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Supply and Demand Chaos

Supply and Demand Chaos. Early Markets in the US. Exchanges. Chicago Board of Trade Chicago Mercantile Exchange Commodity Exchange Incorporated. Exchanges. Kansas City Board of Trade New York Cocoa Exchange. Characteristics of Commodities Traded. Units homogeneous

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Supply and Demand Chaos

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  1. Supply and Demand Chaos Early Markets in the US

  2. Exchanges • Chicago Board of Trade • Chicago Mercantile Exchange • Commodity Exchange Incorporated

  3. Exchanges • Kansas City Board of Trade • New York Cocoa Exchange

  4. Characteristics of Commodities Traded • Units homogeneous • Susceptible to grading and standardization • Supply and demand uncertain

  5. Characteristics of Commodities Traded • Large supply and demand • Supply flows naturally to market • Commodity not very perishable

  6. What is a futures contract? • A transferable agreement to make or take delivery of a standardized amount of a commodity of minimum quality during a specific month.

  7. Terms of a Contract • Commodity • Price • Quantity • Quality

  8. Terms of a Contract • Time of delivery • Place of delivery • Terms of payment

  9. Settlement of a futures contract • Delivery • Offsetting transaction

  10. Concept of Long and Short • Long - Buy • Short - Sell

  11. Open Interest • 1 long position + 1 short position = 1 open contract

  12. E.g.: Open Interest • A sells to B • A-short; B-long • C sells to B • A-short; B-long 2; C-short • Open interest = ? • Open interest = 2

  13. Margin Monies • Secure position of trader • Solvency of Clearing House

  14. Margin Example • Soybean contract (5000 bu) • Original margin = $3,000 • Call point = $2,000

  15. Margin Example • Sold soybeans @ $6 • Then price increases to $6.25 • Would you get a margin call?

  16. Margin Example • Calculate the Trading Result (TR) • TR = (value of contract sold) - (value of contract that must be bought back)

  17. Margin Example • TR = (5000 x $6) - (5000 x $6.25) • TR = $30,000 - $31,250 = -$1,250

  18. Margin Example • Effective Margin = Original Margin +/- Trading Result • EM = $3,000 - $1,250 = $1,750

  19. Speculation vs. Hedging

  20. What is speculation? • Taking a position in the market in order to make money on the rise and fall of futures prices of certain commodities.

  21. Speculation • Buy a contract at a low price, then turn around and sell the contract at a high price. • Buy low, sell high.

  22. Speculation • Sell a contract at a high price, then turn around and buy the contract at a low price. • Sell high, buy low.

  23. Speculator’s Role • Provides risk capital • Provides volume and liquidity • Keeps some markets in alignment through arbitrage

  24. What is hedging? • Taking an equal and opposite position in the futures market to that in the cash market in order to insulate one’s business against price level speculation.

  25. Why hedge? • Too much price risk • Highly leveraged • Some banks require it as part of a loan agreement

  26. Causes of Price Risk • Time difference between production and marketing • Uncertain nature of farm production • National or international policies

  27. The Producer’s Hedge

  28. Date Cash Mar. 1: Est. Price $2.60 Nov. 1: Harvest & sell @ $2.40 Futures Sell: Dec. futures @ $3 Buy: Dec. futures @ $2.80 The Producer’s Hedge

  29. Date Cash 3/1: $2.60 11/1: Sell $2.40 -$0.20 Futures Sell: $3 Buy: $2.80 +$.020 The Producer’s Hedge

  30. The Producer’s Hedge • The producer sold crop at $2.40 in the market at harvest. • Bought back the futures contract for $2.80.

  31. The Producer’s Hedge • The producer gained $0.20 in the futures market to add to earnings in the cash market.

  32. The Producer’s Hedge • Nov. 1 cash price = $2.40 + futures gain = $0.20 Total return = $2.60 • Note: Estimated return = $2.60

  33. The Processor’s Hedge

  34. Date Cash Mar. 1: Lock in $5.40 Nov. 1: Buy @ $7.00 Futures Buy: Mar. @ $5.70 Sell: Mar. @ $7.30 The Processor’s Hedge

  35. Date Cash 3/1: $5.40 11/1: Buy $7.00 Futures Buy: $5.70 Sell: $7.30 +$1.60 The Processor’s Hedge

  36. The Processor’s Hedge • Processor bought grain for $7 in cash market. • Sold futures contract for $7.30. • Gained $1.60 in the futures market to help cover cost of grain purchased.

  37. The Processor’s Hedge • Nov. 1 cash price = $7.00 + futures gain = -$1.60 Net cost = $5.40 • Note: Estimated price = $5.40

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