AGEC 420, Lec 91 AGEC 420 Review Quiz 1 Hedging examples Types of Orders Quiz 2

AGEC 420, Lec 92 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 93 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 on the cash side

AGEC 420, Lec 94 Expected and Realized Price Expected price = futures + expected basis Realized price = futures + actual basis = expected price + change in basis = cash + result on futures

AGEC 420, Lec 95 Example 7 - Long Hedge Feb: plan to buy feeder cattle in May. May $84.00, Exp. basis is +$0.50 Expected price is $ $0.50 = $84.50 Action: buy May May: Local price is $ Futures price is $87.25 Basis weaker than expected, by $0.75 / cwt Action: buy feeder cattle, sell futures Realized net price is $83.75

AGEC 420, Lec 96 Example 8 - Long Hedge Feb 7: Elevator is short cash wheat, needs to buy before March. March $3.50/bu., Exp. basis is -$0.40 Buy March futures. Expected Price = $3.50 – $0.40 = $3.10 Late Feb: Local price is $4.50. March $5.10 Basis = -$0.60, 20c weaker than expected. Realized net price paid is: $4.50 – $1.60 = $2.90 i.e. 20c less than expected due to weaker basis

AGEC 420, Lec 97 Hedging with futures Advantages –Reduce exposure to price risk Disadvantages –Lose the opportunity to gain from favorable price move –Margin calls

AGEC 420, Lec 98 Placing an Order Purcell & Koontz text, Appendix 4A, p162 Different types of Orders –Market order –Limit order –Stop order –MIT

AGEC 420, Lec 99 Market Order An order to take a position “at the market” executes immediately at the best available price Example “sell 1 July wheat at the market” Advantage – guaranteed fill (usually?) Disadvantage – no control over fill price

AGEC 420, Lec 910 Limit Order An order to take a position at a specified price or “better” “Better” = lower if buying, higher if selling Example “sell 1 July wheat at 2.98” Advantage –control over price Disadvantage – may not be filled

AGEC 420, Lec 911 Market if Touched (MIT) A condition that converts a limit order to a market order Example –July wheat at 2.97 –Order - “sell 1 July wheat at $2.98 MIT” –If price reaches $2.98 – order becomes a market order Advantage – some control over price Disadvantage – may not be filled