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Chapter 10 Understanding and Applying Hedging: Using Futures, Options, and Basis Using Futures, Options, and Basis
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Commodity Futures Exchange A marketplace for persons interested in buying or selling commodities—based on today’s information and the perception of where prices will be in the future. Grew out of: –The need for certain parties to guard against undesired price movements over time –The desire by certain parties to assume the risk of price movements in return for profit
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Purposes of a Futures Exchange A place of price discovery A mechanism for people to transfer cash price risk and uncertainty A place for public access to information for decision making
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Locations of Agricultural Commodity Futures Markets Chicago Board of Trade Chicago Mercantile Exchange New York Board of Trade Kansas City Board of Trade Minneapolis Grain Exchange Also Tokyo, China, Brazil
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Futures Market Terminology
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Futures Contract Terminology Futures contract: –A regulated market mechanism in which sellers and buyers agree to sell/buy a commodity at an explicit price and date in the future. Arbitrage: –Process whereby a commodity is simultaneously bought and sold in two different markets to take advantage of a price discrepancy. Hedging: –Process whereby a person who owns a commodity uses the futures markets to transfer the price risk or to establish a price.
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Cattle Futures Price Quotes— Chicago Mercantile Exchange, July 2005
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Corn Futures Price Quotes— Chicago Board of Trade, July 2005
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Options Contracts Put option: –Gives an individual the right but not the obligation to sell a futures contract at a specified price during a specific time period Call option: –Gives an individual the right but not the obligation to buy a futures contract at a specified price during a specific time period Strike price: –The price at which the futures market can be entered under an option
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Strike Prices Option contracts offer a range of strike prices so purchasers can choose the level at which they may eventually want to take a futures position Terms describe where the strike price is relative to the underlying futures contract price: –In-the-money –At-the-money –Out-of-the-money
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Value of the Option Intrinsic value: value relative to the underlying futures price Time value: reflects time between the option premium quote and contract expiration Option premium: value that a hedger or speculator pays for the right to take a futures position later
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Options Price Quotes (Dec. 2005 futures contract for July 15, 2005)
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Hedging When to hedge: farmer needs to determine what prices he might consider forward pricing, based on enterprise cost of production Placing a hedge: done by placing an order through a broker; traders use open out-calls Hedging costs: commission, initial margin, maintenance margin, margin call
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Information and Futures Price Movements Information and its interpretation by buyers and sellers is basis of futures market movements Fundamental analysis: –Symmetric information –Asymmetric information Technical analysis
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Commodity Basis Difference between a local cash price and the relevant futures contract price for a specific time period Basis = Cash price – Futures price
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Basis Terminology and Movement
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Direction and Impact of Basis Movement for Short and Long Hedger
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Historical and Seasonal Basis Patterns Basis tends to vary within marketing year for grains, oilseed crops, and livestock Understanding seasonal patterns/historical trends helps producers and agribusiness personnel make good forward contracting, hedging, and production decisions Basis trends tend to be consistent over time
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5- and 10-year Averages Soybean Basis (Kansas City, KS)
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Feeder Cattle Basis for Various Weight Categories (Dodge City, KS)
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Using Basis to Predict a Local Cash Price An expected price, where E denotes an expectation and t is the futures contract of interest, is given by: E [Cash price] = [Futures price] t + E [Basis]
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Hedging: Futures Contracts Example: short hedge using live cattle futures with cash price decreasing faster than futures (basis weakens).
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Hedging: Futures Contracts Example: short hedge using live cattle futures with cash price increasing faster than futures (basis strengthens).
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Hedging: Futures Contracts Example: Long hedge using corn futures with cash price increasing faster than futures (basis strengthens).
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Hedging: Futures Contracts Example: Long hedge using corn futures with cash price decreasing faster than futures (basis weakens).
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Hedging: Options Contracts Short-hedge example using corn options: Put: Cash and future prices decrease
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Hedging: Options Contracts Short-hedge example using corn options: Put: Cash and futures prices increase.
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Hedging: Options Contracts Long-hedge example using corn options: Call: Cash and futures prices increase.
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Hedging: Options Contracts Long-hedge example using corn options: Call: Cash and futures prices decrease.
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Class Exercise Find out whether there is a contract for your assigned agricultural commodity. Investigate whether contracts are available in markets around the globe. Discuss –Why contracts do or do not exist –Contract specifications and delivery points
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