Great Plains Veterinary Educational Center PRM Price Risk Management Protection of Equity (Just The...

Great Plains Veterinary Educational CenterGreat Plains Veterinary Educational Center

PRMPRMPrice Risk ManagementPrice Risk Management

Protection of Equity(Just The Basics)

Part One


Futures Contracts Futures Contracts (FC)(FC)::• Producers:

– Lock Prices - Planning - Aid Financing.

• Evolved from existing marketing system.

• Forward contracts became standardized futures contracts.

• Exchanges established rules for trading.

• Government established regulations.


FC Standardized:FC Standardized:

• Commodity, Quantity, Quality, Deliver Point, Cash Settlement and Delivery Date.

• Who can trade futures? Anyone.


How do speculators use the How do speculators use the futures market?futures market?

• Speculators have no intention of buying or selling the actual commodity.

• They make money by taking advantages of change in futures prices.


How do producers use the How do producers use the futures markets?futures markets?

• As a temporary substitute for cash price. (sale or purchase)

• As the delivery month approaches the pressure of possible delivery causes the futures and the cash price to line up. – At delivery: futures price reflects the cash.


How do producers use the How do producers use the futures markets? futures markets? (cont)(cont)

• Futures contracts– allow producers to

"lock in a price” ahead of actual (sale or purchase).

• Transfer risk to speculator.


HedgingHedging

• Buying or Selling futures contracts as protection against the risk of loss due to changing prices in the cask market.

»

• A Price Risk Management tool.


Price Discovery:Price Discovery:

• On the floor of the exchange by interaction between buyer and seller.

• Represents supply and demand from all over the country / world.


Futures Contract Obligation:Futures Contract Obligation:

• Removed (offset) by buying or selling a contact that has been sold or bought.

• Short hedgers offset their obligation by buying the hedge back when the commodity they raise is sold.


Futures Contract Obligation: Futures Contract Obligation: (cont)(cont)

• Long hedgers offset their obligation by selling the hedge back when the commodity they need is bought.

• Cash Settlement: For futures contracts that do not rely on physical delivery (feeder cattle).


Futures Contracts Offer Futures Contracts Offer ProtectionProtection

• Selling (Short) a futures contract protects the seller of the commodity against falling prices.

• Buying (Long) a futures contract protects the buyer of the commodity against rising prices.


Using Futures Contacts:Using Futures Contacts:

• FC: bought / sold through brokerage firms

– (execute the trade).• Broker fee typically covers one "round-turn”

– (sell-buy / buy-sell)• Performance Bonds pre-pay possible loss

– (margin accounts-One days trade).• Clearing House: FC transactions guarantor

– Also, cash settlements on the last contract day


Cash Settlement:Cash Settlement:

• LONG FCs open the last trading day– Automatically offset by Clearing House

against remaining short contacts

– Price set equal to the CME “Composite Weighted Average Price” for the Contract.


CME Composite Weighted CME Composite Weighted Average PriceAverage Price

• Calculated from the USDA data.– Formula & data available to the public.

• Data includes:– Auction Markets, Direct & Video Sales

– Of typical commodity (FC=700-799)

– 12 states over the previous seven days


Contract Specifications:Contract Specifications:• Futures Contract

• Months

• Minimum Fluctuation

• In Price

• Limit

• Strike Price

• Interval/Notes


• Live Cattle– 40,000 lbs. Feb, Apr, Jun, Aug, Oct, Dec– Limit 3¢/100 lb or $1,200/Contract (Maintain 2¢/lb or $800)

• Live Cattle Options– Feb, Apr, Jun, Aug, Oct, Dec

• Feeder Cattle– 50,000 lbs. Jan, Mar, Apr, May, Aug, Sep, Oct, Nov– Limit 3¢/100 lb or $1,500/Contract (Maintain 2¢/lb or $1,000)

• Feeder Cattle Options– Jan, Mar, Apr, May, Aug, Sep, Oct, Nov

Contract Specifications:Contract Specifications:




Part Two


• Relationship of local cash markets to futures price at marketing time.

(Basis = Cash - Futures)

• Futures and cash prices differ– because of delivery cost

– local demand.

BasisBasis


Two QuestionsTwo Questions

• Why is basis knowledge important?

• Where do you find basis info.?

• Expected Selling Price:

• Futures contract (+/-) the Basis

—NOTE: Historical basis is only a guideline Not Absolute


Short Hedge Short Hedge (Locking In A Selling Price)(Locking In A Selling Price)

• Sell (SHORT) futures contact =>– Buy futures contract back

• (basis has no effect)

– + Sell commodity in cash market• (basis has effect)

– Note: include fees


Long Hedge Long Hedge (Locking In A Purchase Price)(Locking In A Purchase Price)

• Buy (LONG) futures contact => – Sell futures contract back

• (basis has no effect)

– + Buy commodity in cash market• (basis has effect)

– Note: include fees


Types Of Orders Types Of Orders

• Market Orders: (Sell/Buy "at the market")

– order to be filled as soon as possible.

• Limit Orders: (Sell/Buy "at $$$$ price")

– order to be filled at a certain price.

• Stop Orders: (Sell/Buy "at $$$$ stop")

– order to be filled when (+/-) price changes.

• Stop Close Only Orders: (S/B "at a stop only of $$$$")

– order filled when (+/-) price closes at $$$$. • Note: Orders are not always filled.


Develop Marketing PlanDevelop Marketing Plan• Start with a BREAK-EVEN.

– Est. consistent w/ financial goals

• Develop CALENDARS:– PRODUCTION & PRM

• Define DECISION POINTS– When &/or What will be done.


Things Not To Do:Things Not To Do:

• Hedge w/o "accurate" BE estimates

• Manage without a plan

• Change from Hedger to Speculator• “Texas Hedge” FC added to production (needs/output)

• Worry about Margins• Offset commodity before marketable




Part 3


OptionsOptions• Provide producers the:

– "right" but not the "obligation"

– to sell/buy a specified commodity.

• For every option buyer there is an option seller (guarantor).

• Options are set for:– corresponding futures contract.


Option Buyers Option Buyers (Hedger types)(Hedger types)

• Buying Put Option: – provide "right" but not the "obligation"

– to sell (Short) a specified commodity.

• Buying Call Option:– provide "right" but not the "obligation”

– to buy (Long) a specified commodity.


Option Sellers (Speculators)Option Sellers (Speculators)

• Selling Put Option:– assumes "obligation" to buy specified

commodity if settles in adverse position

• Selling Call Option: – assumes "obligation" to buy specified

commodity if settles in adverse position


Option Player SummaryOption Player Summary• Put Buyer:

– (pays premium & has right to sell)

• Put Seller: – (collects premium & has obligation, if exercised, to pay

different between strike & current price)

• Call Buyer:– (pays premium & has right to buy)

• Call Seller:– (collects premium & has obligation, if exercised, to pay

difference between strike & current price)


Strike (Exercise) PriceStrike (Exercise) Price

• The price the option holder may sell/buy the futures contact.

• Exercising the option results in futures position at the designated strike price.

• Choose the strike price that reflects the amount of risk you are willing to accept.


PremiumPremium• Market determines the premium (bid/ask)• Influenced by strike price relative to futures price, market

expectations, volatility risk, and time risk

• In-the-money (strike price not asked to match all of future price) … Has "Intrinsic Value”

• At-the-money (strike price asked to match futures price)

• Out-of-the-money ((strike price asked to match futures price plus additional $)


Note about Time ValueNote about Time Value• Time risk decreases as the time between

the purchase of the option an the expiration date

• Delta ( +/- change) refers to change in option value relative change in future value.

• A 0.3 delta would mean that if the futures price dropped $1.00 the value of a Put would increase as by $0.30.


Expiration DateExpiration Date

• The last day an option may be exercised (offset).

• Put option would be exercised by selling (Short) a futures position at the strike price.

• Call option would be exercised by buying (Long) a futures position at the strike price.


Contract Specifications:Contract Specifications:

• Futures Contract• Months• Minimum Fluctuation• In Price• Limit• Strike Price• Interval/Notes


Three Alternatives After You Three Alternatives After You Purchase An OptionPurchase An Option

• Sell the option back if it has value (offset at the current price and collect the premium)

• Exercise the option • (sell/buy futures at specified strike price and

buy/sell at current price)

• Let option expire if it has no value.


Intrinsic ValueIntrinsic Value

• The amount of money that could be realized

by exercising an option at its strike price.




Part 4


Basic StrategiesBasic Strategies• Lock in Fixed Price

– Fixed Selling Price => Short Futures– Fixed Purchase Price => Long Futures

• Establish Minimum Selling Price => Buy Puts

• Establish Maximum Purchase Price => Buy Calls


Advanced StrategiesAdvanced Strategies

• Collect Option Premium => Sell (Put/Call)

• Typically: used on to offset the premium paid for opposite position option.


Establish Maximum Establish Maximum Purchase PricePurchase Price

• Buy Call and Sell Put ("The Fence") reduces premium cost

• Buy (Long) futures contact (or Cash contract) and buy Put


Establish Minimum Establish Minimum Selling PriceSelling Price

• Buy Put and Sell Call reduces premium cost

• Sell (Short) futures contact (or Cash contract) and buy Call


Adjustment StrategiesAdjustment Strategies

• Convert a fixed price to minimum price => buy Call after selling (short) futures

• Convert a fixed price to minimum price => buy Put after liquidating a short futures position


Adjustment Strategies Adjustment Strategies (cont)(cont)

• Convert a minimum price to a fixed price => selling futures (cash contract) after a Put purchase

• Adjust the minimum price to a fixed price => buy Put option as price increases

• Cashing-in minimum price protection => buy Put option as price decreases


• Convert a fixed price to maximum price => purchase Put after buying (long) futures

• Convert a fixed price to maximum price => purchase Call after liquidating a long futures position

• Convert a maximum price to a fixed price => buying futures (cash contract) after a Call purchase



• Adjust maximum price to a fixed price =>buy Call option as price decreases

• Cashing-in maximum price protection

=> buy Call option as price increases



Save a Cow … Save a Cow …

Eat a VegetarianEat a Vegetarian

Good Luck To YouGood Luck To YouThanks for having me come.

Date post:	11-Jan-2016
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