AGEC 420, Lec 8 1 AGEC 420 Hedging examples

AGEC 420, Lec 8 2 Hedging Expected (net forward) price: =futures + expected basis If basis is at the expected level –then realized price = expected price –regardless of whether the overall price level goes up or down

AGEC 420, Lec 8 3 Realized Price – 2 ways to calculate it Jan 31: July $3.20, Expected basis -$0.10. July 1: Local price $2.90, July $3.00 A. Realized price = futures* + actual basis (i.e., = $3.20* - $0.10 = $3.10) The futures price when hedge was established or B. Realized price = Cash + Result on futures i.e., = $2.90 (cash price) + $0.20 (profit on futures) = $3.10

AGEC 420, Lec 8 4 Example 2 – Basis Strengthens Jan 31: plan to sell 5,000bu wheat in early July July $3.20, Expected basis -$0.10. Expected price = = $3.10 ACTION: sell 1 July 3.20 July 1: Local price $2.95, July $3.00 Basis is stronger than expected ACTION: sell 2.95, buy 3.00 Realized net price is = $3.15

AGEC 420, Lec 8 5 Basis Risk A strengthening (or stronger than expected) basis helps the short hedger. It means that his local cash price is (relatively) stronger than expected.

AGEC 420, Lec 8 6 Example 3 – Prices Rise, Basis same Jan 31: plan to sell 5,000bu wheat in early July July $3.20, Expected basis -$0.10. Expected price = = $3.10 ACTION: sell 1 July 3.20 July 1: Local price $3.60, July $3.70 Basis is as expected ACTION: sell 3.60, buy 3.70 Realized net price is = $3.10

AGEC 420, Lec 8 7 Example 4 – Prices Rise, Basis weakens Jan 31: plan to sell 5,000bu wheat in early July July $3.20, Expected basis -$0.10. Expected (net forward) price = = $3.10 ACTION: sell 1 July 3.20 July 1: Local price $3.55, July $3.70 Basis is weaker than expected ACTION: sell 3.55, buy 3.70 Realized net price is = $3.05

AGEC 420, Lec 8 8 Stronger Basis Basis at the expected level:  realized price = expected price Basis stronger than expected  realized price above expected price  stronger basis helps the short hedger. It means that cash price is (relatively) stronger than expected.

AGEC 420, Lec 8 9 Weaker Basis Basis at the expected level:  realized price = expected price Basis weaker than expected  realized price above expected price  stronger basis helps the short hedger. It means that cash price is (relatively) weaker than expected.

AGEC 420, Lec 8 10 Example 5. In Feb.: plan to sell 40 fed cattle in June June $70.55/cwt, Exp. basis is +$0.25. Expected price = = $70.80 ACTION: sell In June: Local price is $64.50, June futures price is $64.45 Basis weaker than expected, by $0.20/cwt Realized net price is $70.60

AGEC 420, Lec 8 11 Long Hedge An agent who will need to buy the commodity. –Would lose if prices rose

AGEC 420, Lec 8 12 Long Hedge – for the buyer 1 st Question: What is the risk ? - or - What do you want to protect yourself from? Answer: a rise in price Therefore – you want a position in futures that will make $$ if price rises.

AGEC 420, Lec 8 13 Long Hedge An agent who will need to buy the commodity. –Would lose if prices rose To establish the hedge –buy futures At some future date –buy wheat in local cash market –sell futures (to offset)

AGEC 420, Lec 8 14 Example 6. Long hedge Feb: Elevator needs to buy wheat by July. July $3.50, Exp. basis is -$0.20 Expected net forward price is = $3.30 buy 3.50 May: Local price is $3.85. Futures price is $3.95 Basis stronger than expected, by $0.10/bu buy 3.85, sell 3.95 Realized price paid is $3.85-$0.45 = $3.40

AGEC 420, Lec 8 15 Basis risk Strengthening basis –helps the short hedger –works against the long hedger

AGEC 420, Lec 8 16 Example 4. Long Hedge Feb: plan to buy feeder cattle in May. May $84.00, Exp. basis is -$0.50 Expected net forward price is = $83.50 buy May: Local price is $ Futures price is $85.75 Basis weaker than expected, by $0.25 / cwt buy cattle locally, sell futures Realized net price paid is $83.25

AGEC 420, Lec 8 17 Hedging (summary) Objective: to reduce risk –works because basis risk < cash price risk If maturity basis = expected basis then realized price = expected price (regardless of whether prices go up or down)

AGEC 420, Lec 8 18 Approach to hedging problems identify the risk in the cash position will money be lost if price rises or if it falls decide appropriate action in futures one that makes money if there are losses in the cash expected price = futures + expected basis