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Hedging with Futures

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... Cash Corn Price. What does 1-Cent Mean to a Corn Farmer? ... 1-cent move equals $480! Hedging ... 'The cash price is cents under/over the futures price' ... – PowerPoint PPT presentation

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Title: Hedging with Futures


1
Hedging with Futures
2
Central Illinois Cash Corn Price
3
What does 1-Cent Mean to a Corn Farmer?
  • Corn Variable Production Costs140/acre
  • Corn Fixed Production Costs145/acre
  • Normal Production 130 bushels/acre
  • Break-even price2.20 per bushel
  • On a 1000 Acre Farm
  • 3.00 Market Price 100,000 profit
  • 2.00 Market Price -25,000 loss
  • 1-cent move equals 1,300!

4
(No Transcript)
5
What does 1-Cent per cwt Mean to a Maryland Dairy
Farmer?
  • Total Production Costs13/cwt
  • Average Farm Milk Price (94-99)13.75/cwt
  • On a 200-Cow Farm
  • 15 Annual Price 96,000 profit
  • 12 Annual Price -48,000 loss
  • 1-cent move equals 480!

6
Hedging
  • The use of a futures contract to offset price
    risk in the cash market.
  • Commercials
  • Use futures as a temporary substitute for a later
    transaction in the cash (physicals) market.
  • Do today in the futures market what you will do
    tomorrow in the cash market.

7
Hedging
  • No guarantees that you will get a better price by
    hedging as compared to waiting to sell or buy on
    the cash market.
  • Routine hedging vs. Selective Hedging

8
December Corn Futures Contract Price Range and
Harvest Time Close
9
Kevin McNew, University of Maryland
10
Kevin McNew, University of Maryland
11
Mechanics of Hedging What you Do Today.
  • Plan for the future. Right price, right outlook?
  • Delivery month closest to when cash transaction
    will be made, but will still trade on cash date.
  • Equal position in the futures market (sellers go
    short, buyers go long).

12
Short Hedger
  • Today 9/99 An Oklahoma farmer is planting his
    wheat to be harvested and sold in June 2000.
  • Sell July 2000 Futures at 3.00.

Long Hedger
  • Today 9/99 A Pennsylvania flour miller wants to
    price wheat it will buy in June 2000.
  • Buy July 2000 Futures at 3.00.

13
Mechanics of Hedging What you Do Tomorrow.
  • Buy or sell in the cash market as planned.
  • Offset futures position (equal, but opposite
    position in the futures market).
  • Profit/Loss on Futures Transaction.
  • Net-price (accounts for cash and futures
    transactions)

14
Net-Price Formula
  • As a Seller
  • Net-Price Cash Price Profit on Futures
  • As a Buyer
  • Net-Price Cash Price - Profit on Futures

15
June 2000--Lower Prices
  • Farmer harvests wheat and delivers it to his
    local market.
  • Cash Price 2.40
  • Offset futures contract (buy July 2000 futures)
    at 2.55.
  • Net-Price Cash Price Profit on Futures
  • Cash Price(F. price sold - F. price bought
  • 2.40 (3.00-2.55)
  • 2.85

16
June 2000--Higher Prices
  • Farmer harvests wheat and delivers it to his
    local market.
  • Cash Price 3.60
  • Offset futures contract (buy July 2000 futures)
    at 3.75.
  • Net-Price Cash Price Profit on Futures
  • 3.60 (3.00-3.75)
  • 2.85

17
June 2000--Lower Prices
  • Flour miller buys cash wheat.
  • Cash Price 2.80
  • Offset futures contract (sell July 2000 futures)
    at 2.55.
  • Net-Price Cash Price - Profit on Futures
  • Cash Price - (F. price sold - F. price
    bought)
  • 2.80 - (2.55-3.00)
  • 3.25

18
June 2000--Higher Prices
  • Farmer harvests wheat and delivers it to his
    local market.
  • Cash Price 4.00
  • Offset futures contract (sell July 2000 futures)
    at 3.75.
  • Net-Price Cash Price - Profit on Futures
  • 4.00 - (3.75-3.00)
  • 3.25

19
Net-Prices
  • Prices in June 2000 OK Farmer PA Miller
  • High Prices 2.85 3.25
  • Low Prices 2.85 3.25

20
DEFINING THE BASIS
  • Basis Cash - Futures
  • "The cash price is cents under/over the
    futures price"
  • Basis is defined for a specific place, time, and
    futures contract.
  • Cash Price Basis Nearby Futures.

21
Cash and Futures Prices
  • July Futures in June 2000 OK Cash PA Cash
  • 3.75 3.60 4.00
  • 2.55 2.40 2.80

22
Basis
  • July Futures in June 2000 OK Basis PA Basis
  • 3.75 -15 25
  • 2.55 -15 25

23
FUTURES HEDGE The Formula
  • The Expected Price is...
  • Current Futures Price Expected Basis
  • For Wheat Example
  • Expected Farmer Price (OK) 300 - 15 285
  • Expected Miller Price (PA) 300 25 325
  • Does not matter whether the price level is higher
    or lower.
  • Actual Price only changes if the Basis is
    different then what was expected.
  • Can Compare Expected Price to Forward Contracts.
  • Retain Flexibility in Cash Market.

24
Calculating Pessimistic/Optimistic Basis
  • The Average Basis reflects what value is most
    likely for the Actual Basis.
  • In Reality, however, the Actual Basis can be
    Either Stronger (larger) or Weaker (smaller) than
    the Average.
  • To reflect this variation, one can calculate an
    Optimistic Basis and a Pessimistic Basis.
  • Optimistic Basis Average Basis SD
  • Pessimistic Basis Average Basis - SD
  • About 2/3 of the time the Actual Basis will be
    between the Optimistic and Pessimistic Basis.

25
Optimistic and Pessimistic Basis
  • Example Basis forecast for CMD Corn in October.
  • Average Basis15 SD10
  • Optimistic Basis 15 10 25
  • Pessimistic Basis 15 - 10 5
  • So, 2/3 of the time the Basis will be 5,25
  • Effective Selling Price 28915304
  • Lower ESP 289 5 294
  • Upper ESP 289 25 314
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