chap 15 - hedging and risk farming & risk (quantity, quality, price) hedging transfer of risk to...
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Chap 15 - Hedging and Risk
Farming & Risk (quantity, quality, price)
Hedging transfer of risk to a counterparty (incomplete)
similar to insurance
cost - margin account, brokerage fees
weather & pests > crop insurance
price > forward or futures contract
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Example: Perfect Short Hedge
Simplifying Assumptions:
October - post harvest; crop in storage (long physical corn)
Return to storage = f(spot sale in May)
Target return to storage = $0.25/bu (October to May)
Current spot price = $3.50 spot market = delivery point
Current May futures = $3.75
Return to storage = $0.25 (expected)
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The Short Hedge
October: SELL May contract @ $3.75
May: May Futures and May Spot price (rises) = $3.75
SELL (deliver) Physical corn @ $3.75
Futures contract satisfied
Return to storage = $0.25 = Target return
Spot and Futures Convergence at contract expiry
Arbitrage between spot and futures
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Spot & Futures ConvergenceMarch Contract
Oct March
Price
Spot
Futures
Basis
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The Hedge: Prices Change
October: SELL May contract @ $3.75
Assume: Unexpected large crop in Argentina
Lower cash price in May = $3.60
Farmer still protected (October cash price = $3.50)
May: BUY May contract @ $3.60 NET = $ 0.15
SELL physical corn @ $3.60 NET = $ 0.10
Return to storage = $ 0.25
The Result:
The same regardless of price increase or decrease
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Hedging & the Basis
Space: Local Spot Price ≠ Delivery Point Spot Price
Basis: Price difference between two locations in
Space OR Time OR Both
Basis = cost of transfer (transport + storage + insurance etc.)
Bt = Ft - Pt Current May Futures - Current Local Spot Price
Successful Hedge <= Basis now vs Basis in May (time of delivery)
Time: Current local Price ≠ Current May Futures Price
Perfect Hedge <= Basis now = Basis in May
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Ontario BasisDecember 2011
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Hedging, the Basis & the Return to Storage
Result: Actual return to storage > or < anticipated return
Generally: The basis is not stable over time
Cash Market (physical) Futures Market
NOW: BUY/OWN Corn @ P1 SELL May Futures @ F1
MAY: SELL Corn @ P2 BUY May Futures @ F2
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Hedging, the Basis & the Return to Storage
Return to storage = (P2 - P1) + (F1 - F2)
Buy LOW and Sell HIGH in both markets
Return = (F1 - P1) - (F2 - P2) = B1 - B2
B1 > B2 => Positive Return
B1 < B2 => Negative Return
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Hedging: Using Futures to Target Price
Solution: Use futures to “price” the crop & profitability
Problem: Pre-planting, farmers need to “price” the future crop
Futures provide “price discovery”
Banks want insurance against loan to farmer
Locked in Price => less bank risk
Planting Decision: Hedged or not – it is a commitment to sell
Not using futures/forward = Speculation
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Futures & the Pre-Plant Decision
Cash return: (P2 - C1) C1 = Cost of production
Futures return: (F1– F2) Sell - Buy
Profit = Returns in Cash and Futures Markets
Total Return = (P2 - C1) + (F1 – F2)
= F1 – ((C1 + (F2 – P2))
= (F1 – C1) - B2
Anticipated Return – Basis @ delivery + BUY offset
Complication – Anticipated yield ≠ Actual yield (uncertain)
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Futures & the Pre-Plant Decision
Cash return: (P2 - C1) = ($5.25 - $4.00) = $1.25
Futures return: (F1– F2) = ($5.00 - $5.25) = - $0.25
Profit = Cash Return + Futures Return
Total Return = $1.00 above cost of production
$5.00/bu
Rising Futures & Spot Price
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Futures & the Pre-Plant Decision
Cash return: (P2 - C1) = ($4.25 - $4.00) = $0.25
Futures return: (F1– F2) = ($5.00 - $4.25) = $0.75
Profit = Cash Return + Futures Return
Total Return = $1.00 above cost of production
Falling Futures & Spot Price
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Speculative SpreadAcross Delivery Months
Principal => Buy LOW, sell HIGH
Spread => Trade commodity across different delivery months
Arbitrage the price spread
NOW: BUY May SELL Sept B1
LATER: SELL May BUY Sept B2
May too LOW & Sept too HIGH ? => Basis too big ?
RETURN: Profit (loss) on MAY & SEPT Contracts
π = B1 - B2
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Speculative StraddleAcross Commodities
Principal: Act on abnormal price relationship between commodities
Wheat vs corn
NOW: BUY wheat & SELL corn B1
LATER: SELL wheat & BUY corn B2
Wheat too LOW relative to Corn? => Basis too small ?
RETURN: Profit (loss) on wheat & corn contracts
π = B2 - B1