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

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)

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

Spot & Futures ConvergenceMarch Contract

Oct March

Price

Spot

Futures

Basis

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

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

Ontario BasisDecember 2011

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

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

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

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)

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

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

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

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