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Hedging with wheat

futures and options

   
Why Futures and Options Work
Futures Price

Convergence
Time

Cash Price

Delivery

   
How Futures and Options Work

❂ Futures as a temporary substitute for cash


--producers/suppliers can sell futures
before actual cash sale to establish price
--end users can buy futures
before actual cash purchase to establish
price
❂ Options as price insurance
-- premium can be paid to insure
 
against an adverse price
 
move
Futures and Options Comparison
ADVANTAGES
Hedging in Futures Buying Options Writing options
1.Reduces price risk 1.Reduces price risk 1.Generates income
2.Offers marketing 2.Offers marketing from premium
flexibility flexibility received
3.Known cost; risk 2.Offers marketing
limited to premium flexibility
4.Maintains profit
potential
5.No margin account
needed; no margin
calls
6.No further action
required, but may be
offset or exercised if
advantageous

   
Futures and Options Comparison
DISADVANTAGES
Hedging in Futures Buying Options Writing options
1.Margin account 1.Must pay premium 1.Margin account
needed; subject to up front needed; subject to
margin calls 2.Premium may be margin calls
2.Must perform on lost if option expires 2.May be required to
contract or offset worthless perform if option is
3.Profit potential exercised
limited as is loss 3.Risk unlimited if
potential price moves
adversely
4.Profit limited to
premium; no
potential for further
gains from option
position

   
The Short Hedge -
In A Declining Market
Futures Cash
Transaction Transaction
April 15
Sell futures $3.48 -

July 15
Sell cash wheat - $3.29
Buy back futures $3.29 -

Futures profit/
Cash received +.19 3.29

Total Return .19 + 3.29 = $3.48


   
The Short Hedge -
In An Advancing Market
                            Futures Cash
Transaction Transaction
April 15
Sell futures $3.48 -

July 15
Sell cash wheat - $3.60
Buy back futures $3.60 -

Futures loss/
Cash received -.12 3.60

Total Return -.12 + 3.60 = $3.48


   
Producer Hedging At Various Price Levels

Futures Profit/Loss from Proceeds from Net Price Net without


Price Futures Position Cash Sale Received Futures Hedge

$4.00 -.52 +4.00 = 3.48 4.00


$3.75 -.27 +3.75 = 3.48 3.75
$3.48 .00 +3.48 = 3.48 3.48
$3.25 +.23 +3.25 = 3.48 3.25
$3.00 +.48 +3.00 = 3.48 3.00

As the table indicates, the net price received is a constant $3.48. The short hedge protects a
selling price against a declining market, but precludes gains if the market advances. With the
short hedge, additional returns are relinquished to protect an acceptable selling price.

* Note: These examples do not account for basis or commission fees. Hedge results will be
affected by changes in the basis, or the difference between the futures price and the cash price
at a specific location.
   
The Long Hedge -
In An Advancing Market
                            Cash Futures
Transaction Transaction
January 22
Buy futures - $3.60

April 15
Buy cash wheat
(futures price less .20 basis) $3.65 -

Sell Futures - 3.85

Futures profit/ Cash paid $3.65 +.25

  Net Price paid  


$3.65 -.25 = $3.40
The Long Hedge -
In A Declining Market
                            Cash Futures
Transaction Transaction
January 22
Buy futures - $3.60

April 15
Buy cash wheat
(futures price less .20 basis) $3.18 -

Sell Futures - 3.38


Futures loss/ Cash paid $3.18 -.22

Net Price paid $3.18 +.22 = $3.40


    ❂
Elevator Hedging At Various Price Levels

Futures Cash Price Paid - Profit/Loss from Net Price Net without
Price (Futures-Basis) - Futures Hedge Paid Futures Hedge

$4.10 3.90 (+.50) = 3.40 3.90


$3.90 3.70 (+.30) = 3.40 3.70
$3.60 3.40 (+.00) = 3.40 3.40
$3.40 3.20 (-.20) = 3.40 3.20
$3.25 3.05 (-.35) = 3.40 3.05

As the table indicates, the net price paid is a constant $3.40. The long hedge protects a buying
price against an advancing market, but precludes a lower price if the market declines. With the
long hedge, additional gains from lower prices are relinquished to protect an acceptable buying
price.

* Note: These examples do not account for commission fees and assume a constant basis of 20
cents
  under the futures price. Hedge results will be
  affected by changes in the basis. ❂
The Producer: Options Example 1

Option's
Futures Premium Intrinsic Value Net Price Net Price
Cost(bu.) + (Strike-Futures) = Received w/o Option
$3.50 -.10 + .00 = $3.40 $3.50
$3.40 -.10 + .00 = $3.30 $3.40
$3.30 -.10 + .00 = $3.20 $3.30
$3.20 -.10 + .10 = $3.20 $3.20
$3.10 -.10 + .20 = $3.20 $3.10
$3.00 -.10 + .30 = $3.20 $3.00
$2.90 -.10 + .40 = $3.20 $2.90

*Note that the minimum price received with options is equal to the strike price selected less
the premium paid ($3.30-.10=$3.20).
The producer who bought the put has locked in a minimum price of $3.20, but has not
eliminated his potential to gain if prices increase. The producer who does not buy the put
saves the premium cost if prices increase, but has no downside protection.
(This example does not account for basis or commission fees.)
   
The Producer: Options Example 2

Option's

Futures Forward Contract Premium Intrinsic Value Net Price Net Price
Price Price Received -Cost(bu.) +(Futures-Strike) = Received w/o Option
$3.80 $3.30 - .06 + .40 = $3.64 $3.30
$3.70 $3.30 - .06 + .30= $3.54 $3.30
$3.60 $3.30 - .06 + .20 = $3.44 $3.30
$3.50 $3.30 - .06 + .10 = $3.34 $3.30
$3.40 $3.30 - .06 + .00 = $3.24 $3.30
$3.30 $3.30 - .06 + .00 = $3.24 $3.30
$3.20 $3.30 - .06 + .00 = $3.24 $3.30
$3.10 $3.30 - .06 + .00 = $3.24 $3.30

*Note the minimum price with options is equal to the forward contract price less the
premium paid ($3.30-.06=$3.24).
The producer who bought the call has locked in a minimum price of $3.24, but has not
eliminated his potential to gain if prices increase. The producer who does not buy the call
saves the premium cost, but has eliminated his potential to gain if prices increase.
  (This example does not account for basis or commission
  fees.)
The Country Elevator: Options Example

Option's
Futures Premium Intrinsic Value Net Price Net Price
Price +Cost(bu.) -(Futures-Strike) =Paid w/o Option
$3.60 +.20 -.40 =$3.40 $3.60
$3.50 +.20 -.30 =$3.40 $3.50
$3.40 +.20 -.20 =$3.40 $3.40
$3.20 +.20 -.00 =$3.40 $3.20
$3.10 +.20 -.00 =$3.30 $3.10
$2.90 +.20 -.00 =$3.10 $2.90

*Note that the maximum price with options is equal to the strike price selected plus the
premium paid ($3.20+.20=$3.40).
The merchandiser who bought the call has locked in a maximum buying price of $3.40,
but has not eliminated his potential to benefit from price declines. The merchandiser who
does not buy the call saves the premium cost if prices decline, but has no upside protection.
(This example does not account for basis or commission fees.)

   
The Baker: Options Example

Option's Net
Futures Premium Intrinsic Value Inventory Net Value
Price -Cost(bu.) +(Strike-Futures) =Value w/o Option
$3.60 -.10 +.00 =$3.50 $3.60
$3.50 -.10 +.00 =$3.40 $3.50
$3.40 -.10 +.00 =$3.30 $3.40
$3.30 -.10 +.10 =$3.30 $3.30
$3.20 -.10 +.10 =$3.30 $3.20
$3.10 -.10 +.10 =$3.30 $3.10
$3.00 -.10 +.10 =$3.30 $3.00

*Note that the minimum value with options is equal to the strike price selected less the
premium paid ($3.40-.10=$3.30).
The baker who bought the put has locked in a minimum inventory value of $3.30, but
has not eliminated his potential for profit if prices move up. The baker who does not
buy the put saves the premium cost if prices increase, but has no downside protection.
(This example does not account for basis or commission fees.)
   
The Miller: Options Example

Option's
Futures Premium Intrinsic Value Net Price Net Price
Price +Cost(bu.) -(Futures-Strike) +Basis = Paid w/o Option

$3.70 +.19 -.50 +.30 = $3.69 $4.00


$3.60 +.19 -.40 +.30 = $3.69 $3.90
$3.50 +.19 -.30 +.30 = $3.69 $3.80
$3.40 +.19 -.20 +.30 = $3.69 $3.70
$3.30 +.19 -.10 +.30 = $3.69 $3.60
$3.20 +.19 -.00 +.30 = $3.69 $3.50
$3.10 +.19 -.00 +.30 = $3.59 $3.40
$3.00 +.19 -.00 +.30 = $3.49 $3.30
$2.90 +.19 -.00 +.30 = $3.39 $3.20

*Note that the maximum price paid with options is equal to the strike price selected plus
the premium paid, plus the basis ($3.20+.19+.30=$3.69).
The miller who bought the call has locked in a maximum buying price of $3.69, but has
not eliminated his potential to gain if prices decline. The miller who does not buy the
  call saves the premium cost if prices decline, but
  has no upside protection. (This example
does not account for commission fees.)
Individual Considerations

❂ Basis correlation with futures market


❂ Size of operation
❂ Production risks
❂ Storage availability
❂ Personal risk tolerance level

   
Stress-Testing

❂ “What if?” scenarios


❂ “Worst case” scenarios
❂ Range of possible outcomes

   
Kansas City Board of Trade

   

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