Great Plains Veterinary Educational Center PRM Price Risk Management Protection of Equity (Just The Basics) Part One

Great Plains Veterinary Educational Center Futures Contracts (FC) : Producers: –Lock Prices - Planning - Aid Financing. Evolved from existing marketing system. Forward contracts became standardized futures contracts. Exchanges established rules for trading. Government established regulations.

Great Plains Veterinary Educational Center FC Standardized: Commodity, Quantity, Quality, Deliver Point, Cash Settlement and Delivery Date. Who can trade futures? Anyone.

Great Plains Veterinary Educational Center How do speculators use the futures market? Speculators have no intention of buying or selling the actual commodity. They make money by taking advantages of change in futures prices.

Great Plains Veterinary Educational Center How do producers use the futures markets? As a temporary substitute for cash price. (sale or purchase) As the delivery month approaches the pressure of possible delivery causes the futures and the cash price to line up. –At delivery: futures price reflects the cash.

Great Plains Veterinary Educational Center How do producers use the futures markets? (cont) Futures contracts –allow producers to "lock in a price” ahead of actual (sale or purchase). Transfer risk to speculator.

Great Plains Veterinary Educational Center Hedging Buying or Selling futures contracts as protection against the risk of loss due to changing prices in the cask market. » A Price Risk Management tool.

Great Plains Veterinary Educational Center Price Discovery: On the floor of the exchange by interaction between buyer and seller. Represents supply and demand from all over the country / world.

Great Plains Veterinary Educational Center Futures Contract Obligation: Removed (offset) by buying or selling a contact that has been sold or bought. Short hedgers offset their obligationby buying the hedge back when the commodity they raise is sold.

Great Plains Veterinary Educational Center Futures Contract Obligation: (cont) Long hedgers offset their obligation by selling the hedge back when the commodity they need is bought. Cash Settlement: For futures contracts that do not rely on physical delivery (feeder cattle).

Great Plains Veterinary Educational Center Futures Contracts Offer Protection Selling (Short) a futures contract protects the seller of the commodity against falling prices. Buying (Long) a futures contract protects the buyer of the commodity against rising prices.

Great Plains Veterinary Educational Center Using Futures Contacts: FC: bought / sold through brokerage firms –(execute the trade). Broker fee typically covers one "round-turn” –(sell-buy / buy-sell) Performance Bonds pre-pay possible loss –(margin accounts-One days trade). Clearing House: FC transactions guarantor –Also, cash settlements on the last contract day

Great Plains Veterinary Educational Center Cash Settlement: LONG FCs open the last trading day –Automatically offset by Clearing House against remaining short contacts –Price set equal to the CME “Composite Weighted Average Price” for the Contract.

Great Plains Veterinary Educational Center CME Composite Weighted Average Price Calculated from the USDA data. –Formula & data available to the public. Data includes: – Auction Markets, Direct & Video Sales – Of typical commodity (FC= ) –12 states over the previous seven days

Great Plains Veterinary Educational Center Contract Specifications: Futures Contract Months Minimum Fluctuation In Price Limit Strike Price Interval/Notes

Great Plains Veterinary Educational Center Live Cattle –40,000 lbs. Feb, Apr, Jun, Aug, Oct, Dec –Limit 3¢/100 lb or $1,200/Contract (Maintain 2¢/lb or $800) Live Cattle Options –Feb, Apr, Jun, Aug, Oct, Dec Feeder Cattle –50,000 lbs. Jan, Mar, Apr, May, Aug, Sep, Oct, Nov –Limit 3¢/100 lb or $1,500/Contract (Maintain 2¢/lb or $1,000) Feeder Cattle Options –Jan, Mar, Apr, May, Aug, Sep, Oct, Nov Contract Specifications:

Great Plains Veterinary Educational Center PRM Price Risk Management Protection of Equity (Just The Basics) Part Two

Great Plains Veterinary Educational Center Relationship of local cash markets to futures price at marketing time. (Basis = Cash - Futures) Futures and cash prices differ –because of delivery cost –local demand. Basis

Great Plains Veterinary Educational Center Two Questions Why is basis knowledge important? Where do you find basis info.? Expected Selling Price: Futures contract (+/-) the Basis —NOTE: Historical basis is only a guideline Not Absolute

Great Plains Veterinary Educational Center Short Hedge (Locking In A Selling Price) Sell (SHORT) futures contact => –Buy futures contract back (basis has no effect) –+ Sell commodity in cash market (basis has effect) –Note: include fees

Great Plains Veterinary Educational Center Long Hedge (Locking In A Purchase Price) Buy (LONG) futures contact => –Sell futures contract back (basis has no effect) –+ Buy commodity in cash market (basis has effect) –Note: include fees

Great Plains Veterinary Educational Center Types Of Orders Market Orders: (Sell/Buy "at the market") –order to be filled as soon as possible. Limit Orders: (Sell/Buy "at $$$$ price") –order to be filled at a certain price. Stop Orders: (Sell/Buy "at $$$$ stop") –order to be filled when (+/-) price changes. Stop Close Only Orders: (S/B "at a stop only of $$$$") –order filled when (+/-) price closes at $$$$. Note: Orders are not always filled.

Great Plains Veterinary Educational Center Develop Marketing Plan Start with a BREAK-EVEN. –Est. consistent w/ financial goals Develop CALENDARS: –PRODUCTION & PRM Define DECISION POINTS –When &/or What will be done.

Great Plains Veterinary Educational Center Things Not To Do: Hedge w/o "accurate" BE estimates Manage without a plan Change from Hedger to Speculator “Texas Hedge” FC added to production (needs/output) Worry about Margins Offset commodity before marketable

Great Plains Veterinary Educational Center PRM Price Risk Management Protection of Equity (Just The Basics) Part 3

Great Plains Veterinary Educational Center Options Provide producers the: –"right" but not the "obligation" –to sell/buy a specified commodity. For every option buyer there is an option seller (guarantor). Options are set for: –corresponding futures contract.

Great Plains Veterinary Educational Center Option Buyers (Hedger types) Buying Put Option: –provide "right" but not the "obligation" –to sell (Short) a specified commodity. Buying Call Option: –provide "right" but not the "obligation” –to buy (Long) a specified commodity.

Great Plains Veterinary Educational Center Option Sellers (Speculators) Selling Put Option: –assumes "obligation" to buy specified commodity if settles in adverse position Selling Call Option: –assumes "obligation" to buy specified commodity if settles in adverse position

Great Plains Veterinary Educational Center Option Player Summary Put Buyer: –(pays premium & has right to sell) Put Seller: –(collects premium & has obligation, if exercised, to pay different between strike & current price) Call Buyer: –(pays premium & has right to buy) Call Seller: –(collects premium & has obligation, if exercised, to pay difference between strike & current price)

Great Plains Veterinary Educational Center Strike (Exercise) Price The price the option holder may sell/buy the futures contact. Exercising the option results in futures position at the designated strike price. Choose the strike price that reflects the amount of risk you are willing to accept.

Great Plains Veterinary Educational Center Premium Market determines the premium (bid/ask) Influenced by strike price relative to futures price, market expectations, volatility risk, and time risk In-the-money (strike price not asked to match all of future price) … Has "Intrinsic Value” At-the-money (strike price asked to match futures price) Out-of-the-money ((strike price asked to match futures price plus additional $)

Great Plains Veterinary Educational Center Note about Time Value Time risk decreases as the time between the purchase of the option an the expiration date Delta ( +/- change) refers to change in option value relative change in future value. A 0.3 delta would mean that if the futures price dropped $1.00 the value of a Put would increase as by $0.30.

Great Plains Veterinary Educational Center Expiration Date The last day an option may be exercised (offset). Put option would be exercised by selling (Short) a futures position at the strike price. Call option would be exercised by buying (Long) a futures position at the strike price.

Great Plains Veterinary Educational Center Contract Specifications: Futures Contract Months Minimum Fluctuation In Price Limit Strike Price Interval/Notes

Great Plains Veterinary Educational Center Three Alternatives After You Purchase An Option Sell the option back if it has value (offset at the current price and collect the premium) Exercise the option (sell/buy futures at specified strike price and buy/sell at current price) Let option expire if it has no value.

Great Plains Veterinary Educational Center Intrinsic Value The amount of money that could be realized by exercising an option at its strike price.

Great Plains Veterinary Educational Center PRM Price Risk Management Protection of Equity (Just The Basics) Part 4

Great Plains Veterinary Educational Center Basic Strategies Lock in Fixed Price –Fixed Selling Price => Short Futures –Fixed Purchase Price => Long Futures Establish Minimum Selling Price => Buy Puts Establish Maximum Purchase Price => Buy Calls

Great Plains Veterinary Educational Center Advanced Strategies Collect Option Premium => Sell (Put/Call) Typically: used on to offset the premium paid for opposite position option.

Great Plains Veterinary Educational Center Establish Maximum Purchase Price Buy Call and Sell Put ("The Fence") reduces premium cost Buy (Long) futures contact (or Cash contract) and buy Put

Great Plains Veterinary Educational Center Establish Minimum Selling Price Buy Put and Sell Call reduces premium cost Sell (Short) futures contact (or Cash contract) and buy Call

Great Plains Veterinary Educational Center Adjustment Strategies Convert a fixed price to minimum price => buy Call after selling (short) futures Convert a fixed price to minimum price => buy Put after liquidating a short futures position

Great Plains Veterinary Educational Center Adjustment Strategies (cont) Convert a minimum price to a fixed price => selling futures (cash contract) after a Put purchase Adjust the minimum price to a fixed price => buy Put option as price increases Cashing-in minimum price protection => buy Put option as price decreases

Great Plains Veterinary Educational Center Convert a fixed price to maximum price => purchase Put after buying (long) futures Convert a fixed price to maximum price => purchase Call after liquidating a long futures position Convert a maximum price to a fixed price => buying futures (cash contract) after a Call purchase Adjustment Strategies (cont)

Great Plains Veterinary Educational Center Adjust maximum price to a fixed price =>buy Call option as price decreases Cashing-in maximum price protection => buy Call option as price increases Adjustment Strategies (cont)

Great Plains Veterinary Educational Center Save a Cow … Eat a Vegetarian Good Luck To You Thanks for having me come.