Marin BozicUniversity of Minnesota – Twin Cities

Guest Lectures for Cornell University - AEM3040

Dairy Risk ManagementHedging with Options

Volatility vs Risk

Will want to buy the commodity at some point in future

Do not like when price goes up.

Upside risk. Downside potential.

Long futures position.

Have (or will have) a commodity to sell

Do not like when price goes down.

Downside risk Upside potential

Short futures position.

Producers Processors

Risk-Reward Diagram: Unhedged Production

Put Option Contract

Put option gives option contract holder a right, but not the obligation to sell the underlying asset at a pre-negotiated price.

Underlying asset in a case of agricultural commodities is just a futures contract.

Pre-negotiated price is called the strike price.

Like with any insurance contract, policyholder must pay up-front for the privilege of having the insurance policy. That fee is called option premium.

Put Option Contract

Strike Premium$13.00 $0.11$13.50 $0.19$14.00 $0.31$14.50 $0.47$15.00 $0.68$15.50 $0.94$16.00 $1.24$16.50 $1.58

On October 13, 2008, February 2009 Class III Milk Futures Price was $15.31.

Risk-Reward Diagram: Put Option

9.0010.00

11.0012.00

13.0014.00

15.0016.00

17.0018.00

19.0020.00

21.0022.00

23.0024.00

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

10/13/2008:Feb 2009 Class III Milk Futures:

$15.31

Feb '09 Class III Milk Price

Profi

t fro

m h

oldi

ng a

put

opti

on

9.0010.00

11.0012.00

13.0014.00

15.0016.00

17.0018.00

19.0020.00

21.0022.00

23.0024.00

-$2.00

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

Feb '09 Class III Milk Price

Profi

t fro

m h

oldi

ng a

put

opti

onRisk-Reward Diagram: Put Option

Put Premium Paid: $0.68

Put Strike Price: $15.00

Breakeven Point: Strike – Premium = $14.32

Trade-off: Strike vs. Premium

Hedging with Options

Comparing Futures, Options, and Luck

Put Option Contract

Strike price+ Expected Basis ̶ Option Premium_________________Expected Minimum Net Selling Price

Futures + Expected Basis

_______________ Expected Net Selling Price

Using Futures Using Put Options

Put Option Contract

Strike Premium Expected Mailbox Milk Price Floor

$13.00 $0.11 $14.25 $13.50 $0.19 $14.67 $14.00 $0.31 $15.05 $14.50 $0.47 $15.39 $15.00 $0.68 $15.68 $15.50 $0.94 $15.92 $16.00 $1.24 $16.12 $16.50 $1.58 $16.28

On October 13, 2008, February 2009 Class III Milk Futures Price was $15.31. Minnesota Expected Basis: $1.36

2009 Hedging Example (Minnesota)October 13, 2008 February 27, 2009Buy Feb ’09 Class III milk put

with $15.00/cwt strike for $0.68

Announced Class III milk Price @ $9.31/cwt

Expected milk check basis + $1.36 / cwt

Feb Milk Check @ $11.82/cwtRealized basis is +$2.51/cwt

Expected minimum net selling price in February 2009:

Realized net price in February:

$15.00 + $1.36

-$0.68

$15.68

Strike priceexpected basispremium

expected price floor

$11.82+ $5.01

$16.83

cash salenet put profit =Max($15.00-$9.31,0)-$0.68

realized price

2009 Hedging Example (New York)October 13, 2008 February 27, 2009Buy Feb ’09 Class III milk put

with $15.00/cwt strike for $0.68

Announced Class III milk Price @ $9.31/cwt

Feb Milk Check @ $11.72/cwt

Realized net price in February:

$11.72+ $5.01

$16.73

cash salenet put profit =Max($15.00-$9.31,0)-$0.68

realized price

Hedging August 2011 NY Mailbox Milk PriceApril 1, 2011 September 2, 2011Sell Jul’11 Class III milk

contract @ $17.32/cwt July Class III milk contract @

$21.39/cwtExpected Mailbox Milk Price $20.56/ cwt

Expected Basis over Class III Milk: $3.24/cwt

Aug Milk Check @ $21.92/cwtRealized basis is +$0.53/cwt Realized net price in August:

$21.92- $4.07

$17.85

cash salefutures change(sold at $17.32, bought at $21.39)

realized price

2011 Hedging with Puts (NY)April 1, 2011 September 2, 2011Buy Jul’11 Class III milk put

with $17.00 strike for $0.87 July Class III milk contract @

$21.39/cwtAug Milk Check @ $21.92/cwt

Realized net price in August:

$21.92- $0.87

$21.05

cash salePut expired worthless, total cost equal to premium paidrealized price

Call Option Contract

Call option gives option contract holder a right, but not the obligation to buy the underlying asset at a pre-negotiated price.

On Oct 31, 2013, Jan ’14 Class III Milk Futures traded at $17.40. Call premiums were:

Strike Call Premium$17.50 $0.45 $17.75 $0.36 $18.00 $0.29 $18.25 $0.23 $18.50 $0.18 $18.75 $0.14 $19.00 $0.11 $19.25 $0.09

Profit from a long futures position

Profit from a long call position

Protecting the milk purchase price

Reducing Costs of Option Strategies

Puts Calls$13.00 $0.11 $15.50 $0.94$13.50 $0.19 $16.00 $0.55$14.00 $0.31 $16.50 $0.40$14.50 $0.47 $17.00 $0.28$15.00 $0.68 $17.50 $0.20$15.50 $0.94 $18.00 $0.13$16.00 $1.24 $18.50 $0.09$16.50 $1.58 $19.00 $0.06

Date: 10/13/2008Feb ’09 Futures: $15.31

Buy $14.00 put for $0.31Sell $17.00 call for $0.28

Call options: buyers vs sellers

holding options

Pays premium up-front

No margin required.

Can buy a futures contract at the strike price if he so chooses, but he does not have to do it.

selling = writing options

Receives premium up-front

Has to maintain a margin account

Must sell a futures contract at strike price if option holder demands so.

Call option sellerCall option buyer

Short Call Option Position

Reducing Costs of Option Strategies

Reducing Costs of Option Strategies

When Should I Hedge?

Consider this simple risk management program:

• Buy Class III Milk puts consistently, do not try to guess what the price will do next

• Never spend more than 50 cents on a put

Let us evaluate three strategies:1) Always buy puts for milk produced THREE months from now

E.g. in January 2013 hedge April milk, in February hedge May milk, etc.

2) Always buy puts for milk produced SEVEN months from nowE.g. in January 2013 hedge August milk, in February hedge

September milk, etc.3) Always buy puts for milk produced ELEVEN months from now

E.g. in January 2013 hedge November milk, in February hedge December milk, etc.

When Should I Hedge?

Hedging Horizon

What Can You Buy for 50 cents? (Option Strike)

1 month 5 cents below futures 3 months 64 cents below futures5 months 1.08 below futures7 months 1.44 below futures9 months 1.74 below futures

11 months 2.08 below futures

Hedging with Puts: 3-Months Out

Hedging with Puts: 7-Months Out

Hedging with Puts: 11-Months Out

A Simple Hedging Program with Puts

Hedging Horizon

Number of Profitable

TradesNet Profit/Loss

2007-2012Return on

Investment2007-2012

1 month 16/74 -0.14 -41%3 months 21/74 0.06 13%5 months 19/74 0.21 46%7 months 15/74 0.24 52%9 months 09/74 0.26 57%

11 months 10/74 0.33 73%

Why Does this Work?

Why Does this Work?

Why Does this Work?

Lessons Learned?

• Either hedge consistently or not at all.

• Plan for hedging far ahead. When prices decline, they tend to stay low for a while. If you wait for too long, the opportunity to lock in good prices may be gone.

• You are likely to lose money on most of your trades. That’s OK. That does not mean that the market is full of crooks. It means that bad times come around infrequently, but when they do come, you will get back plentifully.