Managing Commodity Price Risk Using Hedging and Options
Table of Contents
IntroductionThis Factsheet provides an overview of commonly-used price risk management tools as well as concise and easily understandable definitions of terms used by those providing risk management advice. Purpose of Futures MarketsFutures markets are price discovery and risk management institutions.
In futures markets, the competing expectations of traders interact to
"discover" prices. In so doing, they reflect a broad range of
information that exists on upcoming market conditions. Futures markets
are actually designed as vehicles for establishing future prices and managing
risk so you can avoid gambling if you want. For example, a wheat producer who plants a crop is, in effect, betting that the price of wheat won't drop so low that he would have been better not to have planted the crop at all. This bet is inherent to the farming business, but the farmer may prefer not to make it. The farmer can hedge this bet by selling a wheat futures contract. ContractsFutures contracts are sometimes confused with forward contracts. While similar, they are not at all the same. Forward ContractsA forward contract is an agreement between two parties (such as a wheat farmer and a cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (cereal manufacturer) a specified quantity and quality of wheat at a specified future date at an agreed-upon price. It is a privately negotiated contract that is not conducted in an organized marketplace or exchange. Both parties to a forward contract expect to make or receive delivery of the commodity on the agreed-upon date. It is difficult to get out of a forward contract unless the other party agrees. All forward contracts specify quantity, quality and delivery periods. If any of these conditions are not met, the farmer will usually have to financially compensate the buyer. It is essential you understand your legal obligations before entering into a forward contract in case you cannot meet the conditions of the contract. Futures ContractsFutures contracts, while similar to forward contracts, have certain features that make them more useful for risk management. These include being able to extinguish contract obligations through offsetting, rather than actual delivery of the commodity. In fact, very few futures contracts are ever delivered upon. Futures contracts are traded on organized exchanges in a variety of commodities (including grains, livestock, bonds and currencies). They are traded by open outcry where traders and brokers shout bids and offers from a trading pit at designated times and places. This allows producers, users and processors to establish prices before commodities are traded. Futures prices are forecasts that can and do change according to a variety of reasons, such as crop or weather reports. TradersThere are basically two types of traders: hedgers and speculators. Hedgers are people who produce, process or use commodities and want to reduce their price risk or establish prices for commodities they will trade in the future. Speculators are people who attempt to profit through buying and selling, based on price changes, and have no economic interest in the underlying commodity. Futures contracts have standardized terms established by the exchange. These include the volume of the commodity, delivery months, delivery location and accepted qualities and grades. The contract specifications differ, depending on the commodity in question. This standardization makes it possible for large numbers of participants to trade the same commodity, which also makes the contract more useful for hedging. Trading Gains and LossesIt helps to study speculation first - trading futures without an interest in the underlying commodity - in order to understand hedging. Example September corn is trading at $3.50/bu, but you believe the price will be lower than this in September. You might take a "short position" (sell futures), and if the price falls, profit from offsetting with a "long position" (buying back futures): Date May 7 Position Short (sell) Sept corn @$3.50/Bu Date May 27 Position Long (buy) Sept corn @$3.25/Bu Profit $0.25/Bu However, if prices rise, you would lose when you offset the position: Date May 7 Position Short September corn @ $3.50/Bu Date May 27 Position Long September corn @$3.60/Bu Loss $(0.10)/Bu Speculating is gambling; trading action either generates an absolute
loss or an absolute gain. Hedging, in contrast, creates price stability. Trading on MarginTo trade futures positions, financial capital must be in place with the exchange and with a broker. However, only a small portion of the value of the position being traded is required. For example, if soybeans are trading at $7.00/Bu, the total value of a 5,000-bushel contract is $35,000, but only a small portion of this value must be in place to begin trading (typically between 2% and 10% of the total value of the contract). Futures trading is conducted using a margin account. An important implication of trading on margin is that losses against trading positions must be covered on a dollar-for-dollar basis by the trader. A futures trader entering into a futures position is required to post an initial margin amount specified by the exchange. Thereafter, the position is "marked to the market" daily - that is to say, if the futures position loses value, the amount in the margin account will decline accordingly. If the amount of money in the margin account falls below the specified maintenance margin (which is set at a level less than or equal to the initial margin), the futures trader will be required to post additional variation margin to bring the account up to the initial margin level. On the other hand, if the margin position is positive, this amount will be added to the margin account. It is important to understand the impact that these margin calls can have on cash flow as they are assessed daily. If the margin level falls below the maintenance margin, the trader must top up the account immediately to avoid losing the futures position. It is important that lenders and financial managers are aware of the potential cash flow commitments that can result. Even futures trading that eventually generates a profit can accrue significant cash obligations for margin servicing over the life of the position. Basis
|
||||||||||||||||||||||||||||||||||||||||||
| May |
$3.55
|
Short @ $3.50 |
| November |
$3.05
|
Long @ $3.00 |
| Profit |
|
$.50 |
| Net Price |
$3.55
|
Long Hedging
A person who does not now own the cash commodity but will require it in the future has the risk that the price will increase. Buying futures (long hedge) can mitigate this risk. A long hedge protects the hedger from a rise in price.
Examples of long hedgers:
- A food manufacturer, who will need product in the future, doesn't own it now but wants to price it now.
- A processor who has offered to price product forward based on current ingredients prices but doesn't own it now.
The risk here is that the price will rise before delivery.
Long Hedge Example
Alternatively, a flour miller is concerned about the risk of wheat price increases for wheat to be purchased in November. Wheat futures for December delivery are currently trading at $4.20/Bu, and the typical basis at the miller's location is $0.15 over futures. The miller hedges this risk by taking a long position (buying) the December wheat future at $4.20. In November, the futures price has increased to $4.40, and wheat is selling locally for $4.55. The miller lifts the hedge by selling back the futures position at $4.40, resulting in a profit of $0.20/Bu This profit is then applied to the cash purchase cost of $4.55/Bu, resulting in a net cost of $4.35, which is the price expected when the hedge was placed.
| Date | Cash | Futures |
|---|---|---|
| August |
|
Long @ $4.20 |
| November |
$4.55
|
Short @ $4.40 |
| Profit |
|
$.20 |
| Net Price |
$4.35
|
In both of these examples, the basis component of pricing did not change. In practice, basis can be variable, but this variation is small, relative to that in the futures price. The basis risk cannot be protected through hedging.
What makes hedging work is the fact that cash and futures prices converge at the delivery point - when one goes up, the other goes up as well.
The hedger takes an equal but opposite position in the futures market to the one held in the cash market to avoid the risk of an adverse price move. However, by doing this, the hedger forfeits any advantage of a cash price improvement.
Options
Options are like insurance - you can cash them in when bad things happen (such as a drop in futures price) but you don't collect when good things happen (such as a rise in futures price). You are paying someone to take on your futures risk.
There are two types of options: put and call.
The put option sets a minimum price for the contracted amount of grain or livestock. This gives the buyer the right but not the obligation to take a short position in the underlying futures at a specific price (called the strike price) within a specified time period.
When a farmer buys a put option, for a premium, there is the option to sell or go short on a specific futures market contract if the price of that contract falls below the strike price. The strike price level, less the premium for the put option, establishes the minimum price the farmer will receive for the contracted commodity.
The call option sets a maximum price for the contracted
amount of grain or livestock. This gives the buyer the right but not the
obligation to take a long position in the underlying futures at the strike
price within a specified time period.
When the farmer buys a call option, for a premium, there is the option to buy or go long on a specific futures market contract if the price of that contract rises above the strike price. The strike price level, less the premium for the call option, establishes the maximum price the buyer will pay for the contracted commodity.
Once an option has been purchased, the buyer (holder) has three alternatives. First, the option can be allowed to expire. Second, the option can be sold to someone else or offset; the original buyer, by selling to a third party, has transferred his rights to that party. Third, the option can be exercised, essentially demanding that the seller provide the underlying futures position.
Options are not purchased on margin; one advantage is not having to make margin calls when the market moves. For example, with a put option, you are protected against the downside but get the benefit of the upside in prices. The perceived benefit of this is dependent on the premium paid.
Premium Values
The option premium is the price that the option trades for. This is determined through competitive bids and offers, but two key considerations guide this process.
The first is intrinsic value, which refers to how profitable an option would be if it were executed. The option profitability is measured by comparing the strike price to the current price of the underlying futures contract.
The second is time value. As the perceived price volatility increases and/or if the time to expire is longer, the value of an option increases. It is a combination of these two factors that determines the premium on the option.
Hedging with Options
Hedging with options is similar to hedging with futures. The main difference is that options are purchased and resold, with the gain in the option value used to offset negative price risk. When futures are used to hedge, it is the change in the value of futures prices directly that generates gains or losses that mitigates price risk.
Conclusion
This Factsheet provides a basic overview of the commodity price risk management tools and terminology. It is not meant to be the only source of information. Anyone planning on using futures as a business risk management tool is encouraged to take a commodity-marketing course and to use the services of a professional futures broker.
Resources
Chicago Board of Trade - www.cbot.com
Chicago Mercantile Exchange - www.cme.com
ICE Futures Canada (ICE) - www.theice.com/homepage.jhtml
DTN - www.dtn.com
George Morris Centre - www.georgemorris.org
Farms.com - www.farms.com
Canadian Farm Business Management Council - www.farmcentre.com
Ontario Ministry of Agriculture, Food and Rural - www.ontario.ca/agbusiness
For more information:
Toll Free: 1-877-424-1300
Local: (519) 826-4047
E-mail: ag.info.omafra@ontario.ca