Hedging with Financial Instruments

Transcription

1 Hedging with Financial Instruments The use of Commodity Exchanges for Coffee It is important to understand the key differences between the financial and physical markets: Differences Local/Physical Market Global/Financial Market Place Tegucigalpa, Honduras The Exchange Activities Delivery Location Export Terms Unit of Measurement Buying & Selling of Physical Coffee Port FOB Quintales Price & Risk Management Exchange licensed warehouse CIF lbs

2 Commodity Exchanges for Coffee Thinking in two markets The physical market Producers Producers Producers Producers Producers Producers Producers The Financial Markets Cooperative or Intermediary or Exporter Importer or Roaster Some few physical transactions The majority of transactions in paper contracts

3 Hedging - BASIS Basis is the difference between the global financial price for coffee and the local physical price. Basis risk increases when the relationship between local and international prices change over time Basis also reflects the quality of the coffee locally in relation to the coffee underlying the global market price (quality differential) - this differential varies by region and by country Basis reflects a number of differences between physical coffee and the coffee underlying the futures contracts, for example futures contract prices will usually be greater than local physical coffee prices, as they include: Storage costs Interest Insurance

4 Hedging BASIS Basis has seasonal variations, it may widen or shrink at different moments during the season In exceptional situations the normal market positions may be reversed, for examples during times of short term local coffee shortages When there is a low correlation between the two markets (when local prices and global financial prices move very differently over time) hedging the global price is less effective

5 Hedging Basis International and local prices do NOT always move together in 1:1 correlation. Financial instruments offer protection against falls on the international market price Financial instruments do not protect against falls in the local market price, i.e. falls that are not related to falls in the international market price

6 Hedging BASIS What does the graph below suggest about the basis between Columbian coffee and the international coffee price? C A B

7 Hedging with Financial Instruments The use of Commodities Exchanges for Coffee Whenever a physical BACK TO BACK operation is not possible the trader then goes to the Commodities Exchange for Coffee and uses it as a Financial counterparty until he finds a Physical counterparty for his physical operation The financial and physical markets are very different marketplaces:

8 The Concept of Hedging Many coffee trading businesses should primarily rely on physical trading to manage their price risk exposure as physicals are their core business Where physical trading is not sufficient to effectively manage the price risk, coffee sector businesses may consider the use of financial strategies (futures & options) In all cases, strategies undertaken will have to be continuously reviewed and amended Appropriate strategies (and selection of strategies) will vary across firms The purpose of HEDGING is to REDUCE price uncertainty and the impact of adverse coffee price movements

9 QuickTime and a decompressor are needed to see this picture. The Concept of Hedging Hedging may involve taking a position in the financial market that is equal and opposite to that which is held in the physical market, with the objective of minimising the adverse affects of coffee price swings on the value of your physical product Timing differences between purchases and sales can be hedged Hedging is complementary to the use of physicals when managing price risk Hedging is not a guarantee of profits, it s a means of locking in prices at a point in time The effectiveness of hedging will depend on the amount of basis risk, the amount of physical position risk and the effectiveness of a traders price risk management program PLAY AT YOUR OWN RISK C A U T I O N

10 Hedging vs. Speculation Hedging is not about speculating Futures speculating involves taking out a futures contract without a corresponding opposite position in the physical coffee market Hedging involves taking positions that reduce a traders exposure to price risk Futures speculators, in the long run, should not expect to make profits, therefore: Speculating on futures increases risk without increasing expected rates of return Hedgers should expect their futures positions to reduce risk but should not expect to profit consistently from their futures transactions