Risk Management Using Futures and Options

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1 Risk Management Using Futures and Options Judith Ganes President J. Ganes Consulting LLC Cumbre Mundial de Cacao Aug. 27, 2014

2 Identify and Calculate Your Risk Hedging is the process to mitigate price risk. This is the opposite of speculating where you bet on market direction for profit. Speculators are necessary to provide liquidity to a market so it functions effectively. Speculators play an important and integral role in the market place despite media reports which often blame speculators for increased price volatility. The opposite is actually true. Before a successful hedging strategy can be implemented the producer, exporter, or cocoa processor must determine the amount of money at risk at various times of the year. The hedger must remember when identifying his risk to include in this analysis any basis risk based on historical differences for select cash and futures positions. The hedger must also understand where prices are relative to the market fundamentals and seasonal patterns.

3 Hedging Strategies and Execution Once a hedger has identified his risk and assessed the market, he must decide on what hedging strategies would be most appropriate and how these will be executed and managed. Improvising and compromising can lead to disastrous results, but modifications based on sound assessments of the positions are critical for success. This includes decision making on when to establish or exit positions. A hedger also needs to be aware of his risk tolerance. This is extremely critical especially in periods of erratic price activity or market uncertainty.

4 What Are Your Needs? For Producers: Swaps I want the security of a fixed price With Options I want protection against price declines, but benefit if prices go up For Consumers: Swaps I want the peace of mind of a fixed price With options I want protection from prices going up, but benefit if prices go down Options on futures provide the greatest degree of flexibility A futures contract is a legal option to buy or sell a specified amount of the underlying commodity. A cocoa contract is 10 metric tons. An options contracts gives you the right but not the obligation to own or sell the underlying futures contract.

5 Producer Swaps For Producers: For planning and budgeting you want to agree to a fixed price now for when you sell your cocoa later in the season. Strategy: A cocoa swap allows you to receive a fixed reference price for your cocoa. Implementation: Obtain credit approval with a bank and enter into a swap agreement. The bank will calculate the fixed price based on certain variables such as the reference price, the pricing dates, the size of the transaction and the transaction period. Results: 1) If the cocoa reference price is lower than the fixed price, the bank pays the difference between the two. 2) If the cocoa reference price is higher than the fixed price, then the producer must pay the bank the difference between the fixed price and reference price 3) If the cocoa reference price is the same as the fixed price, then there is no further obligation with respect to the cocoa swap Benefits: Price protection by fixing the cocoa reference price Cash settlement and no complex exchange rules Caution: No upside benefit. No basis protection. Early termination fees depending on market value

6 Options for Producers For Producers: Want to have benefit if prices go up with protection if they fall Strategy: An option allows the cocoa price to float, while being protected against falling prices in exchange for a premium. Benefits: Price protection against fall in cocoa prices below the agreed put strike price with open ended potential if prices rise Cash settlement and no complex exchange rules or margin requirements Other Considerations: Premium paid upfront. No basis protection. Options can expire worthless resulting in premium being an added cost

7 Case Study: Producer / Exporter Let s suppose it s May, you re an exporter with cocoa you have not yet sold. You are said to have a long cash market position. The current cash market price for cocoa to be delivered in October is $3,200 US Cents per pound. If prices increase between now and September when you plan to sell, you will gain. However, if cocoa prices decrease, you will have a loss. What do you do?

8 Case Study: Producer / Exporter To protect yourself against a possible price decline, you can hedge your position by selling a corresponding number of tonnage in the futures market today and buying them back later when you plan on selling your cocoa on the cash market. If the cash price declines between now and when you sell your cocoa, any loss incurred will be offset by a gain from the hedge in the futures market. This is called a short hedge because you take an initial short futures position i.e. sell futures.

9 Exporter Strategy for Volatile Market Protection Exporters face two potential loss risks as both buyers and sellers of physical cocoa. Before physical cocoa purchases they risk rising prices and after purchasing physical cocoa now are long unsold physicals and have worries about prices falling. What is an example of a strategy to protect exporters against volatile prices?

10 The Short Hedge: Prices Decline Cash market May Cash cocoa is 3,200 USD/ton. September Sell cash cocoa at 2,700 USD/ton. Futures market Sell Sep cocoa futures at USD/ton. Buy Sep cocoa futures at 2, USD/ton. change 500 USD/ton. loss 500 USD/ton. gain Sep sell cash cocoa Gain on futures position 2,700 USD/ton. 700 USD/ton. Net selling price 3,200 USD/ton.

11 The Short Hedge: Prices Increase Cash market May Cash cocoa is 3,200 USD/ton. September Sell cash cocoa at 3,300 USD/ton. Futures market Sell Sep cocoa futures at 3,200 USD/ton. Buy Sep cocoa futures at 3,300 USD/ton. change 100 USD/ton gain 100 USD/ton loss Sep sell cash cocoa Loss on futures position 3,300 USD/ton USD/ton Net selling price 3,200 USD/ton

12 Exporter Strategy to Protect Against Rising Prices If the exporter is worried about selling cocoa too cheaply--buy calls depending on market conditions though, this could be expensive. The greater the market uncertainty and volatility the higher the premium for options are. The seller of an option assumes unlimited risk whereas the buyer can only lose the premium paid. 3 ways/fences (buy put, sell call) if prices go up you are hedged closer to market levels; if prices go down you can sleep at night. You want some protection, but don t want to pay too much. Exporters can use options until they have to fix prices.

13 Short Hedge: Price Decline July Long Cash $3,200 Short Futures $3,200 December: Cash Price $2,700 Cash Loss - $ Futures Price $2,700 Futures Gain + $500 Locked in Price: $3,200 This assumes no basis change.

14 Short Hedge: Price Increase July Long Cash $3,200 Short Futures $3,600 December: Cash Price $3,600 Cash Gain + $400 Futures Price $3,600 Futures Loss - $400 Locked in Price: $3,200 This assumes no basis change. If the market kept rising, the exporter would have benefited more from the price increase without hedging. An alternative would be to purchase a cocoa put.

15 Benefit from Understanding Options with NO COST or Investment There are many farmers that may not have the production or capability to utilize these sophisticated strategies but understanding the market and options can give you an edge and help you improve your selling price even without actually hedging as the next best alternative. Option prices are extremely sensitive to expectations of changes in market conditions and can be used as a leading indicator for predicting price developments. Keeping an eye on the pricing can help you improve your bottom line.

16 Worthwhile Points to Remember Understand your role as a hedger Don t be motivated to make money in your account like a speculator! The bona fide hedger aims to make money in his principal business Make sense of your hedge program Integrate your hedge program into entire corporation Avoid beat the market schemes as profitable hedge strategies Distinguish between profits and gains Know the difference between a hedger and a speculator Recognize that hedging locks in half the profit equation Determine how long or short you really are Do not rationalize trading when hedging Give proper credit to cost savings as vital part of profits Train all involved managers 16

17 Available by subscription: Softs In-Depth Report, Coffee In-depth Report, Softs weekly (cocoa, cocoa, OJ, coffee, & cotton) & Coffee weekly Specializing in risk management workshops and training

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