managing commodity price risk with futures & options
DESCRIPTION
Managing Commodity Price Risk with Futures & Options. Derivatives. “Derivatives”: contracts that convey the right to buy or sell a commodity on a future date e.g. Futures contracts (“futures”) Option contracts (“options”) Derivatives may be traded on an exchange (ETD) - PowerPoint PPT PresentationTRANSCRIPT
Managing Commodity Price Risk with Futures & Options
Derivatives
“Derivatives”: contracts that convey the right to buy or sell a commodity on a future date
e.g. Futures contracts (“futures”) Option contracts (“options”)
Derivatives may be traded on an exchange (ETD) or “over the counter” (OTC)
ETDs: freely tradeable between market participants
Derivatives
The price/value of a derivative derives from the price/value of the underlying commodity
e.g. The price of a wheat future derives from the price of physical wheat
e.g. The price of a corn option derives from the price of physical corn
Managing Price Risk
“Price risk”: the danger that the price of a commodity (e.g. wheat) will move in an adverse direction
How can price risk be managed?
1.Do nothing!2.Trade futures3.Trade options
Managing Price Risk 1: Do Nothing!
Price risk is a fact of life
Oil, interest rates, wheat, etc.
To do nothing is to take a view …in reality, to speculate
“It all averages out in the long run…” But does it?
Milling Wheat Price 2000 - 2011
€120
€280
€200
Managing Price Risk
“Price risk”…the danger that the price of wheat will move in an adverse direction
How can price risk be managed?
1.Do nothing! 2.Trade futures3.Trade options
Managing Price Risk 2: Trade Futures
Futures contracts (“futures”) traded on exchanges
Agreements to buy/sell a commodity on a future date ...with the price agreed in the present
They are contracts…“paper” trading
Consider NYSE Liffe Milling Wheat Futures
Managing Price Risk 2: Trade Forward
1 NYSE Liffe Milling Wheat Future represents 50 tonnes of Milling Wheat of EU origin
Price is quoted in € and € cents per tonne
Various delivery months are available for trading:Jan, March, May, (Aug), Nov (8 months)
www.nyx.com /liffe
Managing Price Risk 2: Trade Forward
Consider a grower who will be “long” 500 tonnes of wheat at harvest in November 2012 (equivalent to 10 NYSE Liffe Milling Wheat Futures)
The grower would like wheat prices to rise The grower is exposed to wheat prices falling
Open ended risk is unacceptable! Correct futures hedge?
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Hedging Example
Assume: Current date is January 1st, 2012 November 2012 Milling Wheat Futures price is €200
Grower wishes to sell (to regular buyer) 500t of wheat with price to be fixed at time of delivery in Oct 2012
Action: Seller agrees to deliver 500t in Oct 2012 (price to be fixed at time of delivery) and sells (goes short) 10 lots (500t) Nov ‘12 Futures @ €200
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Hedging Example
Wheat price falls between Jan 1st and Oct 2012
In October 2012 (i.e. time of delivery): Nov ‘12 Milling Wheat Futures are priced @ €175
Action: Grower fixes physical contract @ €175 per tonne (i.e. prevailing market price) and buys back
10 lots of Nov Milling Wheat Futures @ €175
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Hedging Example
Outcome:
Price of physical wheat has fallen by €25 per tonne since January1st i.e. a loss to the grower of €12,500 but…
Futures hedge profit = €12,500 i.e. sold 10 Nov Futures on Jan1st @ €200 and bought them back in October @ €175
(10 Futures x 50t x €25 = €12,500)
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Hedging Example
N.B. The futures market was not used to secure physical delivery…
…it was used to secure price
Physical delivery took place through normal channels
Futures markets can be used for physical delivery, but this is a rare occurrence
The future is used simply to hedge price risk
Managing Price Risk 2: Trade Forward
In our example, the loss on the price of wheat falling is offset by a profit on the futures hedge
Price risk is removed... but so is profit potential
The grower’s price is “locked in”: a problem?
Managing Price Risk 2: Trade Forward
Futures/forwards may be used to remove price risk... ...but profit potential is simultaneously removed
Potential problems?
Opportunity cost (“trading backwards”) Competitive advantage/disadvantage Cash flows (margin)
Managing Price Risk
“Price risk”…the danger that the price of wheat will move in an adverse direction
How can price risk be managed?
1.Do nothing! 2.Trade forwards (futures)...if “locking in” is no problem3.Trade options...if “locking in” is a problem
Managing Price Risk 3: Trade Options
Options convey the right but not the obligation to buy (call) or sell (put) futures at a specific price
e.g. The buyer of an NYSE Liffe Milling Wheat Put has the right but not obligation to sell a NYSE Liffe Milling Wheat future at a given price
Managing Price Risk 3: Trade Options
Buying options allows market participants to buy or sell the related futures if they need to...if they want to
Options protect against adverse price movement yet allow profit from beneficial price movement to be retained
Hence options command a price (“premium”)
Key question: is the option price correct?
Managing Price Risk: Summary
Price risk is a fact of life
We can:
1.Do nothing: take a market view2.Trade futures: lock in the current price3.Trade options: be hedged and retain profit potential
Resources
www.nyx.com/liffe : market information & education
Specialist futures & options brokers
A wide range of books & websites