options Futures Options Allan Gray and Chris Hurt, Purdue University

16. Why Options over Futures? • Helps overcome Seller’s or Buyer’s Remorse: Which is the emotion attached to a person taking a position and then seeing the market move in the opposite direction • Farmers might says: “As soon as I sell the price moves up,” Or they don’t want to price because they have no further opportunity to gain if prices subsequently rise • Yield Uncertainty: Crop farmers are hesitant to price before they know their yields • Posting and Managing Margin: Buyers of options do not post margin while futures position holders must. Allan Gray and Chris Hurt, Purdue University

17. 6 Pricing Alternatives Example: Say it’s January 10, 2003 and a producer has 50,000 bushels of corn still in the grain bin and wishes to compare 6 different pricing alternatives for mid-June delivery Allan Gray and Chris Hurt, Purdue University

18. The BIG 6 on January 10 • Do no pricing, simply wait and see what prices are in June • Forward price now by selling futures • Establish a minimum price by buying a put option • Consider a second minimum price level by buying another put strike • Establish a maximum price by selling a call option • Establish both a minimum and a maximum by buying a put and selling a call. Allan Gray and Chris Hurt, Purdue University

19. Input Form Allan Gray and Chris Hurt, Purdue University

21. Allan Gray and Chris Hurt, Purdue University

22. Allan Gray and Chris Hurt, Purdue University

23. Allan Gray and Chris Hurt, Purdue University

25. Which Pricing Alternative to Choose: Depends Upon 1. Outlook for Prices 2. Costs of Production 3. Risk Bearing Ability 4. Understanding and Comfort with various Pricing Alternatives Allan Gray and Chris Hurt, Purdue University

26. Agrium Marketing Software • The 6 Price Analysis Program is located at: • http://www.agecon.purdue.edu/staff/gray/agrium/agrium.htm Allan Gray and Chris Hurt, Purdue University

27. Allan Gray and Chris Hurt, Purdue University

28. Allan Gray and Chris Hurt, Purdue University

29. Allan Gray and Chris Hurt, Purdue University