Hedging

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??????

• Hedging Options

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Brief History of Futures

• 1848, CBOT (Chicago Board of Trade)
• ????????????,1860s ????
• grains ? financial instruments, specious metals
  (????????)
• ???????????????? (?????)
• ????????? (?????)???????????
• A futures contract is a legally binding
  commitment to make or take delivery of a
  standardized quantity and quality of a commodity
  at a price agreed upon in the trading pit or ring
  of a commodity exchange at the time the contract
  is executed.

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Brief History of Futures(?)
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Hedging ??????

• Hedge means protection.
• HedgeThe buying and selling of offsetting
  positions in the futures(??) market in order to
  provide protection against an adverse change in
  price.
• Hedging ? ?price risk (If expect P?? sell
  futures contracts
• expect P?? purchase
  futures contract )
• The initiation of a futures position that is
  intended as a temporary substitute for the sale
  or purchase of the actual commodity.
• Usually, actual commodity does not change hands
  in the futures markets The sale of futures
  contracts can be offset by the purchase of an
  equal number of futures contract's at a later
  date before the contract's delivery date.

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The Market Participants

• hedgers (?????), include farmers, country
  elevator operators, processors, livestock
  feeders, exporters, importers.
• To lock in a price and obtain protection
  against
• ??????? They seek protection against
  adverse price changes by initiating a position in
  the futures market as a temporary substitute for
  the sale or purchase of the actual commodity.

P? (buying futures)long position(??)
(bullish)
P? (selling futures)short position(??)
(bearish)
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• speculators(???)- people who assume risk in
  antipation of profiting from a change in prices
• Speculation ???????. Speculators facilitate
  hedging by providing liquidity
• - the ability to enter and exit the market
  quickly easily.
• To profit from P?(buying futures)
  P?(selling futures). They can realize a highly
  leveraged profit if they prove to be correct in
  anticipating the direction and timing of price
  changes.
• Arbitrager (?????)
• ?????????,????????

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• ???
• margin money that buyers and sellers of
  futures contracts must deposit
• with their brokers and that
  brokers in turn must deposit with the
• Clearing Corporation.
• money deposit in case of losses
  happen
• margin call --- loss ?, gain ? minimum
  amount
• ?
  until the open position is closed
• Clearing Corporation (???)assumes the opposite
  side of each open position and thereby assures
  the financial integrity of every futures contract
  traded at the CBOT. Hedge the buying selling
  of offsetting positions in order to provide
  protection against an adverse change in price.

Deposit more money to maintain minimum margin
requirement
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• ????
• 
  ????
• 
  ????
• 
  ??????
• 
  (price
  discovery)
• bearish ???short bullish ??(?)?long
• ?opening transaction,
• ???????????closing transaction liquidation (??)

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• basis cash price - futures price
• ?? ???? ????
• ??Basis???transportation costs, storage costs,
  interests, S
• D (local
  overall market)
• ??cash priceltfuture price "normal market"
• Gulf Coastcashgtfuture price "inverted
  market
• stronger ? ?weakening,
  ?strengthening
• 0 0
• - weaker ? -
  ?strengthening, ?weakening

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Hedging

• long hedge short hedge
• if basis weaken
• (cash falls more or rises less) basis gain
  basis loss
• if basis strengthens
• (cash falls less or rises more) basis loss
  basis gain

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• Hedging????????????????????,??????????,???????????
  ???(basis risk)????????????????,??????????????????
  ???,?hedging??basis risk??price risk?
• Usually, cash price and futures price move in the
  same direction.Basis fluctuations are usually
  smaller than cash price fluctuations.

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• eg1 short, futures gain, no basis change (
  perfect hedge )
• selling (short) hedges a corn farmer wants to
  lock in corn price of 2.20/bu.
• 
  
• 
  0.16/bu gain no change
• results cash sale price 2.04/bu
  cash forward bid 2.20/bu
• futures gain 0.16
  no basis change 0
• net selling price 2.20/bu
  net selling price 2.20/bu

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• eg2 short, futures loss, no basis change (
  perfect hedge )
• cash futures
  basis
• 2.20 sells 2.45
  0.25 under
• selling 2.50 buys 2.75
  0.25 under
• 0.30
  loss no basis change
• results
• cash sale price 2.50 price
  objective 2.20
• futures loss - 0.30 no basis
  gain/loss 0
• net selling price 2.20 net selling
  price 2.20
• perfect hedges basis does not change
  between the time a hedge was placed and lifted

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• eg.3 short, basis weaken ( loss )
• cash
  futures basis
• Sep
• price for new-crop corn sells 2 Dec. corn
  contracts 0.25 under Dec.
• 2.20/bu
  2.45/bu
• Nov.
• sells 10,000 bu corn at buys 2 Dec. corn
  contracts 0.30 under Dec.
• 2.00/bu at
  2.30/bu to offset
• 
  initial short futures position
• 
  0.15/bu gain 0.05 basis
  loss
• results cash sale price 2.00/bu
  price objective 2.20/bu
• futures gain 0.15
  - basis loss 0.05/bu
• net selling price 2.15/bu net
  selling price 2.15/bu

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• eg4 short, basis strengthen ( gain )
• Cash futures
  basis
• Sep 2.20 sell 2.45
  0.25 under
• sell Nov 2.18 buy 2.38
  0.20 under
• 
  0.07/bu gain basis gain 0.05
• results
• cash sale price 2.18/bu
  price objective 2.20
• futures gain 0.07
  basis gain 0.05
• net selling price 2.25/bu
  2.25/bu

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• eg.5 short, basis weaken ( loss )
• A processor hedges to protect his soybean oil
  inventory against price ?
• cash
  futures basis
• May
  (60,000 lbs each)
• cash forward bid for sells 3
  Sep. soybean oil ?1.00/lb over Sep.
  
• soybean oil ?18.5/lb
  contracts at ?17.5/lb
• Aug
• sells 180,000 lbs buys
  3 Sep. soybean oil ?0.75/lb over Sep.
• soybean oil at ?16.25/lb
  contracts at ?15.5/lb
• 
  to offset intial short
• 
  futures position
• 
  ?2.0/lb gain
  ?0.25/lb basis loss
• results
• cash sale 16.25
  cash forward bid 18.50
• futures gain 2.00
  - basis loss 0.25
• net selling price 18.25 cents/lb net
  selling price 18.25

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Buying (Long) Hedges used to protect against ?
in cash price.
eg1.

• Cash
  Futures
  basis
• poultry Oct.
  (100 tons each)
• producer cash price for soybean buys 1
  Jan soybean meal 5 under Jan
• meal 148/ton
  contract at 153/ton
• Dec.
• buys soybean meal at
  sells 1 Jan soybean meal 5under
  Jan
• 156/ton
  contract at 161/ton
• 
  to offset initial long
• 
  futures position
• 
  8/ton gain
  no change
• results
• cash purchase price 156/ton price
  objective 148/ton
• - futures gain 8/ton
  no basis change 0
• net purchase price 148/ton net
  purchase price 148/ton

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eg3. long, basis weaken ( gain )

• cash
  futures
  basis
• Oct.
• cash price for soybean buys u Jan
  soybean meal 5 under Jan.
• meal 148/ton
  contract at 153/ton
• Dec.
• buys soybean meal at sells 1 Jan
  soybean meal 9 under Jan.
• 151/ton
  contract at 160/ton to
• 
  offset initial long futures
• 
  position
• 
  7/ton gain 4 basis
  gain
• results
• cash purchase price 151/ton price
  objective 148/ton
• - futures gain 7/ton
  - basis gain 4/ton
• net purchase price 144/ton net
  purchase price 144/ton

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eg4 long, basis strengthen ( loss )

• cash
  futures
  basis
• Oct.
• cash price for soybean buys 1 Jan
  soybean meal 5 under Jan.
• meals 148/ton contract
  at 153/ton
• Dec.
• buys soybean meal at sells 1 Jan
  soybean meal 2 under Jan.
• 156/ton
  contract at 158/ton to
• 
  offset initial long futures
• 
  position
• 
  5/ton gain 3 basis
  loss
• results
• cash purchase price 156/ton
  price objective 148/ton
• - futures gain 5/ton
  basis loss 3/ton
• net purchase price 151/ton net
  purchase price 151/ton

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eg5. long, basis weaken ( gain )

• grain exporter
• cash
  futures basis
• July
• make commitment to sell buys 100 Dec.
  wheat 0.10 over Dec.
• 1 million bu wheat at contract
  at 2.62/bu
• 2.72/bu
• Nov.
• buys 1 million bu wheat sells 200
  Dec. wheat 0.04 over Dec.
• at 2.78/bu
  contract at 2.74/bu to
• 
  offset initial long futures
• 
  position
• 
  0.12/bu gain 0.06 basis gain
• results
• cash purchase price 2.78/bu
  price objective 2.72/bu
• - futures gain 0.12/bu
  - basis gain 0.06/bu
• net purchase price 2.66/bu net
  purchase price 2.66/bu

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Options ( ??? )

• Options the right, but not the obligation, to
  buy or sell a futures contract at some
  predetermined price at anytime within a specific
  time period
• Oct. 31, 1984 - soybeans
• Feb. 27, 1985 - corn
• wheat, soybean oil, soybean meal etc.
• An option is a legally binding contract that
  gives the option buyer the right, but not the
  obligation, to buy or sell something under
  specific conditions in exchange for the payment
  of a premium.

strike price
( the price of an option )
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• ( It is the buyer's (holder) decision whether to
  exercise that right only the seller (writer) of
  the option is obligated to perform.)
• options
• (not opposite side of the same transaction)

calls the right to buy ?? puts the
right to sell ??
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eg Buy Nov. 8.00 soybean put option before
Nov. harvest.

• If at harvest, market price of soybean futures is
  7.00,you would certainly exercise your right to
  sell at 8.00, or you would sell the option
  rights to someone else.
• If Nov. soybean futures at harvest are
  trading at 8.50/bu, you would not exercise the
  right to sell at only 8.00. You would simply let
  the option expire (and lose the premium) or sell
  it to someone else.
• And option buyer ( holders ) has several choices
• 1.liquidate his option position by selling an
  identical option anytime prior to
• expiration
• 2.let the option expire
• 3.exercise his option
• Choices of writers
• 1.before been noticed for exercise buy an
  offsetting option
• 2.after been noticed selling an offsetting
  futures contract

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• Options on Futures Contract
• The buyer of a call obtains protection
  against rising prices -- similar to the
  protection of a long hedge with futures -- but
  without giving up the chance to benefit from
  rising prices.
• The buyer of a put obtains protection against
  declining prices -- similar to the protection of
  a short hedge with futures of forward contracting
  -- but without giving up the chance to benefit
  from declining prices.
• Strike price -- the price at which the holder of
  a call (or put) may choose to exercise his right
  to purchase (or sell) the underlying futures
  contract.

????
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????

• Intrinsic value the difference between strike
  price current
• market price
• An option is not worth
  exercising if it has no intrinsic value.
• In-the-money (worth exercising) -- an option that
  has intrinsic value
• Out-of-the-money -- an option that has no
  intrinsic value
• An option that is
  out-of-the-money at expiration will have
• no value, and the holder
  will allow it to expire worthless.
• At-the-money -- strike price underlying futures
  price
• ( i.e. intrinsic value 0 )

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• Time value -- the amount that buyers are
  currently willing to pay for a given option over
  and above any intrinsic value, in anticipation
  that, over time, a change in the underlying
  futures price will cause the option to increase
  in value.
• Option premiums -- time value intrinsic value
• the price of an option (the
  option buyer pays the option writer)
• Options are traded the same way futures contracts
  are traded, with the exception of margin
  requirements.
• Most option buyers and sellers elect to liquidate
  their option positions by an offsetting sale or
  purchase at or prior to expiration.

???
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??

• Exercise only an option buyer (holder) has the
  right to exercise an option when a call (put) is
  exercised, the holder will acquire a long (short)
  futures position at the strike price.
• factors influencing premiums
• 1. The length of time remaining until
  expiration
• 2. The volatility of the underlying futures
  price
• 3. The relationship of strike price and market
  price
• 4. Short-term risk-free interest rates

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• Strategies for buying and selling options
• Buying put options to establish a minimum
  price for sales
• A farmer might wish to purchase a put
  during the spring or
• summer in order to establish a minimum
  price for the sale of his
• crop at harvest.

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• eg1 In May a soybean producer pays a premium of
  0.25 for a Nov. 7.50 put.
• (This gives him the right to go short in the
  futures market at a price of 7.50. The right
  continues for as long as he holds the option --
  until he sells it, or exercise it, or until it
  expires in October)
• By harvest time, the Nov. futures price has
  declined to 6.50
• the put with a strike price of 7.50 have an
  intrinsic value of 1.00

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• Cash
  Option
• May.
• price for new-crop buy Nov. 7.50
  put at a premium of 0.25/bu
• soybeans is 7.25/bu
• Nov.
• sells 5,000 bu sells Nov.
  7.50 put to receive premium of 1.00/bu
• soybeans at 6.50/bu and offset
  initial long option position
• 
  0.75 (1.00 - 0.25) .... option gain
• result cash sale price 6.50/bu
• option gain
  0.75/bu
• net selling price
  7.25/bu

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• eg2
• cash
  options
• May.
• price for new-crop buys
  Nov. 7.50 put
• soybeans is 7.25 at a
  premium of 0.25/bu
• Nov.
• sells 5,000 bu let
  option expire
• soybeans at 8.00/bu
• result
• cash sale price
  8.00/bu
• - cost of option premium 0.25/bu
• net selling price
  7.75/bu

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• Buying call options to sell the crops now (at
  harvest) and avoid storage costs (and P ?), and
  also profit from P?in winter or spring
• futures
  options
• Oct.
• May soybean futures buys May.
  8.00 call
• are 8.00/bu
  at a premium of 0.15/bu
• Apr.
• May soybean futures sells May
  8.00 call at a
• are 8.50/bu
  premium of 0.50/bu and offsets initial
• 
  long option position
• result gain from option position
  0.50/bu
• - cost of
  premium 0.15/bu
• net
  gain 0.35/bu

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• Selling call options
• - to earn the option premium
• - when do not expect a substantial price
  increase
• "covered call" - write a call
  option against a commodity
• you
  own.
• - own
  commodity, cash market value
• of
  your commodity move with the same
• 
  direction as the futures price
• "uncovered" or "naked" option -
  options not covered by
• 
  having a cash or futures
• 
  market position in the
• 
  commodity

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• Selling put options
• - to earn the option premium
• - puts are written by individuals who do not
  expect a substantial
• decrease in price
• 1. Buying put options for protection against
  lower prices.
• 2. Buying put options for "price insurance" when
  you store your crop.
• 3. Writing call options to achieve a higher
  effective selling price for a crop
• you are storing.
• 4. Buying call options at harvest to profit form
  a winter/spring price
• increase.
• 5. Buying call options for short-term protection
  against rising prices.

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If futures price at expiration is (basis maintains at 0.20) Your net return if you Your net return if you Your net return if you Your net return if you Your net return if you Your net return if you Your net return if you
If futures price at expiration is (basis maintains at 0.20) Write call with strike price of Write call with strike price of Write call with strike price of Write call with strike price of Hedge or contract at 7.50 Buy put with 7.50 strike price at a premium of 0.30 Do nothing
If futures price at expiration is (basis maintains at 0.20) 7.25 7.50 7.75 8.00 Hedge or contract at 7.50 Buy put with 7.50 strike price at a premium of 0.30 Do nothing
If futures price at expiration is (basis maintains at 0.20) premiums premiums premiums premiums Hedge or contract at 7.50 Buy put with 7.50 strike price at a premium of 0.30 Do nothing
If futures price at expiration is (basis maintains at 0.20) 0.43 0.30 0.20 0.13 Hedge or contract at 7.50 Buy put with 7.50 strike price at a premium of 0.30 Do nothing
6.50 7.00 7.50 8.00 8.50 6.73 7.23 7.48 7.48 7.48 6.60 7.10 7.60 7.60 7.60 6.50 7.00 7.50 7.75 7.75 6.43 6.93 7.43 7.93 7.93 7.30 7.30 7.30 7.30 7.30 7.00 7.00 7.00 7.50 8.00 6.30 6.80 7.30 7.80 8.30
8.50-0.20(7.25-8.50)0.43
6.50-0.20(7.50-6.50)-0.30
Futures price when you sell your crop Local
basis at the time you sell Premium paid for
option Intrinsic value of option (if any) Net
return
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