1. Price Risk Management Jim Dunn Penn State University

2. Options AG BM 102

3. Introduction Often farmers want protection against bad prices but to enjoy good prices – i.e., one- way protection Options do this Essentially an insurance policy against bad prices

4. Option - The right, but not the obligation, to either make or take future delivery on a commodity.

5. Put The right to sell a futures contract during a fixed time period for a fixed price. Useful to protect a corn farmer against lower corn prices.

6. Call The right to buy a futures contract during a fixed time period for a fixed price. Useful to protect a hog farmer against higher corn prices.

7. Strike Price The price at which a put or a call may be exercised.

8. Premium The cost of buying a put or a call. This payment goes to the seller for providing the price insurance.

9. Advantages of Options Protection against lower prices (for someone buying a put), while allowing farmer to receive high prices if they occur. Liquidity Low Transaction Costs

10. Disadvantages of Options Higher costs for protection than futures Delivery locations in Midwest Quantity fixed at a level that may not suit you Quality fixed at a level that may not suit you Contract expiration fixed at a time that may not suit you Lock in price that may be bad, looking back

11. Options Insurance against price risk Put – insurance against low prices Call – insurance against high prices Pretty expensive Allow you to enjoy favorable price changes but not suffer from unfavorable price changes No margin calls Basis risk remains

12. You are a corn grower and will be selling corn in December 2016

13. An Options Example - put Now Dec futures $4.00 Buy a Dec 16 put $3.60 put for 0.16/bu. This establishes a floor of about $3.60 -$0.16premium -$0.01comm. +$0.23basis $3.67 In December, futures is $3.25 and local cash is $3.45 Sell corn for $3.45 Sell put for $0.35 Profit from put $0.18 Net from corn $3.45 $0.18 $3.63

14. How this works If price falls, floor price is engaged If price rises, put becomes worthless Only risk is basis value Insurance is expensive

15. Calls The right to buy a futures contract during a fixed time period for a fixed price. Useful to protect a hog farmer against higher corn prices.

16. You are producing hogs and need to buy corn to feed in May 2016

17. An Options Example -call Now May 16 futures $3.88 Buy a May 16 call $4.00 call for 0.18/bu. This establishes a floor of about $4.00 +$0.18premium +$0.01comm. +$0.35basis $4.54 In May, futures is $4.60 and local cash is $5.00 Buy corn for $5.00 Sell call for $0.60 Profit from call $0.41 Net cost of corn $5.00 -$0.41 $4.59

18. Risk Management Having no plan is a decision – but not a good one Especially if you have debts, or large financial obligations You can develop a plan, and institute it, and concentrate on your farming Farms go out of business because of high costs, low revenues, and unforeseen events Some of this is not understanding costs or risk management well