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Overview

Overview. Price risk Futures markets and hedging Options on futures Definitions Strategies Livestock price and margin insurance. Why worry about price risk?. Steer feeding profit variation explained (%) Placement wt <600 700-800 Fed price 58.07 50.46 Feeder price 2.30 19.31

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Overview

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  1. Overview • Price risk • Futures markets and hedging • Options on futures • Definitions • Strategies • Livestock price and margin insurance

  2. Why worry about price risk? Steer feeding profit variation explained (%) Placement wt <600 700-800 Fed price 58.07 50.46 Feeder price 2.30 19.31 Corn price 5.29 4.19 Feed/gain 7.22 3.55 ADG 1.36 6.31 Interest rate 1.55 -.38 Total explained 75.79 83.44

  3. Average Hog Price Forecast Error,1995-2004

  4. Standard Deviation of Hog Price Forecast Error, 1995-2004 Actual price expected at the forecast price +/- the standard deviation 68% of the time.

  5. Fed Cattle Price Forecast Error, 1995-2004: Seasonal Index and Basis Adjusted Futures http://www.econ.iastate.edu/faculty/lawrence/

  6. 68% of time 16% 16% S D S D

  7. Futures markets • Organized and centralized market • Today’s price for products to be delivered in the future. • A mechanism of trading promises of future commodity deliveries among traders.

  8. Futures markets • Biological nature of ag production • Excess supply at harvest • Shortage in spring and summer • Producers need price forecast because prices not known when production decision is made • Processors need year around supply • Modern futures market began long ago • 1848 Chicago Board of Trade • 1919 Chicago Mercantile Exchange

  9. Futures Market Exchanges • Trading pits and e-trading • Centralized pricing • Buyers and sellers represented by brokers in the pits • All information represented through bids and offers • Perfectly competitive market • Open out-cry trading • Beginning electronic trading

  10. The futures contract • 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 (wt, grade, specifications) • Time (delivery date) • Place (delivery location)

  11. Standardized contract • Certain delivery (contract) months • Fixed size of contract • Grains 5,000 bushels • Corn, Wheat, Soybeans • Livestock in pounds • Lean Hogs 40,000 lbs carcass • Live Cattle 40,000 lbs live • Feeder Cattle 50,000 lbs live • Specified delivery points • Relatively few delivery points

  12. The futures contract • No physical exchange takes place when the contract is traded. • Payment is based on the price established when the contract was initially traded. • Deliveries are made when the contract expires (delivery time).

  13. Market position • Objective: Buy low, sell high • You can either buy or sell initially to open a position • “Make” a promise • Do the opposite to close the position at a later date • “Offset” the promise • Trader may also hold the position until expiration and make or take physical delivery of the commodity • Exceptions include Lean Hogs and Feeder Cattle

  14. Terms and Definitions • Basis • The difference between the spot or cash price and the futures price of the same or a related commodity. • Margin • The amount of money or collateral deposited by a client with his or her broker for the purpose of insuring the broker against loss on open futures contracts.

  15. Hedging definition • Holding equal and opposite positions in the cash and futures markets • The substitution of a futures contract for a later cash-market transaction

  16. Short Hedgers • Producers with a commodity to sell at some point in the future • Are hurt by a price decline • Short hedgers • Sell the futures contract initially • Buy the futures contract (offset) when they sell the physical commodity

  17. Long Hedgers • Processors or feeders that plan to buy a commodity in the future • Are hurt by a price increase • Long hedgers • Buy the futures initially • Sell the futures contract (offset) when they buy the physical commodity

  18. Producer short hedge example • A farmer will have 800 hogs to sell in June • The farmer is longthe cash market • Damaged by a price decline

  19. Hedging results • In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis. • Basis estimation is critical to successful hedging

  20. Long Hedge Example • An pork producer needs corn year around and wants to protect itself from higher corn prices in July. • It is short the cash market. • Will be hurt by a corn price increase • Will take a long futures position, buy July corn • Will benefit from higher July corn prices

  21. Forward Contracts • Contract for delivery • Defines time, place, form • Tied to the futures market • Buyer offering the contract must lay off the market risk elsewhere • The buyer does the hedging for you

  22. Futures Summary • Today’s price for delivery in future • Standardized contract/promise to make or take delivery • Contract/promise can be offset • Several participants for different positions • Basis estimation important to hedgers

  23. Options on Futures • Separate market • Option on the futures contract • Can be bought or sold • Behave like price insurance • Is different from the new insurance products

  24. Options on Futures • Two types of optionsFour possible positions • Put • Buyer • Seller • Call • Buyer • Seller • Calls and puts are not opposite positions of the same market. They are different markets.

  25. Put option • The Buyer pays the premium and has the right, but not the obligation tosell a futures contract at the strike price. • The Seller receives the premium and is obligated to buy a futures contract at the strike price.

  26. 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.

  27. Options as price insurance • Person wanting protection pays a premium • If damage occurs the buyer is reimbursed for damages • Seller keeps the premium but must pay for damages • Option buyer has unlimited upside and limited (premium) downside risk • Option seller has limited upside (premium) and unlimited downside risk

  28. Options • May or may not have value at end • The right to sell at $2.20 has no value if the market is above $2.20 • Buyer can chose to offset, exercise, or let it expire • Seller can only buy back or wait for buyer to choose

  29. Strike price • Level of price insurance • Set by the exchange (CME, CBOT) • A range of strike prices available for each contract

  30. Premium • Is traded in the option market • Different premium • 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

  31. In-the-money • If expired today it has value • Put: futures price below strike price • Call: futures price above strike price

  32. At-the-money • If expired today it would breakeven • Strike price nearest the futures price

  33. Out-of-the-money • If expired today it does nothave value • Put: futures price above strike price • Call: futures price below strike price

  34. Option decisions • Buyer can choose • Let option expire • Exercise right • Re-sell option rights to another • Seller has less flexibility • Obligated to honor option contract • Can buy back option to offset position

  35. Buyer decision depends upon • Remaining value and costs of alternative • Time mis-match • Most options contracts expire 2-3 weeks prior to futures expiration • Cash settlement expire with futures • Improve basis predictability

  36. Setting a Floor Price • Short hedger • Buy put option • Floor price = SP – Prem + Basis – Com • At maturity • Futures < SP the Net price = Floor Price • Futures > SP the Net price = Cash – Prem - Com

  37. Setting a Ceiling Price • Long hedger • Buy call option • Ceiling price = SP + Prem + Basis + Com • At maturity • Futures > SP the Net price = Ceiling Price • Futures < SP the Net price = Cash + Prem + Com

  38. Combination strategies • Option fence • Buy put and sell call • Higher floor but now have ceiling • Put spread • Buy ATM put and sell OTM put • Higher middle and higher prices, but also no floor below OTM strike

  39. Net Price with Options • Buy Put • Minimum price • Cash price - premium - comm • Buy Call • Maximum price • Cash price + premium + comm

  40. Summary on Options • Options on futures contract • Buyer • Pays premium, has limited risk and unlimited potential • Seller • Receives premium, has limited potential and unlimited risk

  41. William M. Edwards, Iowa State University Insuring Iowa’s Agriculture Analyzing Livestock Risk Protection

  42. Livestock Risk Protection (LRP) • Coverage for hogs, fed cattle and feeder cattle • 70% to 95% guarantees available, based on CME futures prices. • Coverage is available for up to 26 weeks out for hogs and 52 for cattle.

  43. Livestock Risk Protection • Guarantees available are posted at: www.rma.usda.gov/tools/ • Posted after the CME closes each day until 9:00 am central time the next working day. • Assures that guarantees reflect the most recent market movements.

  44. Size of Coverage Futures and options have fixed contract sizes • Hogs: 400 cwt. or about 150 head • Fed cattle: 400 cwt. or about 32 head • Feeder cattle: 500 cwt., 60-100 head • LRP can be purchased for any number of head or weight

  45. Some Risks Remain • LRP, LGM do not insure against production risks • Futures prices and cash index prices may differ from local cash prices (basis risk) • Selling weights and dates may differ from the guarantees

  46. Expiration Date of Coverage • LRP ending date is fixed. Price may change after date of sale. • Hedge or options can be lifted at any time before the contract expires.

  47. Who can benefit from LGM/LRP? • Producers who depend on the daily cash market or a formula related to it. • Producers with low cash reserves. • Smaller producers who do not have the volume to use futures contracts or put options. • Producers who prefer insurance to the futures market. No margin account.

  48. LRP Analyzer • Covers swine, fed cattle, feeders • Compares net revenue distribution • No risk protection • LRP • Hedge • Put options

  49. Case Example • Small cow herd producer will have 62 head of 650 pound steer calves to sell in 4 months. • What price will LRP lock in? • How much will it cost? • How does LRP compare to futures?

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