Beef and Grain Commodity Price Risk
Managing Commodity Toll Gamble Using Hedging and Options
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| Agdex#: | 840 |
|---|---|
| Publication Date: | Nov 2017 |
| Order#: | 17-041 |
| Last Reviewed: | |
| History: | Replaces OMAFRA Factsheet 08-053 of the same name |
| Written by: | Robb Wagner - Concern Opportunities and Marketplace Strategies Specialist/OMAFRA |
PDF Version - 140 KB
As part of providing accessible customer service, please electronic mail the Agricultural Information Contact Middle (ag.info.omafra@ontario.ca) if you lot require communication supports or alternate formats of this publication.
Table of Contents
- Purpose of futures markets
- Contracts
- Traders
- Trading gains and losses
- Trading on margin
- Hedging
- Options
- Hedging with options
- Decision
- Resource
The use of imperial measurement in this factsheet reflects the way information is reported within the industry.
This factsheet provides an overview of unremarkably used price risk management tools too as curtailed and hands understandable definitions of terms used past those providing risk direction advice.
Purpose of futures markets
Futures markets are price discovery and gamble management institutions. In futures markets, the competing expectations of traders collaborate to "find" prices. In and then doing, they reverberate a broad range of information that exists on upcoming marketplace conditions. Futures markets are actually designed as vehicles for establishing future prices and managing gamble so y'all tin can avoid gambling if y'all desire.
For example, a wheat producer who plants a crop is, in upshot, betting that the price of wheat won't drop so low that he would take been better not to have planted the crop at all. This bet is inherent to the farming business, but the farmer may prefer not to go far. The farmer can hedge this bet by selling a wheat futures contract.
Contracts
Futures contracts are sometimes confused with frontward contracts. While similar, they are non at however.
Forrad contracts
A forward contract is an agreement betwixt two parties (such equally a wheat farmer and a cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (cereal manufacturer) a specified quantity and quality of wheat at a specified future appointment at an agreed-upon toll. It is a privately negotiated contract that is non conducted in an organized market place or exchange.
Both parties to a forward contract expect to make or receive delivery of the article on the agreed-upon date. It is difficult to get out of a forward contract unless the other party agrees.
All forrad contracts specify quantity, quality and delivery periods. If any of these conditions are not met, the farmer will usually take to financially compensate the buyer. It is essential you sympathise your legal obligations earlier entering into a forward contract in case you cannot meet the conditions of the contract.
Futures contracts
Futures contracts, while similar to forward contracts, have certain features that make them more than useful for risk direction. These include being able to extinguish contract obligations through offsetting, rather than actual delivery of the commodity. In fact, very few futures contracts are ever delivered upon.
Futures contracts are traded on organized exchanges in a variety of commodities (including grains, livestock, bonds and currencies). They are traded by open outcry where traders and brokers shout bids and offers from a trading pit at designated times and places. This allows producers, users and processors to establish prices earlier commodities are traded. Futures prices are forecasts that can and do modify according to a diverseness of reasons, such every bit crop or weather reports.
Traders
There are basically two types of traders: hedgers and speculators.
Hedgers are people who produce, procedure or use commodities and want to reduce their price gamble or plant prices for bolt they will trade in the future.
Speculators are people who endeavor to profit through ownership and selling, based on price changes, and have no economic interest in the underlying commodity.
Futures contracts have standardized terms established by the exchange. These include the volume of the article, commitment months, delivery location, and accepted qualities and grades. The contract specifications differ, depending on the commodity in question.
This standardization makes it possible for big numbers of participants to merchandise the same article, which as well makes the contract more useful for hedging.
Trading gains and losses
Information technology helps to written report speculation first - trading futures without an interest in the underlying commodity - in order to understand hedging.
Example of Speculation
September corn is trading at $three.50/bu, but y'all believe the price volition be lower than this in September. You might have a "brusque position" (sell futures), and if the price falls, turn a profit from offsetting with a "long position" (ownership back futures):
| Date | Position |
|---|---|
| May seven | Short (sell) Sept corn @ $three.50/bu |
| May 27 | Long (buy) Sept corn @ $3.25/bu |
| Profit | $0.25/bu |
Even so, if prices rise, you lot would lose when you get-go the position:
| Engagement | Position |
|---|---|
| May 7 | Short Sept corn @ $three.l/bu |
| May 27 | Long Sept corn @ $three.sixty/bu |
| Loss | $(0.x)/bu |
Speculating is gambling; trading action either generates an absolute loss or an absolute gain. Hedging, in dissimilarity, creates price stability.
Trading on margin
To trade futures positions, financial majuscule must be in identify with the commutation and with a banker. Nonetheless, only a pocket-sized portion of the value of the position being traded is required. For instance, if soybeans are trading at $7.00/bu, the total value of a 5,000-bu contract is $35,000, simply only a small portion of this value must exist in place to brainstorm trading (typically betwixt ii% and 10% of the total value of the contract). Futures trading is conducted using a margin account.
An important implication of trading on margin is that losses confronting trading positions must exist covered on a dollar-for-dollar basis by the trader.
A futures trader entering into a futures position is required to mail an initial margin amount specified by the exchange. Thereafter, the position is "marked to the marketplace" daily - that is to say, if the futures position loses value, the amount in the margin account volition decline accordingly.
If the amount of money in the margin business relationship falls below the specified maintenance margin (which is set at a level less than or equal to the initial margin), the futures trader volition be required to post additional variation margin to bring the account up to the initial margin level.
On the other hand, if the margin position is positive, this amount will be added to the margin account. It is important to understand the impact that these margin calls tin can have on cash period as they are assessed daily. If the margin level falls below the maintenance margin, the trader must pinnacle up the account immediately to avert losing the futures position. It is important that lenders and financial managers are enlightened of the potential cash flow commitments that can result. Even futures trading that somewhen generates a profit can accumulate significant cash obligations for margin servicing over the life of the position.
Basis
"Ground" is the difference between local cash price and a nearby futures cost, quoted in mutual currency. For example, if the nearby futures toll is $4.75, and cash is $4.55, and so basis is $0.20 nether (-$0.20). If the futures price is $iv.75 and cash is $four.95, basis is $0.xx over (+$0.20).
Basis is typically measured against the nearest futures month after a greenbacks transaction. For case, a cash corn transaction occurring in March will be measured against the May futures price; a forward price for Nov will be matched to the December futures, etc.
The basis measures local supply-and-demand weather condition relative to the futures commitment region. The footing in regions with surplus production will have a more negative ground (or less positive); in deficit production regions, the basis volition be more positive (or less negative). Many factors can influence footing, notably changes in local supply-and-demand remainder and transportation costs. Ground too represents the portion of cost risk that cannot be mitigated by hedging.
Hedging
To hedge is to take a futures position that is equal and opposite to a position held in the greenbacks market. The objective is to mitigate the adventure of an adverse motility in prices.
Hedging works in mitigating price risk because futures prices and cash prices are highly correlated. For example, a producer of soybeans has the risk that the cash price will decrease before the beans are harvested and tin be sold. Selling soybean futures mitigates this risk. If the cash soybean cost in fact declines, the futures toll volition have decreased as well. Then, the producer can buy back (or offset) the futures contract for less than he sold information technology for, generating a turn a profit. This profit can be applied to the revenue he gets from selling the soybeans on the cash market place, thereby mitigating the cash price decrease.
Hedging using futures very seldom results in delivery confronting the futures contract; contracts are liquidated via offset and do not upshot in delivery. The purpose of the delivery provision is to ensure convergence between futures cost and the cash market price. Information technology is the threat of delivery that causes greenbacks and futures to come together.
Short hedging
A person who already owns or is in the process of producing a commodity has the risk that the price volition fall. This run a risk can be mitigated by selling futures (short hedge), protecting the hedger from a decline in the toll of the commodity/production owned or existence produced.
Examples of short hedgers:
- a farmer with livestock on feed or a crop in the field
- an elevator with grain inventory in the elevator
- an elevator that has contracted to take delivery of grain in the future at a fixed cost
- a meat packer who has contracted to accept beast delivery in the futurity
The take a chance here is that prices may fall before commitment.
Example of a short hedge
Every bit an example (Table 1), suppose information technology is May and a corn producer is considering pricing his corn ingather. Based on history, the producer expects the ground at harvest to exist $0.10 over December futures, which are currently trading at $3.50. The lift is currently offering a forrard price that is $0.05 over December.
The producer'south risk is that corn prices will fall, so to hedge with futures, the producer takes a short futures position.
Equally the corn is being harvested in November, the futures cost has fallen to $three.00, and the local basis is even so $0.05 over December. The producer buys dorsum the short position, resulting in a $0.fifty profit, which he combines with the $3.05 cash toll to obtain a internet price of $3.55, thereby mitigating the effect of the price subtract.
Conversely, if the futures toll had increased by $0.50, a loss on futures would effect, and the net price would remain $iii.55.
| Appointment | Cash | Futures |
|---|---|---|
| May | $3.55 | Short @ $3.50 |
| November | $3.05 | Long @ $3.00 |
| Profit | $0.50 | |
| Cyberspace Price | $3.55 |
Long hedging
A person who does not now own the cash commodity only will require it in the hereafter has the run a risk that the cost will increase. Ownership futures (long hedge) can mitigate this risk. A long hedge protects the hedger from a ascension in toll.
Examples of long hedgers:
- a nutrient manufacturer, who will demand product in the hereafter, doesn't own it now but wants to price information technology now
- a processor who has offered to toll production forward, based on current ingredients prices, but doesn't own it now
The risk here is that the cost will rise before delivery.
Instance of a long hedge
Alternatively (Table 2), a flour miller is concerned almost the take chances of wheat cost increases for wheat to be purchased in Nov. Wheat futures for Dec delivery are currently trading at $4.20/bu, and the typical ground at the miller'southward location is $0.15 over futures.
The miller hedges this gamble by taking a long position (buying) the December wheat time to come at $iv.20. In November, the futures price has increased to $four.40, and wheat is selling locally for $4.55.
The miller lifts the hedge past selling back the futures position at $4.xl, resulting in a profit of $0.twenty/bu.
This profit is and then applied to the cash buy cost of $four.55/bu, resulting in a internet price of $four.35, which is the price expected when the hedge was placed.
| Date | Cash | Futures |
|---|---|---|
| August | Long @ $4.20 | |
| Nov | $four.55 | Short @ $4.forty |
| Profit | $0.20 | |
| Internet Price | $4.35 |
In both of these examples, the basis component of pricing did non alter. In practice, basis tin exist variable, simply this variation is pocket-sized, relative to that in the futures price. The basis chance cannot be protected through hedging.
What makes hedging work is the fact that cash and futures prices converge at the delivery indicate - when one goes up, the other goes up besides.
The hedger takes an equal simply reverse position in the futures market to the i held in the greenbacks market place to avoid the risk of an adverse price move. However, by doing this, the hedger forfeits whatever reward of a cash price improvement.
Options
Options are like insurance - you tin can cash them in when bad things happen (such as a drop in futures toll) simply you don't collect when good things happen (such as a rising in futures toll).You are paying someone to take on your futures risk.
In that location are ii types of options: put and phone call.
The put selection sets a minimum price for the contracted amount of grain or livestock. This gives the heir-apparent the correct just non the obligation to take a brusk position in the underlying futures at a specific toll (called the strike price) within a specified time catamenia.
When a farmer buys a put option, for a premium, there is the option to sell or go short on a specific futures market contract if the price of that contract falls beneath the strike cost. The strike price level, less the premium for the put pick, establishes the minimum price the farmer will receive for the contracted article.
The call selection sets a maximum price for the contracted amount of grain or livestock. This gives the buyer the correct simply non the obligation to have a long position in the underlying futures at the strike price within a specified time menstruum.
When the farmer buys a call option, for a premium, there is the pick to buy or become long on a specific futures market contract if the price of that contract rises above the strike price. The strike price level, less the premium for the call option, establishes the maximum price the buyer will pay for the contracted article.
Once an option has been purchased, the heir-apparent (holder) has 3 alternatives. Outset, the option can be allowed to expire. Second, the selection can be sold to someone else or offset; the original heir-apparent, by selling to a 3rd party, has transferred his rights to that party. Third, the option can exist exercised, essentially demanding that the seller provide the underlying futures position.
Options are not purchased on margin; one advantage is not having to make margin calls when the marketplace moves. For example, with a put choice, you are protected against the downside but go the benefit of the upside in prices. The perceived do good of this is dependent on the premium paid.
Premium Values
The option premium is the cost that the option trades for. This is determined through competitive bids and offers, but two key considerations guide this procedure.
The kickoff is intrinsic value, which refers to how profitable an option would be if it were executed. The option profitability is measured past comparing the strike cost to the electric current cost of the underlying futures contract.
The second is time value. Every bit the perceived cost volatility increases and/or if the time to decease is longer, the value of an option increases. It is a combination of these 2 factors that determines the premium on the option.
Hedging with options
Hedging with options is similar to hedging with futures. The principal difference is that options are purchased and resold, with the gain in the option value used to first negative price risk. When futures are used to hedge, information technology is the alter in the value of futures prices direct that generates gains or losses that mitigates price risk.
Decision
This factsheet provides a basic overview of the commodity cost risk management tools and terminology. It is non meant to exist the only source of information. Anyone planning on using futures as a concern risk management tool is encouraged to take a commodity-marketing course and to use the services of a professional futures broker.
Resources
- Chicago Mercantile Exchange
- ICE Futures Canada (ICE)
- DTN
- Canadian Farm Business Management Quango
- Ontario Ministry of Agriculture, Food and Rural Affairs
Source: http://www.omafra.gov.on.ca/english/busdev/facts/17-041.htm
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