1 Evaluating Risk Management Tools John D. Lawrence Extension Livestock Economist Iowa State University

2 Tools Futures Forward contracts Options Livestock Revenue Protection Livestock Gross Margin Option combinations

3 Cash is a 45 o line X-axis is possible futures prices at end of contract Y-axis is the net price received

4 Futures and Options Data JUNE 2009 LIVE CATTLE Dec 17 Closing Prices Futures$85.80 Expected Basis$0.56 Strike Premium Price CallPut

5 Futures Hedge Futures priceF85.80 Expected basis+B0.56 Commission-C0.12 Expected Hedge PriceEHP86.24 Establishes a flat price with basis risk around it. If Futures fall to $80: Cattle are worth $ Futures gain of $5.80 – Com of $.12 If Futures rise to $90: Cattle are worth $90.56 – Futures loss of $4.20 – Com of $.12 In either case the net price is $ /- the change in basis from expected

6 Futures Hedge Futures priceF85.80 Expected basis+B0.56 Commission-C0.12 Expected Hedge PriceEHP86.24

7 Forward Contract v. Futures They look the same on the graph Flat price Difference: Forward contact –Contract with buyer –Must deliver commodity (deliver specs) –Basis is known and no basis risk –No margin calls –Typically flexible sizes

8 Establishes a floor price, but not a ceiling and has basis risk At Futures prices below SP: Net price is the Floor Price because the futures gains off set cash price decline, but subtract premium and commission. At Futures prices above SP: Net price is the cash price minus the premium and commission that have already been paid. Buy Put option Strike priceSP84.00 Premium-P4.65 Expected basis+B0.56 Commission-C0.12 Floor Price: SPp-Pp+B-CFP79.79

9 Buy Put option Strike priceSP84.00 Premium-P4.65 Expected basis+B0.56 Commission-C0.12 Floor Price:FP79.79 P+C Corner at intersection of Strike and Floor Prices

10 Compare Futures hedge to ATM Put Futures has higher net price until the lines cross 45 o line so rise/run = 1. “Rise” is P+C is also “Run” from current futures to the futures price where the lines cross

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12 Livestock Revenue Protection Looks like buying put option on graph Floor price with upside potential Difference: LRP –Is both through insurance agent –Flexible size of contract –Expiration time is fixed –Cannot be resold –Basis is slightly different as is basis risk

13 Livestock Gross Margin Protect a “margin” –Revenue – feed cost – feeder cost –Budgeted quantities and weights –Uses futures prices Focus on profits not price Flexible size Purchased from insurance agents

14 Combination Option Strategies Buy one option and sell another –Income from option sold raises the floor –Get premium, but give up something else Option sellers –Must establish an margin account and will get margin calls if futures price moves against you

15 Fence or Window Strategy Buy PutSPp82.00 Put Premium-Pp3.88 Sell CallSPc90.00 Call Premium+Pc3.35 Net PremiumNP-0.53 Expected basis+B0.56 Commission x 2-2C0.24 Fence Floor: SPp+NP+B-CFF81.79 Fence Ceiling:SPc+NP+B-CFC89.79 In Between: Cash price + NP - 2C, Cash price

16 Buy 82 $3.88 Sell 90 $3.35

17 Put Spread Buy ITM putSPi88.00 ITM Put Premium-Pip6.60 Sell OTM PutSPo82.00 OTM Put Premium+Pop3.88 Net PremiumNP-2.73 Expected basis+B0.56 Commission x 2-2C0.24 Between SPi and SPo = SPi + NP + B – 2C85.60 Above SPi = Cash price + NP – 2C, Cash Below SPo = Cash price + (SPi - SPo)+ NP – 2C Cash = Cash +3.04

18 Buy 88 put at $6.60 Sell 82 Put at $3.88 This not a floor. It is a shelf There is down side risk, but no ceiling and higher over range of prices.

19 Summary Tools are available to include into a well developed marketing plan Tools have different strengths and weaknesses to achieve different objectives Understand the math and basis first Marketing clubs are good ways to learn