USING FUTURES TO MANAGE RISK RICHARD BRIGGS RBC Dominion Securities

What is a Basis?  Basis Spot price of hedged asset - Futures price of contract  A negative number means futures above spot price. A positive number means spot price above futures.  Basis varies less then spot or futures prices

Basis  Spot prices reflect current conditions where as futures reflect anticipatory conditions  Seasonality may affect the basis Narrow basis occur during Aug-Sept period Increasing supply conditions Widening basis occur during Dec-Jan period Decreasing supply conditions  At futures maturity both prices will be about the same

Spot and Future Price -Daily Spot Price -Daily Future Price

Using Futures to Hedge Price Risk  Futures and Spot prices will move up or down together  Hedging involves taking the opposite side of the spot position  Remaining risk is Basis which has a lower risk profile then remaining un-hedged  CME Lean Hog contract is for lbs  Currency of contract is USD  Margin requirement per contract $1250

Hedging - Upward moving market DateSpot MarketFutures MarketBasis January Hedge is placed cwt Sell 1 CME LH J April Hedge is lifted cwt Buy 1 CME LH J – Operation in futures market results in loss of ( )x40000= -$740 usd per contract FINAL PRICE RECEIVED Spot Price + G/L on Futures Operation – 1.85= cwt

Hedging - Downward moving market DateSpot MarketFutures MarketBasis January Hedge is placed cwt Sell 1 CME LH J April Hedge is lifted cwt Buy 1 CME LH J – Operation in futures market results in gain of ( )x40000= +$740 usd per contract FINAL PRICE RECEIVED Spot Price + G/L on Futures Operation = cwt

How many contracts does one need to hedge? 1.Verify the impact of $1 cwt change in futures 2.Divide 400 by this (LH contract is 40k lbs, about 150 market ready pigs each penny change represents $ This number represents the amount of contracts to place on your hedge Number of Pigs per 1 LH Contracts = X % of futures used for pig price Example: finisher buys 100 feeder pigs for 85% of July LH futures price Number of Pigs per 1 LH Contracts = X.85 Number of Pigs per 1 LH Contracts = 470

Using Options to Hedge  Using options is another way to hedge your production  Can sell calls or buy puts when prices falling  Can buy calls and sell puts when prices are rising  Can create neutral, bullish and bearish option strategies through options

Using Options to Hedge (cont’d)  Options can be combined with futures to enhance risk profile  Buying options to hedge = producer knows maximum cash outlay  Options provide flexibility in your hedge

Reasons to Hedge with Futures  Most Marketing contracts don’t have a fixed price  Many contractors use LH futures to determine a sales price  Usually restricted on how far out you can hedge your price  Can protect against un-priced physical  Producers can use futures to manage price risk  Flexible, offset at any time

Reasons to Hedge with Futures (cont’d)  Futures can be used to manage input price risk and currency risk  Basis may change but the reduction in risk through hedging outweighs being un-hedged.  Will enhance your credit profile with lenders  Flexible, offset at any time

Hedging no Panacea  Hedging does not always guarantee best selling price  Basis does change Quality of hogs Delivery location Time Contracts may not match exactly with production

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