USES OF OPTIONS: HEDGING Spot price risks: 1.Risk of spot price FALL –Person/firm committed to sell good (output) in the future 2.Risk of spot price RISE –Person/firm committed to buy good (input) in the future

USES OF OPTIONS: HEDGING “Equal and opposite position” Short (or Selling) Hedge: – Protects from FALL in spot price –Benefit in futures from a price fall to offset the loss in the cash market

USES OF OPTIONS: SHORT HEDGE

USES OF OPTIONS: HEDGING Short (or Selling) Hedge: –Buy a put option –Protects from FALL in spot price –“Locks in” a SELLING FLOOR price

USES OF OPTIONS: SHORT HEDGE

USES OF OPTIONS: HEDGING Short (or Selling) Hedge: – Protects from FALL in spot price –“Locks in” a SELLING FLOOR price Long (or Buying) Hedge: – Protects from RISE in spot price

USES OF OPTIONS: LONG HEDGE

USES OF OPTIONS: HEDGING Short (or Selling) Hedge: – Protects from FALL in spot price –“Locks in” a SELLING FLOOR price Long (or Buying) Hedge: –Buy a call –Protects from RISE in spot price –“Locks in” a BUYING CEILING price

USES OF OPTIONS: LONG HEDGE

SHORT-HEDGING WITH OPTIONS Protection from FALL in spot price “Lock in” selling FLOOR price

OPTIONS: SHORT HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to sell Buy PUTs (Long in spot)(Right to be short in futures)

OPTIONS: SHORT HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to sell Buy PUTs (Long in spot)(Right to be short in futures) LATER:Sell commoditySell back PUTs, or let (Spot positionPUTs expire cleared) (PUT position cleared)

USES OF OPTIONS: SHORT HEDGE

PUT Strike - PUT Premium + Expected Basis Expected Selling FLOOR Price OPTIONS: SHORT HEDGE

EXAMPLE of Short Hedge with Options: CORN PRODUCER It is April You are about to plant corn. Current December futures price is $2.35/bu. Basis in mid-November has been: $0.25/bu (in ’04), $0.28/bu (in ’03), $0.30/bu (in ’02), $0.32/bu (in ’01), $0.30/bu (in ’00), $0.33/bu (in ’99), $0.36/bu (in ’98) under December, so your predicted basis is $0.32/bu under December. Expected spot price for mid-November 2005 = $2.03/bu (= 2.35 – 0.32)

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price (-0.32) = 1.77

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price (-0.32) = (-0.32) = 1.82

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price (-0.32) = (-0.32) = (-0.32) = (-0.32) = (-0.32) = 1.93

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price (-0.32) = (-0.32) = (-0.32) = (-0.32) = (-0.32) = 1.93

EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 1: Futures FALL from 2.35 to 1.85 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu

EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 1: Futures FALL from 2.35 to 1.85 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $1.53/buSell back for $0.65/buActual -$0.32

EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 1: Futures FALL from 2.35 to 1.85 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $1.53/buSell back for $0.65/buActual -$0.32 Spot Price+PUT Gain (Loss)= Net Selling Price $1.53/bu+$0.37 = $1.90 (as expected)

EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 2: Futures RISE from 2.35 to 2.70 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu

EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 2: Futures RISE from 2.35 to 2.70 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $2.38/buSell back for $0/buActual -$0.32

EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 2: Futures RISE from 2.35 to 2.70 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $2.38/buSell back for $0/buActual -$0.32 Spot Price+PUT Gain/Loss= Net Selling Price $2.38/bu+($-0.28) = $2.10 (as expected)

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Expected Net Selling Price PUT Selling (November spot = $1.53/bu) Strike FLOOR (Futures = $1.85/bu) (Premium) Price 2.20 (0.11) (0.16) (0.22) (0.28) (0.35)

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Expected Net Selling Price PUT Selling (November spot = $2.38/bu) Strike FLOOR (Futures = $2.70/bu) (Premium) Price 2.20 (0.11) (0.16) (0.22) (0.28) (0.35)

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Short Hedge with Options: CORN PRODUCER December Expected Net Selling Price PUT Selling (Nov. spot (Nov. spot Strike FLOOR = $1.53/bu) = $2.38/bu) (Premium) Price (Fut. = $1.85/bu) (Fut. = $2.70/bu) 2.20 (0.11) (0.16) (0.22) (0.28) (0.35)

SHORT-HEDGING WITH OPTIONS

OPTIONS: SHORT HEDGING Many possible FLOOR prices –Must pick “right” one for your situation Note: Actual FLOOR  expected FLOOR only if Actual Basis  expected Basis

LONG-HEDGING WITH OPTIONS Protection from RISE in spot price “Lock in” buying CEILING price

OPTIONS: LONG HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to buy Buy CALLs (Short in spot)(Right to be long in futures)

OPTIONS: LONG HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to buy Buy CALLs (Short in spot)(Right to be long in futures) LATER:Buy commoditySell back CALLs, or (Spot positionlet CALLs expire cleared) (CALL position cleared)

USES OF OPTIONS: LONG HEDGE

CALL Strike + CALL Premium + Expected Basis Expected Buying CEILING Price OPTIONS: LONG HEDGE

EXAMPLE of Long Hedge with Options: SOY PROCESSOR It is April You will buy soybeans in late October. Current November futures price is $6.15/bu. Basis in late October has been $0.32/bu under November. Expected spot price for late October 2005 = $5.83/bu (= 6.15 – 0.32)

EXAMPLE of Long Hedge with Options: SOY PROCESSOR November Current ExpectedExpected CALL + November - October = Buying Strike CALL Basis CEILING Premium Price (-0.32) = 1.77

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Long Hedge with Options: SOY PROCESSOR November Current ExpectedExpected CALL + November - October = Buying Strike CALL Basis CEILING Premium Price (-0.32) = (-0.32) = (-0.32) = (-0.32) = (-0.32) = 1.93

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Long Hedge with Options: SOY PROCESSOR November Current ExpectedExpected CALL + November - October = Buying Strike CALL Basis CEILING Premium Price (-0.32) = (-0.32) = (-0.32) = (-0.32) = (-0.32) = 1.93

EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 1: Futures FALL from 6.15 to 5.60 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu

EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 1: Futures FALL from 6.15 to 5.60 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $5.28/buSell back for $0/buActual -$0.32

EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 1: Futures FALL from 6.15 to 5.60 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $5.28/buSell back for $0/buActual -$0.32 Spot Price -CALL Gain/Loss= Net Buying Price $5.28/bu -($-0.39/bu)= $5.67 (as expected)

EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 2: Futures RISE from 6.15 to 7.10 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu

EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 2: Futures RISE from 6.15 to 7.10 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $6.78/buSell back for $0.70/buActual -$0.32

EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 2: Futures RISE from 6.15 to 7.10 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $6.78/buSell back for $0.70/buActual -$0.32 Spot Price -CALL Gain/Loss= Net Buying Price $6.78/bu -$0.31/bu= $6.47 (as expected)

EXAMPLE of Long Hedge with Options: SOY PROCESSOR December Expected Net Buying Price CALL Selling (October spot = $5.28/bu) Strike CEILING (Futures = $5.60/bu) (Premium) Price 6.00 (0.54) (0.46) (0.39) (0.33) (0.28)

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Long Hedge with Options: SOY PROCESSOR December Expected Net Buying Price CALL Selling (October spot = $6.78/bu) Strike CEILING (Futures = $7.10/bu) (Premium) Price 6.00 (0.54) (0.46) (0.39) (0.33) (0.28)

SHORT-HEDGING WITH OPTIONS

EXAMPLE of Long Hedge with Options: SOY PROCESSOR December Expected Net Buying Price CALL Selling (Oct. spot (Oct. spot Strike CEILING = $5.28/bu) = $6.78/bu) (Premium) Price (Fut. = $5.60/bu) (Fut. = $7.10/bu) 6.00 (0.54) (0.46) (0.39) (0.33) (0.28)

SHORT-HEDGING WITH OPTIONS

OPTIONS: LONG HEDGING Many possible CEILING prices –Must pick “right” one for your situation Note: Actual CEILING  expected CEILING only if Actual Basis  expected Basis

Futures Net Price Strike Price Long Cash Adjust for basis Hedge Adjust for basis Buy Put Hedger Position

Futures Net Price Strike Price Long Cash Adjust for basis Hedge Adjust for basis Buy Call Hedger Position