Supply and Demand Chaos Early Markets in the US

Exchanges Chicago Board of TradeChicago Board of Trade Chicago Mercantile ExchangeChicago Mercantile Exchange Commodity Exchange IncorporatedCommodity Exchange Incorporated

Exchanges Kansas City Board of TradeKansas City Board of Trade New York Cocoa ExchangeNew York Cocoa Exchange

Characteristics of Commodities Traded Units homogeneousUnits homogeneous Susceptible to grading and standardizationSusceptible to grading and standardization Supply and demand uncertainSupply and demand uncertain

Characteristics of Commodities Traded Large supply and demandLarge supply and demand Supply flows naturally to marketSupply flows naturally to market Commodity not very perishableCommodity not very perishable

What is a futures contract? A transferable agreement to make or take delivery of a standardized amount of a commodity of minimum quality during a specific month.A transferable agreement to make or take delivery of a standardized amount of a commodity of minimum quality during a specific month.

Terms of a Contract CommodityCommodity PricePrice QuantityQuantity QualityQuality

Terms of a Contract Time of deliveryTime of delivery Place of deliveryPlace of delivery Terms of paymentTerms of payment

Settlement of a futures contract DeliveryDelivery Offsetting transactionOffsetting transaction

Concept of Long and Short Long - BuyLong - Buy Short - SellShort - Sell

Open Interest 1 long position + 1 short position = 1 open contract1 long position + 1 short position = 1 open contract

E.g.: Open Interest A sells to BA sells to B A-short; B-longA-short; B-long C sells to BC sells to B A-short; B-long 2; C-shortA-short; B-long 2; C-short Open interest = ?Open interest = ? Open interest = 2Open interest = 2

Margin Monies Secure position of traderSecure position of trader Solvency of Clearing HouseSolvency of Clearing House

Margin Example Soybean contract (5000 bu)Soybean contract (5000 bu) Original margin = $3,000Original margin = $3,000 Call point = $2,000Call point = $2,000

Margin Example Sold $6Sold $6 Then price increases to $6.25Then price increases to $6.25 Would you get a margin call?Would you get a margin call?

Margin Example Calculate the Trading Result (TR)Calculate the Trading Result (TR) TR = (value of contract sold) - (value of contract that must be bought back)TR = (value of contract sold) - (value of contract that must be bought back)

Margin Example TR = (5000 x $6) - (5000 x $6.25)TR = (5000 x $6) - (5000 x $6.25) TR = $30,000 - $31,250 = -$1,250TR = $30,000 - $31,250 = -$1,250

Margin Example Effective Margin = Original Margin +/- Trading ResultEffective Margin = Original Margin +/- Trading Result EM = $3,000 - $1,250 = $1,750EM = $3,000 - $1,250 = $1,750

Speculation vs. Hedging

What is speculation? Taking a position in the market in order to make money on the rise and fall of futures prices of certain commodities.Taking a position in the market in order to make money on the rise and fall of futures prices of certain commodities.

Speculation Buy a contract at a low price, then turn around and sell the contract at a high price.Buy a contract at a low price, then turn around and sell the contract at a high price. Buy low, sell high.Buy low, sell high.

Speculation Sell a contract at a high price, then turn around and buy the contract at a low price.Sell a contract at a high price, then turn around and buy the contract at a low price. Sell high, buy low.Sell high, buy low.

Speculator’s Role Provides risk capitalProvides risk capital Provides volume and liquidityProvides volume and liquidity Keeps some markets in alignment through arbitrageKeeps some markets in alignment through arbitrage

What is hedging? Taking an equal and opposite position in the futures market to that in the cash market in order to insulate one’s business against price level speculation.Taking an equal and opposite position in the futures market to that in the cash market in order to insulate one’s business against price level speculation.

Why hedge? Too much price riskToo much price risk Highly leveragedHighly leveraged Some banks require it as part of a loan agreementSome banks require it as part of a loan agreement

Causes of Price Risk Time difference between production and marketingTime difference between production and marketing Uncertain nature of farm productionUncertain nature of farm production National or international policiesNational or international policies

The Producer’s Hedge

Date CashDate Cash Mar. 1: Est. Price $2.60 Mar. 1: Est. Price $2.60 Nov. 1: Harvest & $2.40 Nov. 1: Harvest & $2.40 Futures Sell: Dec. $3 Buy: Dec. $2.80

The Producer’s Hedge Date CashDate Cash 3/1: $2.60 3/1: $ /1: Sell $ /1: Sell $2.40 -$0.20 -$0.20 Futures Sell: $3 Buy: $2.80 +$.020

The Producer’s Hedge The producer sold crop at $2.40 in the market at harvest.The producer sold crop at $2.40 in the market at harvest. Bought back the futures contract for $2.80.Bought back the futures contract for $2.80.

The Producer’s Hedge The producer gained $0.20 in the futures market to add to earnings in the cash market.The producer gained $0.20 in the futures market to add to earnings in the cash market.

The Producer’s Hedge Nov. 1 cash price = $2.40Nov. 1 cash price = $ futures gain = $ futures gain = $0.20 Total return = $2.60 Total return = $2.60 Note: Estimated return = $2.60Note: Estimated return = $2.60

The Processor’s Hedge

Date CashDate Cash Mar. 1: Lock in $5.40 Mar. 1: Lock in $5.40 Nov. 1: $7.00 Nov. 1: $7.00 Futures Buy: $5.70 Sell: $7.30

The Processor’s Hedge Date CashDate Cash 3/1: $5.40 3/1: $ /1: Buy $ /1: Buy $7.00 Futures Buy: $5.70 Sell: $7.30 +$1.60

The Processor’s Hedge Processor bought grain for $7 in cash market.Processor bought grain for $7 in cash market. Sold futures contract for $7.30.Sold futures contract for $7.30. Gained $1.60 in the futures market to help cover cost of grain purchased.Gained $1.60 in the futures market to help cover cost of grain purchased.

The Processor’s Hedge Nov. 1 cash price = $7.00Nov. 1 cash price = $ futures gain = -$ futures gain = -$1.60 Net cost = $5.40 Net cost = $5.40 Note: Estimated price = $5.40Note: Estimated price = $5.40