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Price Risk Management and the Futures Market

Price Risk Management and the Futures Market. Hedging. Market Risk. Economic vs. Product Risk product deterioration in value ; product destruction Risk is a Marketing Function (Facilitative function) Risk as Cost; Risk Taking for Profit Farmers Have Unavoidable Price Risk

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Price Risk Management and the Futures Market

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  1. Price Risk Management andthe Futures Market Hedging

  2. Market Risk • Economic vs. Product Risk • product deterioration in value ; product destruction • Risk is a Marketing Function (Facilitative function) • Risk as Cost; Risk Taking for Profit • Farmers Have Unavoidable Price Risk • Risk Transfer May Be Desirable, Profitable

  3. Examples of Your Risk Management • Plant Now, Price Now by Contract • College Tuition (Pay in July for Year) • College Study (Protect Against Low Pay Job) • Magazine Subscription: Pay for copies in advance • Home rental contract ; Insurance

  4. Grain Farmers’ Market Risk • Plant in Spring Without Knowing Fall Harvest Price • Sell in Spring Without Knowing Fall Yield • Sell in Fall Without Knowing Spring Price • Store in Fall Without Knowing Spring Price

  5. Farmer Tools For ManagingPrice Risk • Cash Sale (at Harvest or From Storage) • Forward Pricing: • Forward Contracts: Cash and Basis contracts • Hedging using Futures • Options • Minimum Price Contract

  6. Futures Markets • Futures Exchanges : CBOT, CME, KCBT etc., • Futures price is today’s price for products to be delivered in the future. • Contract specifications • Order execution process (open outcry) • Margin requirements

  7. Speculators: Risk Takers Profit From Correctly Anticipating Price Changes Could Not Deliver or Take Delivery of Futures Commodities Hedgers: Have Inherent Price Risk Wish to Reduce or Manage Risk Could Deliver Against Futures Contract Futures Market Participants

  8. Using the Futures or Options Markets To Manage Price Risks A Temporary Substitution of A Futures Market Transaction for a Planned Cash Market Transaction Taking Equal and Opposite Positions on the Cash and Futures Markets Hedge: Definitions

  9. Hedging Decisions • What is my attitude toward price risk? • What do I expect price to do? • What are my costs? • When should I set the hedge? When to lift it? • What are my alternatives to hedging?

  10. Hedging Guidelines • Decide on a definite hedging objective - reasons, month • Discuss hedging plan with those involved; e.g. bankers • Know how to calculate your productions costs - FC, VC, BEP • Follow basis patterns • Hedge reasonable amounts of commodity • Keep adequate records

  11. Production and Marketing Periods Spring Planting Spring/ Summer Fall Harvest Pre-Harvest Period Storage Period Risk: Store without knowing Spring Price Risk: Plant without knowing Fall Price

  12. The Perfect Hedge(Falling Price Period) Cash Price Futures Price Basis $.50 Nov. 1 Sell @ $2.50 Buy @ $2.00 Buy @ $2.40 $.50 Dec. 1 Sell @ $1.90 10 cent gain Cash sale = $1.90 + Futures Gain = .10 Return to Hedge = $2.00

  13. Perfect Hedge Returns For a Perfect Hedge (Basis = Constant), The Return To The Hedge (Cash Price + Futures) Will Always Be the Same.

  14. The Perfect Hedge(Rising Price Period) Cash Price Futures Price Basis $.50 Nov. 1 Sell @ $2.50 Buy @ $2.00 Buy @ $2.60 $.50 Dec. 1 Sell @ $2.10 10 cent loss Cash sale = $2.10 - Futures Loss = .10 Return to Hedge = $2.00

  15. The Slightly Imperfect Hedge Cash Price Futures Price Basis $.50 Nov. 1 Sell @ $2.50 Buy @ $2.00 Buy @ $2.45 $.55 Dec. 1 Sell @ $1.90 Cash sale = $1.90 $1.95 is better than $1.90… But not $2.00 + Futures Gain = .05 Return to Hedge = $1.95

  16. Characteristics of a SuccessfulHedge • Equal and Opposite Positions on Cash and Futures Markets • Cash and Futures Markets Move In Same Direction • Predictable Basis Pattern • Nullify Futures Position, Sell on Cash Market • Loss on One Market = Gain on Other Market • Transfer of Risk from Hedgers to Speculators • No Tears, No Regrets

  17. Types of Hedges • Short Hedge (Protects Against Falling Prices) • Long Cash, Short Futures • Sell Cash, Buy Back Futures • Long Hedge (Protects Against Rising Prices) • Short Cash, Long Futures • Buy Cash, Sell Futures • Texas “Hedge” (Not a True Hedge) • Same Position on Cash and Futures Markets • Doubles the Risk

  18. Three Farmer Hedges • Perfect Hedge • Useful for Learning; Rare in Practice • Storage Hedge • Set During Storage; Oct. to May • Protects Against Falling Prices • Helps Earn Storage Returns • Pre-Harvest Hedge • Set in Spring • Protects Fall Harvest Price

  19. Storage Hedges • Harvest-to-Sale Period (Storage Season) • Risk of Price Decline, Inventory Loss • Will Price Rise Cover Storage Costs? • Carrying Charges: • Storage Costs • Handling Charges • Insurance and Interest Costs • Key to Success: Narrowing Basis Pattern

  20. The Storage Hedge Futures Price Cash Price Basis Nov. 1 $.50 Buy/Store @ $2.00 Sell @ $2.50 June 1 Sell @ $2.30 Buy @ $2.40 $.10 Cash sale = $2.30 - $.40 + Futures Gain = .10 =Return to Hedge = $2.40 - Original Cost = $2.00 = Storage Return = $.40

  21. Storage Hedge Rule The Storage Hedger’s Carrying Charge (Return to Storage) Will Always Equal The Change in Basis Over the Storage Period The Storage Hedge Transfers the Basis Change From the Speculators to Hedgers

  22. Hedging Principle The Basis Determines the Success of A Hedge

  23. Corn Storage Hedge Date Cash Market Futures Market October Harvest Price = $3.00 Sell July Fut. = $3.50 Est. June Basis = $.10 Storage Cost = $.30 Forward Price = $3.50-.10= $3.40 Storage Profit= $3.40 -3.00 - .30= $.10 June Cash Sale @ $3.30 Buy Back Fut. @ $3.40 Return to Hedge: $3.30 + $.10 = $ 3.40

  24. Pre-Harvest Hedge • Set During Planting or Growing Period • Protects Against Harvest Price Risk • Will Harvest Price Cover Production Costs? • Locks-In Fall Harvest Target Price • Key to Success: Requires Accurate Harvest Basis Prediction

  25. The PreHarvest Hedge Futures Price Cash Price Basis Plant at Target Price: $3.00-.40=$2.60 May 1 Planting Sell @ $3.00 Nov. 1 Harvest Buy @ $2.80 Expected $.40 Sell @ $2.40 Cash Sale = $2.40 + Futures Gain = .20 Return to Hedge = $2.60 = Spring Target

  26. Corn Pre-Harvest Hedge Date Cash Market Futures Market May Sell Dec Fut. = $2.80 Cost of Production = $2.10 Expected basis = $.30 Forward Price = $2.80-.30 basis= $2.50 Expected Profit= $2.50 -2.10 = $.40 Oct. Cash Sale @ $2.40 Buy Back Fut. @ $2.70 Net Return to Hedge: $2.40 + $.10- $2.10 = $ .40

  27. Calculating the ReturnTo a Hedge Today: Current Futures Price……...$4.00 Less: Expected Basis at Sale Time ….. .50 Equals: Lock-In Forward Price……..$3.50 Future Sale: Cash Price…………………..$3.00 Plus/Minus Futures Transaction……… $.50 Equals: Total Return to Hedge…..…. $3.50 Less: Costs (Prodn. Or Storage)….…$3.20 Equals: Net Return To Hedge……….…..$.30

  28. Combination Pre-Harvestand Storage Hedge Cash Dec. 98 June 99 Market Futures Futures May 1998 Target $3.00 Sell@$3.40 $3.40-.20 Est. Spr. = $3.20 basis=$.20 May 1999 $2.30 xxxx Buy@$2.50 Return to Hedge: $2.30 + .90 =$3.20

  29. Why Don’t More Farmers Hedge? • Lack of Understanding of Hedging • Mistrust of Futures Market • Prefer Ease of Forward Contracts • Like Risk; Prefer to Speculate on Cash Market • Dislike Margin Calls • Other????

  30. Summary: Risk ManagementTools • Hedging • Options • Forward Cash Contracts • Basis Contracts • Minimum Price Contracts

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