2. Copyright © 2005 JSE Limited The Agricultural Products Division of the JSE Agricultural Derivatives 101

3. Copyright © 2005 JSE Limited 2.2. Agriculture in South Africa 3,5 – 4,0% contribution to GDP (but 40% of population dependant on agriculture) 10% of South African exports (by value) Major agric export earner = sugar (maize, wine, fruit) Farmers:50 000 commercial 240 000 small scale farmers 3m subsistence farmers 13% of South Africa is arable land (only 20% is high potential) Major limiting resource is WATER RSA = 6% of African population 4% of African land area 25 – 30% of maize produced in Africa 10% of wheat produced in Africa 50 – 60% of maize produced in SADC

4. Copyright © 2005 JSE Limited 3.3. Agriculture in South Africa 1930 – early 90’s Regulated Marketing Centralized marketing Centralized price determination 1995Agricultural market deregulated Control Boards / Marketing Boards scrapped NO centralized price determination

5. Agricultural marketing in South Africa is a whole new ball game in a deregulated market place

6. Agricultural marketing in South Africa is a whole new ball game in a deregulated market place

7. Copyright © 2005 JSE Limited 6.6. Agricultural Markets Regulated Advantages:No price risk Information supply Disadvantages:Cost to economy Distortion to economy Free Market Disadvantages:Price Risk Information Unfair Competition Advantages:Opportunities Economic Basis

8. Copyright © 2005 JSE Limited 7.7. Challenges of the Free Market Unfair Competition – not level playing field One sided – inputs / outputs (no link) Requires decisions Requires sourcing and interpretation of information Does not respect tradition or history Makes use of technological progress

9. Copyright © 2005 JSE Limited 8.8. Background to Derivatives Mesopotamia, China, France, USA - agriculture Fluctuating Prices depending on supply and demand of product Forward Contracts Standardized Forward Contracts to facilitate trading Add guarantee to the market Futures Contracts Financial Markets

10. Copyright © 2005 JSE Limited 9.9. A futures market is... A trading operation that provides market participants with a price determination mechanism and a price risk management facility through which they can manage their exposure to adverse price movements on the underlying physical market and where performance by both counterparties to the contract is guaranteed

11. Copyright © 2005 JSE Limited It is NOT a “get rich quick” scheme

12. Copyright © 2005 JSE Limited …. it is to avoid losing money!

13. Copyright © 2005 JSE Limited 12. The Agricultural Derivatives Market in South Africa Establishment of the South African Futures Exchange (SAFEX) in 1988 to trade financial derivative instruments Establishment of the Agricultural Markets Division of SAFEX in 1995 separate membership start-up capital raised by the issue of seats Initial futures contracts (chilled beef and potatoes) not successful White and yellow maize contracts listed in 1996 August 2001 - became Agricultural Products Division of the JSE Securities Exchange South Africa Presently trade maize, wheat, sunflower seeds and soyabean futures and options contracts Recognised as the price discovery facility for grains in South and Southern Africa

14. Copyright © 2005 JSE Limited futures contracts..... standardised agreement through exchangestandardised agreement through exchange (product, quality, quantity, time & place) indirect locked-in priceindirect locked-in price physical delivery not impliedphysical delivery not implied profit / loss profile exactly opposite to physical marketprofit / loss profile exactly opposite to physical market basis riskbasis risk margins payablemargins payable

15. Copyright © 2005 JSE Limited WHY use a futures market ?..........for two very good reasons ! price determination price determination and and price-risk management price-risk management

16. Copyright © 2005 JSE Limited 15. Maize Price determinants South African Demand and Supply - role of weather - input suppliers - crop estimates committee Regional Demand and Supply - actual economic demand ? International Demand and Supply Exchange Rates

17. Copyright © 2005 JSE Limited Price determination...... futures exchanges do not set prices,futures exchanges do not set prices, they are free markets where the forces that influence prices, notably supply and demand, are brought together in a transparent way. they are free markets where the forces that influence prices, notably supply and demand, are brought together in a transparent way.

18. Copyright © 2005 JSE Limited How are prices determined? by brokers representing clients who trade on a trading floor (pit) or electronically on a trading screen - the trading screen reflects the best bids (highest) and offers (lowest).

20. Copyright © 2005 JSE Limited 19. July 04 White Maize

21. Copyright © 2005 JSE Limited 20. July 05 White Maize Realization of large carry over and good planting possibilities Possibility to lock in prices of +/- R1000/t

22. Copyright © 2005 JSE Limited 21. July 06 White Maize Where to next ??

23. Copyright © 2005 JSE Limited 22. SAFEX nearby White Maize (R/t) since 1998

24. Copyright © 2005 JSE Limited Price-risk management instruments.. state intervention state intervention hold physical stocks hold physical stocks forward contracts futures contracts futures contracts options options

25. To hedge or not to hedge, that is the question! Whether it is better for farmers in the production of maize to suffer the ups and downs of outrageous maize prices, or to take precautions against a sea of uncertainty and by managing price risk, end the uncertainty. RMGB (with apologies)

26. Copyright © 2005 JSE Limited 25. Guarantee in Market Structure of the market Margin Payments - initial margin - variation margin

27. Copyright © 2005 JSE Limited Clearing Member Broker Trade Broker Client A Client X Client B Client Y Client C Client Z Clearing House Structure of the Exchange

28. Copyright © 2005 JSE Limited 27. Margin Flows DateContract Contract Action Seller’s Buyer’s price value acc. acc. 8/3 R550 R55000 init. margin R10000 R10000 11/3 R545 R54500 var. margin R10500  R500  R10000 (R500) 12/3 R547 R54700 var. margin R10300  R200  R10200 15/3 R540 R54000 var. margin R11000  R700  R10000 (R500) 17/3 R520 R52000 var. margin R13000  R2000  R10000 (R2000) 18/3 R510 R51000 var. margin R14000  R1000  R10000 (R1000) Seller receives margin R10000 plus profit R4000 (R550-R510 x 100) from the futures market and R510/t from the physical market. Buyer receives margin R10000, but has lost R4000 (which as a hedger will be compensated for by a lower physical purchase cost: R510/t).

29. Copyright © 2005 JSE Limited...... by using the futures market individuals, companies or countries selling or buying a commodity can protect themselves against price movements in the underlying physical market. This is achieved by selling or buying futures or options contracts through a broker who is a member of the futures exchange.

30. Copyright © 2005 JSE Limited 29. Requirements for a Successful Agric Futures Market Liquidity in underlying spot market (volume of production, multiple buyers and multiple sellers) Commodity must be able to be standardized Price must be volatile (must be a need for price risk management) No state intervention in the price making mechanism Guaranteed contract performance (clearing & financial system) Deliverability (infrastructure / grading regulations / warehouse receipts)

31. Copyright © 2005 JSE Limited 30. Growth of the Market...

32. Copyright © 2005 JSE Limited 31. Total contracts traded – futures and options

33. Copyright © 2005 JSE Limited Physical delivery in completion of a futures contract….

34. Copyright © 2005 JSE Limited 33. Delivery starts at the silo ….

35. Copyright © 2005 JSE Limited 34. Why allow for physical delivery on the futures market. no underlying cash market to base prices off –therefore no cash index available to settle the futures contract guaranteed delivery to the buyer of a Safex silo receipt representing good delivery guaranteed payment to the seller standardisation of the contract is required (quantity, quality, place, storage)

36. Copyright © 2005 JSE Limited 35. physical delivery is a two day process on Safex, first the notice day followed by the delivery day delivery can take place anytime during the delivery month ie May commodity is deliverable all months of the year, five main hedging months with the remainder as constant delivery months short position holder gives notice any time during the delivery month long position holder is randomly allocated commodity as deliveries are received Delivery onto Safex….

37. Copyright © 2005 JSE Limited 36. DECEMBER 2004 30 1 31 21

38. Copyright © 2005 JSE Limited 37. Initial margin requirements Contracts traded before delivery require R10000 for white and yellow maize, Extended price limits margins increase on the first delivery day margins move to R13000 per contract and price limits removed, from last trading day to expiry, margins are increased to R23000 per contract,

39. Copyright © 2005 JSE Limited 38. A short futures position is required in the particular delivery month before any notice can be tendered Short position holder tenders notice through his broker –the following information is required silo receipt number quantity location date storage is paid to Delivery notice is faxed/emailed to Safex before 12h45 on notice day Detail required for delivery…

40. Copyright © 2005 JSE Limited 39. Copy of a delivery notice

41. Copyright © 2005 JSE Limited 40. Copy of a assignment notice

42. Copyright © 2005 JSE Limited 41. broker will deliver silo receipt by 12h00 on the delivery day silo receipt has to be signed off payment is finalised by 12h00 on delivery day buyer’s broker can pick up silo receipt from 14h00 on delivery day initial margin to both buyer and seller will be returned the following day Settlement as follows…

43. Copyright © 2005 JSE Limited 42. Lets step outside for some refreshments…..

44. Copyright © 2005 JSE Limited Welcome back ! Lets look at your “OPTIONS”

45. Copyright © 2005 JSE Limited 44. DUCK or DIVE Hope you’ve taken out travel insurance !

46. Copyright © 2005 JSE Limited Price-risk management instruments.. state intervention state intervention hold physical stocks hold physical stocks forward contracts futures contracts futures contracts exchange traded options exchange traded options

47. Copyright © 2005 JSE Limited 46. PRICE RISK OPTIONS….another type of insurance! Fire DroughtFloods Hail

48. Copyright © 2005 JSE Limited Futures vs Options as a buyer, fundamentally different risks buyer and seller of futures assume the same risk, and face a legally binding obligation – margin requirements seller of an option has legally binding obligation if the option is exercised buyer of an option has no legally binding obligation, BUT to pay for the option (premium) the most a buyer of an option can lose is the price paid for the option (the premium agreed on) the seller of an option is potentially exposed in the same fashion as a futures contract (variation margin)

49. Copyright © 2005 JSE Limited 48. willing buyer\willing seller Two types of options: –PUT options (floor price insurance) A farmer would buy this instrument –CALL options (ceiling price insurance) Millers interested in this insurance

50. Copyright © 2005 JSE Limited 49. Buying floor price insurance…. as a buyer of floor price insurance (PUT options) you buy the RIGHT but not the obligation to sell maize at an agreed floor price a seller of PUT options is OBLIGATED to buy your product should you exercise your right the PUT option trade involves a willing buyer\willing seller at an agreed premium for a specific strike price the buyer can exercise the right to sell maize at any time (American style options) the buyer pays premium (negotiated on market) seller receives the premium, but is margined by the exchange to make sure that he can meet his commitment

51. Copyright © 2005 JSE Limited 50. Option terms ? Premium- the price you agree to pay for an option Strike price the price at which you buy or sell the product will be in R20 price intervals for APD Volatility in simple terms it’s a measure of how fast or slow the market is moving over a given time period regardless of direction. In other words it tells what the probability is of a price occurring within a certain time period

52. Copyright © 2005 JSE Limited 51. in-the-money: option which is made up of both time and intrinsic value. In the case of a put the strike price is above where the market is trading at-the-money : the premuim consists of time value and the strike price is near to the current trading levels out-the-money :the premium is entirely time premium. With puts the strike price is below the market trading levels When is your option worth something ?

53. Copyright © 2005 JSE Limited 52. Illustration for Put Options 800 PutIn the money by R180 720 PutIn the money by R100 Current market trading at R620 620 PutAt the money 580 PutOut the money by R40 400 PutOut the money by R220

54. Copyright © 2005 JSE Limited 53. The higher the floor price you want the more it will cost you Premium costs

55. Copyright © 2005 JSE Limited 54. An producer example..no 1 Farmer Brown would like to manage his price risk using Put options: –He buys a JulWMAZ 700 Put for R60 in Dec the previous year –In June when the option contract expires, the underlying market is trading at R900….. The put option expires worthless and he sells his maize at R900 less the premium cost of R60, therefore R840 Safex price, after hedging he still makes an additional R140

56. Copyright © 2005 JSE Limited 55. An producer example..no 2 Farmer Brown would like to manage his price risk using Put options: –He buys a JulWMAZ 700 Put for R60 in Dec the previous year –In June when the option contract expires, the underlying market is trading at R700….. The put option expires at the money and no option is automatically exercised. He can sell his maize in the cash market for R700 less the premium cost of R60, therefore R640 Safex price as per his original hedge price

57. Copyright © 2005 JSE Limited 56. An producer example..no3 Farmer Brown would like to manage his price risk using Put options: –He buys a JulWMAZ 700 Put for R60 in Dec the previous year –In June when the option contract expires, the underlying market is trading at R500….. The put option expires in the money by R200, he exercised his option and sells his maize at R700 less the premium cost of R60, therefore attaining the R640 Safex price, by hedging he has achieve a price which is R200 better then no hedge at all

58. Copyright © 2005 JSE Limited 57. Buying options to manage price risk can only result in a win-win situation, once you have decided on the relevant strike price and paid the premium, if it expires in the money you have read the market well and reap the rewards, if it expires out the money you lose the premium but can sell your product at a higher market price CJS (with sincere apologies)

59. Copyright © 2005 JSE Limited 58. Buying ceiling price insurance…. as a buyer of CALL options you buy the RIGHT but not the obligation to BUY maize at an agreed ceiling price a seller of CALL options is OBLIGATED to sell you product should you exercise your right the CALL option trade involves a willing buyer\willing seller at an agreed premium for a specific strike price the buyer can exercise the right to BUY maize at any time (American style options)

60. Copyright © 2005 JSE Limited 59. Illustration for Call Options 400 CallIn the money by R220 560 CallIn the money by R80 Current market trading at R620 620 CallAt the money 700 CallOut the money by R80 780 CallOut the money by R160

61. Copyright © 2005 JSE Limited 60. The lower the ceiling price, the higher the price (premium) of the option

62. Copyright © 2005 JSE Limited 61. WITH THE HELP OF A REGISTERED JSE AGRICULTURAL BROKER, BE GUIDED TO MAKE THE RIGHT DECISIONS !

63. Copyright © 2005 JSE Limited 62. Failure is an opportunity to begin again, more intelligently – Henry Ford