ECON 339X: Agricultural Marketing

Econ 339X, Spring 2010

ECON 339X:Agricultural Marketing

Chad HartAssistant Professor/Grain Markets Specialist

[email protected]


Today’s Topic

Risk Management Tools

Price Risk

Futures, Options


Iowa Corn Yields

Source: USDA, NASS

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Iowa Corn Prices

Source: USDA, NASS

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Iowa Corn Revenues

Source: USDA, NASS

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elCorn Futures Prices

Source: CME Group

Corn users are worried about this

Corn suppliers are worried about this


Crop Price VariabilityPrice distributions for corn based on March prices for the following July futures

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5%

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Price

2006 2009


Futures and Options

Market tools to help manage (share) price risks

Mechanisms to establish commodity trades among participants at a future time

Available from commodity exchanges / futures markets


Futures Markets

Chicago: Corn, soybeans, wheat (soft red), oats, riceAlong with the livestock complex

Kansas City: Wheat (hard red winter)

Minneapolis: Wheat (hard red spring)

Tokyo: Corn, soybeans, coffee, sugarHas a market for Non-GMO soybeans

Other markets in Argentina, Brazil, China, and Europe

A market where contracts for physical commodities are traded, the contracts set the terms of quantity, quality, and delivery


Agricultural Futures Markets

Has some unique features due to the nature of the grain business

Supply comes online once (or twice) a yearSo at harvest, supply spikes, then diminishes until the next harvest

Production decisions are based price forecastsPlanting decisions can be made a full year (or more) before the crop price is realized

Users provide year-round demandLivestock feeding, biofuel production, food demand


Futures Market Exchanges

Competitive marketsOpen out-cry and electronic trading

Centralized pricingBuyers and sellers are both in the marketRelevant information is conveyed through the bids and offers for the trades

Bid = the price at which a trader would buy the commodityOffer = the price at which a trader would sell the commodity


The View from the Corn Pit

Source: M. Spencer Green, AP Photo


Options What are options?

An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period.

Options on futures are the right to buy or sell a specific futures contract.

Option buyers pay a price (premium) for the rights contained in the option.


Option Types Two types of options: Puts and Calls

A put option contains the right to sell a futures contract.

A call option contains the right to buy a futures contract.

Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets.


Put Option

The Buyer pays the premium and has the right, but not the obligation, to sell a futures contract at the strike price.

The Seller receives the premium and is obligated to buy a futures contract at the strike price if the Buyer uses their right.


Call OptionThe Buyer pays a premium and has the

right, but not the obligation, to buy a futures contract at the strike price.

The Seller receives the premium but is obligated to sell a futures contract at the strike price if the Buyer uses their right.


Options as Price InsuranceThe person wanting price protection (the

buyer) pays the option premium.

If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages.

The seller keeps the premium, but must pay for damages.


Options as Price InsuranceThe option buyer has unlimited upside

and limited downside risk.If prices moves in their favor, the option

buyer can take full advantage.If prices moves against them, the option

seller compensates them.

The option seller has limited upside and unlimited downside risk.The seller gets the option premium.


Option Issues and ChoicesThe option may or may not have value at

the endThe right to buy at $4.00 has no value if the

market is below $4.00.

The buyer can choose to offset, exercise, or let the option expire.

The seller can only offset the option or wait for the buyer to choose.


Strike PricesThe predetermined prices for the trade of

the futures in the options

They set the level of price insurance

Range of strike prices determined by the futures exchange


Options Premiums Determined by trading in the marketplace Different premiums

For puts and calls For each contract monthFor each strike price

Depends on five variablesStrike pricePrice of underlying futures contractVolatility of underlying futuresTime to maturity Interest rate


Option References In-the-money

If the option expired today, it would have valuePut: futures price below strike priceCall: futures price above strike price

At-the-moneyOptions with strike prices nearest the future price

Out-of-the-money If the option expired today, it would have no valuePut: futures price above strike priceCall: futures price below strike price


Options Premiums

Dec. 2010Corn Futures$3.85 per bushel

Source: CME Group, 3/26/10

In-the-money

Out-of-the-money


Options Premiums

Dec. 2010Corn Futures$3.85 per bushel

In-the-money

Out-of-the-money

Source: CME Group, 3/26/10


Setting a Floor Price Short hedger Buy put option

Floor Price = Strike Price + Basis – Premium –

Commission

At maturity If futures < strike, then Net Price = Floor Price If futures > strike,

then Net Price = Cash – Premium – Commission


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Futures Price ($ per bushel)

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Cash Price Put Option Return Net Hedge

Put Option GraphPut Option Dec. 2010 Corn @ $3.90Premium = $0.43


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Cash Price Put Option Return Net

Out-of-the-Money PutPut Option Dec. 2010 Corn @ $3.00Premium = $0.07


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Cash Price Put Option Return Net

In-the-Money PutPut Option Dec. 2010 Corn @ $5.00Premium = $1.26


Setting a Ceiling Price Long hedger Buy call option

Ceiling Price = Strike Price + Basis + Premium +

Commission

At maturity If futures < strike,

then Net Price = Cash + Premium + Commission If futures > strike, then Net Price = Ceiling Price


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Cash Price Call Option Cost Net Hedge

Call Option GraphCall Option Dec. 2010 Corn @ $3.90Premium = $0.38


Combination StrategiesOption fence

Buy put and sell callHigher floor, but you now have a ceiling

Put spreadBuy At-the-money put and sell Out-of-the-

money putHigher middle and higher prices, but no floor

below Out-of-the-money strike price


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Cash Price Put Option Return Call Option Return Net w/ Fence

FenceBuy Put Option Dec. 2010 Corn @ $3.40Premium = $0.18

Sell Call Option Dec. 2010 Corn @ $4.40Premium = $0.23


Summary on OptionsBuyer

Pays premium, has limited risk and unlimited potential

Seller Receives premium, has limited potential and

unlimited riskBuying puts

Establish minimum pricesBuying calls

Establish maximum prices


Class web site:http://www.econ.iastate.edu/classes/econ339/hart-lawrence/

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ECON 339X: Agricultural Marketing

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