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FUTURES: SPECULATION

FUTURES: SPECULATION. Types of speculators: Short term Scalpers Day traders Long term. FUTURES: SPECULATION. Types of speculators: “Spreaders” Spread Price difference between two different markets or commodities

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FUTURES: SPECULATION

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  1. FUTURES: SPECULATION • Types of speculators: • Short term • Scalpers • Day traders • Long term

  2. FUTURES: SPECULATION • Types of speculators: • “Spreaders” • Spread • Price difference between two different markets or commodities • Spreads across commodities: Steers vs. corn, soybeans vs. soyoil and soymeal • Spreads across time: Corn December vs. July futures

  3. FUTURES: SPECULATION • “Spreaders” simultaneously buy and selling in two related markets in the expectation of making a profit when positions are offset

  4. FUTURES: SPECULATION • Example of spreading: • Suppose on April 15th: • KCBT HRW December wheat futures price is $4.07/bu • CBOT SRW December wheat futures price is $4.04/bu • Suppose a person is bullish about the KCBT-CBOT spread (e.g., he believes spread will rise to $0.10/bu) • Trading strategy for bullish speculator on the spread: • Go “long” (i.e., buy) the spread now at $0.03/bu • “Offset” (i.e., sell back) the spread sometime before December (hopefully, for more than $0.03/bu) Spread KCBT-CBOT = $4.07/bu – $4.04/bu = $0.03/bu

  5. FUTURES:SPREADING EXAMPLE • Correct forecast scenario, prices rise KCBT CBOT Spread Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu

  6. FUTURES:SPREADING EXAMPLE • Correct forecast scenario, prices rise KCBT CBOT Spread Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu Sep. 20 Sell back Buy back @4.57/bu @4.47/bu $0.10/bu

  7. FUTURES:SPREADING EXAMPLE • Correct forecast scenario, prices rise KCBT CBOT Spread Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu Sep. 20 Sell back Buy back @4.57/bu @4.47/bu $0.10/bu Gain (Loss) $0.50/bu (–$0.43/bu) NET GAIN $0.07/bu (minus broker commissions)

  8. FUTURES:SPREADING EXAMPLE • Correct forecast scenario, prices fall KCBT CBOT Spread Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu

  9. FUTURES:SPREADING EXAMPLE • Correct forecast scenario, prices fall KCBT CBOT Spread Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu Sep. 20 Sell back Buy back @3.57/bu @3.47/bu $0.10/bu

  10. FUTURES:SPREADING EXAMPLE • Correct forecast scenario, prices fall KCBT CBOT Spread Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu Sep. 20 Sell back Buy back @3.57/bu @3.47/bu $0.10/bu Gain (Loss) (–$0.50/bu) $0.57/bu NET GAIN $0.07/bu (minus broker commissions)

  11. Basis • BASIS = Cash - Futures • Local Spot Price – Futures Price • Cash = Basis + Futures • Provides a forecast of cash prices • Basis is more predictable than futures

  12. BASIS: GENERALITIES • Basis reflects factors that affect local cash price relative to futures price at delivery point • Local supply and demand factors • Yield • Quality • Storage availability • Processing capacity • Rail car availability • Consumption

  13. FUTURES: DEFINITIONS

  14. FUTURES: DEFINITIONS

  15. BASIS: GENERALITIES • Spot and futures tend to move together. • Futures price converges to spot price (at delivery location) as maturity gets closer • Hence: • Basis converges to zero (at delivery location) as maturity gets closer

  16. BASIS: GENERALITIES

  17. BASIS: GENERALITIES • For storable commodities at delivery location: Current Futures Price  Current Spot price + Storage Cost • Hence: • Basis  - Storage Cost

  18. BASIS: GENERALITIES • Basis generally follows seasonal patterns • Grains typically widest at harvest then narrow until the next harvest • Livestock varies, but follows the tendencies • Seasonal spot price • Converging at expiration

  19. FUTURES: DEFINITIONS • There is a BASIS for each futures contract and for each location • If futures contract not specified, basis implicitly calculated using “nearby” contract month

  20. 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

  21. HEDGING • Manage risk • Risk: A chance of an unfavorable outcome • Risk Management • Management is not avoidance • No risk, no reward • Too much risk and you may not be in business to receive the reward

  22. Why Hedge? • Two major types of risks • Production risk • Yield, efficiency, death loss, fire, spoilage • Price risk • For most commodity producers and handlers, price risk is greater than production risk

  23. HEDGING • Risk Management • Production • Management practices • Crop insurance • Price • Alternative contractual arrangements • Hedging with futures • Buying or selling futures contracts to protect from losses due to adverse movements in spot prices

  24. FUTURES: HEDGING • Hedgers: • Either “produce” or “consume” the commodity • Face “spot price risk” • Risk of losses from unfavorable spot price movements • Buy or sell futures in an attempt to reduce their spot price risk

  25. 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

  26. SHORT HEDGE:WHY DOES IT WORK?

  27. 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

  28. LONG HEDGE:WHY DOES IT WORK?

  29. Short (Selling) Hedge Protects from FALL in spot price “Locks in” a SELLING price Long (Buying) Hedge Protects from RISE in spot price “Locks in” a PURCHASING price FUTURES: HEDGING

  30. Preharvest short hedge example • A farmer will have 50,000 bushels of corn to sell after harvest • The farmer is longthe cash market • Damaged by a price decline

  31. Preharvest short hedge example • To have an equal and opposite hedge the farmer wouldsell10 corn futures contracts that expires near the expected marketing time. • The farmer would short the futures • The futures position would benefit from a price decline

  32. Preharvest short hedge example Step 1: Know cost of production Step 2: Convert futures price to local price using the basis For this farmer the historic basis for December corn is $0.25 under the board. Currently Dec corn trading at $2.50 Local basis -.25 Commission -.01 Expected hedge price $2.24

  33. Preharvest short hedge example • Step 3: Call broker and place order to sell10 Dec Corn contracts at the market • Step 4: Broker calls to confirm fill • Step 5: Send margin money to broker

  34. Preharvest short hedge example • It is now November and the farmer harvests 50,000 bu of corn and delivers it to the local elevator. • Prices could have gone up or down • Basis could be wider or narrower than expected

  35. Hedging example Higher Prices Dec Corn futures = $3.00 Basis as expected -$0.25 Cash corn $2.75 Futures position loss $2.50 - 3.00 -0.01 -$0.51 Net price $2.24

  36. Hedging example Lower Prices Dec Corn futures = $2.20 Basis as expected -$0.25 Cash corn $1.95 Futures position gain $2.50 - 2.20 -0.01 +$0.29 Net price $2.24

  37. Hedging example Basis Change Dec Corn futures = $2.20 Basis is wider -$0.30 Cash corn $1.90 Futures position gain $2.50 - 2.20 -0.01 +$0.29 Net price $2.19 Expected $2.24 and received $2.19 Difference is due to basis change

  38. 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

  39. Long Hedge Example • An ethanol plant 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

  40. Long Hedge Example Currently July corn trading at $2.70 Local basis -.25 Commission +.01 Expected hedge price $2.46 Call Broker and buy July corn at $2.70

  41. Long Hedge Example It is now July and prices went up. Call broker and sell July corn to offset: Currently July corn trading at $2.90 Local basis -.25 Cash price $2.65 Futures position gain $2.90 - 2.70 -0.01 +$0.19 Net price $2.46

  42. Long Hedge Example It is now July and prices went down. Call broker and sell July corn to offset: Currently July corn trading at $2.30 Local basis -.25 Cash price $2.05 Futures position loss $2.30 - 2.70 -0.01 -$0.41 Net price $2.46

  43. SHORT HEDGEExample 1: MIDDLEMEN • “Storage” Hedge: • It is March. You own a grain elevator and must decide whether to buy and store soybeans until July • Current soybeans spot price = $5.75/bu • Storage cost = $0.13/bu

  44. SHORT HEDGEExample 1: MIDDLEMEN • Soybean Contract Months: • March • May • July • August • September • November • January • Current August futures = $6.30/bu • Expected July basis = $0.25/bu UNDER August Expected Local Spot Price Next July = $6.30/bu + (–$0.25/bu) = $6.05/bu

  45. SHORT HEDGEExample 1: MIDDLEMEN • Storage is expected to be profitable BUT Risky because price of soybeans may fall • Decision: Storage and short hedge Expected profits from storage = $6.05/bu – $5.75/bu – $0.13/bu = $0.17/bu

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