Agricultural Futures and Options Key Terms

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Agricultural Futures and OptionsKey Terms

• ISQA 458/558 Food Logistics
• 12 April 2005

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Futures Contract

• Commitment to make or take a specific quality of
  a commodity (e.g. 2 yellow corn) and specific
  quantity at a predetermined time and place in the
  future
• Only variable is price.
• Deliveries on futures contracts occur lt1 of time

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Commodity Broker

• If you are not a member of the CBOT, you must
  place trades through a commodity broker, who
  calls in orders to the exchange and earns a
  commission in return.

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Hedge

• A counterbalancing investment that involves
  taking a position in the futures market that is
  opposite ones position in the cash market to
  protect or lock in a price.
• Hedging is effective only if cash and futures
  markets generally move in tandem with each other.
  
• Hedgers generally use the futures contract that
  immediately follows the time they plan to
  purchase or sell the physical commodity.

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Perspectives On Hedging

• Tony Flagg, former president of Pendleton Flour
  Mills noted by definition a farmer and a
  consumer cannot hedge. He said that hedging is a
  tool used by middlemen, who take a risk and then
  offset it.

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CBOT Has More Expansive View Of Hedging

• Farmers hedge to protect against declines in
  prices for crops that are in the ground.
• Merchandisers, elevators hedge their profit
  margin on grains that they buy and later sell or
  sell and later buy.
• Processors and livestock producers hedge to
  protect against increasing raw material costs or
  against decreasing inventory values.
• Exporters hedge to protect the cost of materials
  that they have contracted to sell at a later
  date.

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Other Definitions

• Speculator Buy or sell futures in order to make
  a profit on the transaction itself.
• Short hedge uses a short futures position to
  protect against falling commodity prices.
• Long hedge uses a long futures position to
  protect against increasing commodity prices.

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Other Definitions

• Basis Difference between the cash and futures
  price. The difference is comprised of variables
  including freight, local supply and demand, as
  well as storage and handling costs
• Strengthening basis cash prices increase
  relative to futures price
• Weakening basis cash price weakens relative to
  futures price
• Flat Price Futures price basis.

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Other Definitions

• Option is the right not an obligation to buy or
  sell a futures contract at a predetermined price
  (strike price) at anytime within a specified time
  period.
• Cost of option the option premium
• Enables sellers to establish floor (i.e. minimum)
  selling prices for protection against falling
  markets without giving up upside potential in
  rising markets
• Buyers can establish ceiling (maximum) purchase
  prices for protection against rising markets
  without giving up savings opportunities in
  falling markets.

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Other Definitions

• Call option right to buy underlying futures
  contract.
• Put option right to sell underlying futures
  contract.
• Option writer individual who sells either a put
  or call option in exchange for collecting
  premium. In exchange for premium, writer bears
  risk of margin calls and unlimited loss potential.

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Other Definitions

• Premium intrinsic value time value
• Where intrinsic value what option is currently
  worth (based on value of underlying security).
• A call option strike price lt underlying security
  price, it has intrinsic value also know as
  in-the-money.
• A put option has intrinsic value if the strike
  price is gt than underlying security price. Why?
  You have the right to sell something for say 10
  that might really be worth only 5
• Time value length of time to expiry
  volatility.