Introduction. This module examines:

Transcription

1 Introduction Financial Instruments - Futures and Options Price risk management requires identifying risk through a risk assessment process, and managing risk exposure through physical or financial hedging instruments. In order to identify a trader s risk exposure, he has to perform the three step risk assessment process: frequently assess his trading positions, monitor the break even price and perform mark to market analysis. The trader, with an identified exposure, can mitigate (or offset) the risk by taking an equal and opposite physical trading position in contracts for the sale of cocoa during a cocoa season, using forward physical contracts. When a trader is unable to secure a forward contract for a physical exchange of cocoa to offset their exposure, a trader can use financial instruments to hedge. This module examines the financial instruments that a trader may use for hedging. This module examines: 1. Commodity Exchanges - how financial commodity exchanges operate and how they can be accessed by cocoa traders to hedge their exposure to risk. 172 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

2 2. Basis and Basis Risk - how cocoa traders need to calculate and understand the differential between world cocoa price i.e. prices used by the international commodity exchanges, and local cocoa prices. It also re-examines the issue of basis risk; an understanding of the relationship between world and local cocoa prices, which determines the appropriateness of using financial instruments to hedge. 3. Futures Contracts - what are cocoa futures contracts, how they work and how to use them for hedging. 4. Options Contracts - how options contracts can be used for hedging by a cocoa trader. And the two types of options contracts: put option contracts and call option contracts. By the end of this module course participants will have a good understanding of how the commodity exchanges for cocoa work, and how cocoa traders can make use of these markets, when they are unable to hedge using physical cocoa contracts. 173 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

3 Use of Commodity Exchanges for Cocoa The Use of Commodity Exchanges for Cocoa Commodity exchanges are institutions where futures and options cocoa contracts are traded. These financial contracts can be used by cocoa traders for hedging their exposure when they are unable to hedge using physicals (i.e. forward contracts for the sale or purchase of cocoa). In the majority of situations a cocoa trader will not need to use the financial commodity exchanges to hedge, as they will be able to hedge using their physical contracts. Hedging with physicals is preferable as it involves no additional costs and since the trading of physical cocoa is the core business of the cocoa trader, it is also where their expertise lies. However at times when physical contracts are not available, or the risk needing to be hedged is greater than the hedging ability of the trader s physical contracts, the commodity exchanges offer an alternative hedging solution. Commodity Exchanges as a Financial Counterparty 174 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

4 The commodity exchanges offer the same hedging solutions for a trader as a physical contract for the sale or purchase of cocoa. Rather than having a physical counterpart that will purchase the cocoa by agreeing a forward contract with the trader, the commodity exchange provides a trader with a "financial" counterpart who is willing to accept risk but who does not anticipate receiving physical cocoa. A trader can use the commodity exchange to provide a financial counterpart, until such time that a suitable physical counterpart can be secured. In short, the financial markets will be used to fill the "gap" until the trader can find a buyer to offset his risk. Physical and Financial Markets are Different Marketplaces The key differences between the financial and physical market, are the use and purpose of the markets, and the actual movement of the physical cocoa. The main purpose of a financial market is to provide a means of pricing cocoa and managing price risk. Whereas, the physical market is used for delivery of physical cocoa to different parts of the cocoa supply chain, all the way through to the chocolate consumer. Managing Price Risk with Financial Markets The reason that cocoa traders should understand the commodity exchanges is because financial markets offer the opportunity for a trader to hedge when physical hedging solutions are not available at a particular moment in time. 175 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

5 Use of Commodity Exchanges for Cocoa Commodity Exchanges and Transparency Global Commodity Exchanges An Overview The combined activity on the global commodities markets results in the determination of the international price for that good listed on the exchange The prices on the global commodity markets are governed by the laws of supply and demand on the exchanges. The global commodity markets or the exchanges match buyers and sellers and the international cocoa price is determined by the thousands of transactions that occur each day between these two groups. Buyers and sellers in the global markets drive prices up and down, as they accept and reject prices, respectively. Major players in the market such as major investment funds with millions of dollars, or a large group of producers such as Ivorian cocoa producers, can impact the prices on the exchange due to the size of their transactions. 176 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

6 Global commodity markets are regulated to ensure fair, transparent, and open operations These markets are highly regulated by the authorities in the countries where they are located. For example, the London International Financial Futures Exchange is regulated by the Financial Services Authority which is a United Kingdom regulatory authority. Similarly, the Intercontinental Exchange in the US is regulated by the Commodities Futures and Trade Commission (CFTC). These regulators monitor the buying and selling that occurs on the exchange and set the rules for participation in the exchange. The rules are established to make sure the market is operating efficiently and to ensure that buyers and sellers are interacting in a fair, transparent and open manner. In order to protect buyers and sellers, the exchanges monitor the participants in the markets. They do so, by allowing only licensed brokers to buy and sell these instruments. These brokers can buy and sell price risk management instruments on behalf of other people and institutions, though these groups must also meet the requirements of the regulatory bodies. Most brokers have a system of registration for the organizations they do business with to make sure they meet the requirements of the regulatory bodies. Regulators are highly concerned with proper review by financial institutions to prove that they know their counterparty. Regulations have become increasingly stringent since September 11 th, 2001, due to concerns about money laundering and links to terrorism. Global Commodities Markets operate all over the world Originally, global commodities markets were established to help buyers and sellers of these goods deal with uncertainty over time and distance. In addition, it determined a place where buyers and seller could meet for the exchange of these goods. International exchanges typically used to have a trading floor that acts like an auction area, where contracts for these products are bought and sold. In the past, trading was done by open outcry, in the auction pits where buyers and sellers (or their representatives) yelled their bids and offers, on a given commodity from the auction floor. This ensured a fair, open, and transparent process. With improvements in technology, it is increasingly common for this same type of negotiations to occur electronically or over the phone. In some cases, these global commodity markets have eliminated the trading floor all together. These markets are found in the major financial centers around the world. Many of these exchanges are in London, New York, Chicago, Singapore, and Tokyo. The table below provides examples of commodity exchange locations, and the commodities traded on them. 177 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

7 The exchanges listed above are some of the major commodity exchanges around the world. Cocoa is traded on both the ICE in New York and the LIFFE in London. There are a large number of other smaller exchanges for commodities that are not as largely traded. The quantity of transactions determines the activity and liquidity of the exchange. If liquidity is not adequate then an exchange has no ability to provide price discovery or risk management. Participants in global commodity markets Commodity Producers and Consumers These groups use commodity markets as a central location for price discovery and risk transfer. The exchange provides an efficient meeting place for a large number of buyers and sellers across the world. It also ensures transparency in transactions and eliminates counterparty risk. Buyers and sellers, matched to each other may not know one another, but in order to participate, they are reviewed and approved by the exchange. This screening of buyers and sellers, along with strict rules for entry, eliminates counterparty risk while allowing interaction between large groups of participants. Producers and consumers participate in global commodity markets to manage their price risk without delivering the physical product. Producers and consumers can match their physical commodity needs with financial contracts and eliminate the risk of being adversely effected by price movements. Brokerage Firms Brokerage firms participate in the market and earn a commission on the transactions between buyers and sellers. Most buyers and sellers cannot go directly to the exchange to purchase contracts. They have to go through qualified brokers, who are eligible to trade on the exchange. By being eligible to trade on the exchange, the brokers can charge a commission to trade on behalf of buyers and sellers. Banks 178 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

8 Banks participate in global commodities markets for two main reasons: to extend the services they offer and to protect their investments. Banks sometimes offer commodity linked products as a financial service to their clients. This allows the banks to offer lending to commodity producers who lack traditional collateral and have little means of mitigating price risk. Banks offer access to commodity exchanges for producers as a way to reduce repayment risk. At the same time, the banks also use these markets to protect risks in their own agricultural lending portfolio. Other Financial Interest Groups Other groups and individuals, who are not necessarily otherwise involved in commodities or agriculture, participate in the commodity exchange markets as an investment. They are searching for ways to both buy and sell these contracts and make a profit. Essentially, they use these markets to speculate on prices in the hope of making a profit. Accessing Commodity Exchange Markets Regulatory bodies that oversee the commodity exchanges, have strict requirements for accessing the markets directly. In addition to requiring those who want to access the market to provide documents about their business and operations, the regulatory agencies also set minimum requirements for capital and credit. A more indirect way but less expensive way to access these markets, is to work through a financial institution that offers these services. Institutions like brokerage companies or banks, can provide access to the market as a service, and will charge a commission for offering this service. This allows organizations who may not necessarily have large credit or capital to meet the regulatory minimum requirements, to enter the commodity exchange market. Interaction of brokers, the traders and the clearing house Broker The broker s role is to facilitate the clients interaction with the market. He places the client orders on the market, and provides the client with market information so that they make decisions about their hedging strategies. The broker is also responsible for managing his own risk in relationship to the client. Traders 179 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

9 While the brokers represent the client (may include a cocoa cooperative, cocoa trader or a cocoa producer) to the commodity exchange market, the traders represent the broker to the cocoa market. The traders are essentially responsible for placing the orders with the brokers who are working at the market. In this way, the traders participate in the physical matching processing between orders. Traders are slowly being replaced by electronic trading systems. Clearing House The clearing house carries out key elements of the business of the exchange. It provides the entity for passing risk and ensures that all transactions are legal. It also provides the pricing platform for all exchange transactions and provides statistical and price data. Essentially the clearing house acts as the buyer to all sellers, and as the seller to all buyers. In this way it takes responsibility for contract execution as a result buyer and seller have no need to know each other as each only deals with the Clearing House. Through brokerage services and financial institutions, developing country organizations and producers, can gain access to the market. There are a number of steps that organizations must undertake, before contacting a broker to enter the market: 1) Confirming that doing business with these international partners has local government approval and is legal 2) Understanding the financial instruments that are traded at the commodity exchange 3) Preparing and training their management staff to understand the concepts and practicalities of hedging using financial instruments 4) Informing the organization s members or clients regarding the decisions to enter into financial contracts 5) Design a price risk management strategy Once these steps have been completed, the organization can begin the registration process with financial services providers, and pending approval, access the international commodity markets through brokerage institutions. Commodity Exchanges and Transparency To ensure that the market operates effectively and transparently, the commodity exchanges have regulations in place. These regulations include the standardized cocoa 180 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

10 contracts as well as ensuring that market participants are able to meet financial obligations that come due from trading the contracts. The regulations ensure that the market is transparent, with all parties knowing the price and volumes traded. This ensures open information with regards to pricing. Such regulations also ensure that no dominant party can manipulate the market for its own gain. Primary Purposes of Exchanges Commodity exchanges have two main purposes. The first purpose is to facilitate price discovery of a commodity, and the second purpose is to enable organizations to manage risk: Price discovery is defined as "the process of determining the price level of a commodity based on supply and demand factors". This means that prices for a commodity (such as cocoa) are determined by the buying and selling of cocoa contracts by market participants. When there is greater demand than supply for cocoa, prices will rise. When there is greater supply than demand for cocoa, prices will fall. By having a marketplace with thousands of buyers and sellers, commodity exchanges can establish the current market price for cocoa. Price discovery is useful to all people and organizations working in the cocoa industry. Even those participants, who are not using the financial markets, review the prices determined on the markets, when negotiating to buy and sell cocoa. Risk management is also greatly facilitated by commodity exchanges. They enable buyers and sellers of cocoa, who are unable to hedge with physicals, to meet their hedging requirements through the purchase or sale of financial cocoa contracts. For example, a cocoa roaster may know that in six months time, he will need a certain amount of cocoa to meet his obligations. He is however unable to purchase the physical cocoa for another four months. However, he can buy futures contracts on the financial market, which guarantee him sufficient supplies of cocoa at the price stated in the contract - in six months time. This protects him from cocoa price rises that may occur between this point and the point where he is able to purchase the physical cocoa. He would hold his futures contracts until such time that he is able to purchase the physical cocoa from cocoa traders. At that point, he would close or settle his futures position by selling them. Matching Transactions Commodity exchanges remove the need for a buyer to find a seller, or a seller to find a buyer, as the exchange automatically matches buyers and sellers. A trader wanting to 181 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

11 sell physical cocoa for delivery in six months time may not be able to find a buyer in the physical market. However, he should be able to find a buyer on the futures market, until such time that he finds a physical buyer and exits the futures position. The commodity exchange is centred around a clearing house function that processes all transactions and ensures that the contracts are honoured. Large Actors Can Influence Prices No one party can dictate the price of cocoa on the exchange. However, at quiet times, a big commercial actor taking large positions, may influence the market price. This is unusual and such peaks and dips are normally rounded off, as activity increases. 182 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

12 Use of Commodity Exchanges for Cocoa The Players in Commodity Exchanges for Cocoa Who Does Business On the Exchanges and Why Key parties using the exchanges include: Commodity Producers, Traders & Buyers of Cocoa Cocoa producers, cocoa traders and buyers (processors and importers) of cocoa are all active on the exchanges. The most active, or those with the greatest volumes, are generally the largest cocoa businesses. However many smaller businesses also use the markets to manage their risk positions. All of these organizations will have the same reasons for using the exchanges: Central location for pricing cocoa - an international commodity exchange is a central location, where organizations active in buying and selling cocoa come together to trade cocoa and determine prices. Prices are set through a competitive process. By coming to the exchange, all cocoa market businesses can gain an understanding of cocoa prices, and direct their buying and selling accordingly. 183 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

13 Efficient exposure to the widest number of buyers and sellers - the vast number of traders, producers and buyers using the markets, provides the greatest access to the largest number of buyers and sellers. In the "real world" finding sufficient numbers of buyers and sellers trying to buy and sell physical cocoa at the same time can be a challenge. On the futures market where they all gather, sufficient liquidity can be built. Prices on the market are fully transparent - commodity exchanges publish prices so that any one can see the prices at which cocoa futures are trading. Real time data can be purchased from the exchange or from a data provider for a monthly fee, or accessed online with delayed prices for free. This pricing information is vital for traders wanting to know what direction prices are taking, and hence for setting prices with their counterparts, when buying and selling physical cocoa. Commodity exchanges remove counterparty risk - or rather the exchange manages counterparty risk. A trader who has sold physical cocoa forward to a buyer always faces a risk that, should prices move sharply, the buyer may not honour the contract. However such risk does not exist when a trader is entering a financial contract via the exchange. The commodity exchange has rules and procedures to ensure that all contracts are honoured (we will see more on this when we discuss margins). For price risk management - unlike physical contracts a trader (or a buyer), can use the commodity exchange to manage the price risk even if he is not planning on delivering physical cocoa. Most contracts on the exchange never reach fulfillment (where the cocoa has to be delivered) because they are offset. Therefore, traders can use futures to cover a position without necessarily having to make or accept delivery. But physical contracts, used to manage price risk, of course include the firm obligation to deliver cocoa. Brokerage Firms Cocoa traders and buyers do not visit the market directly to purchase financial contracts, but do so through specialist financial firms of brokers. Brokers take orders for the sale and purchase of cocoa contracts and place them on the market, on behalf of their cocoa business clients. Brokers earn an income from this activity by charging a commission, based upon the size and value of the contracts that they place on the market. Banks Banks access the commodity markets to offer commodity linked products, as a financial service to their clients. For example, a bank may offer hedging services to cocoa sector clients. This will assist their clients in managing risk and hence becoming more creditworthy. Others Other financial institutions may speculate on commodity markets hoping to make gains from price movements. They will see price movements (up and down) as a chance to make profits. This adds liquidity (additional parties willing to buy and sell) to the market. 184 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

14 The Cocoa Contract The Cocoa Contract Cocoa is traded on two primary international commodity exchanges. The main exchange for trading in cocoa is the NYSE LIFFE ( A secondary exchange but less commonly used is the Intercontinental Exchange ( which merged with the New York Board of Trade (NYBOT) in The NYSE LIFFE trades cocoa futures in GBP ( 's) per ton. The ICE trades cocoa in USD ($'s) per ton. These two markets cater to clients from different areas of the world. In general cocoa from West Africa is typically delivered to London, and the US exchange attracts clients from Indonesia and Latin America. Purposes of the Futures Market To Establish a Future Price, Today There will be different prices set for contracts dependent upon the month of delivery (there are futures contracts for different months of delivery). These are the future prices of cocoa, which enable traders to hedge their exposure to risk, by contracting future sales and deliveries of cocoa. A trader wishing to see what 185 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

15 futures contracts are currently trading for (and their price), can do so by accessing a variety of different online services that provide pricing information. These services usually charge a fee for real time details of future prices of cocoa but time delayed information is often available on the website of the primary exchanges. The delivery months for cocoa contracts on both exchanges are March, May, July, September and December. Ten positions are always traded, giving a two-year period. Standardized transaction sizes All futures represent a specific physical amount of cocoa. Both the NYSE LIFFE contract and the ICE is for ten tonnes. The NYSE Liffe is traded in British Pounds per tonne while the ICE is traded in dollars per tonne. Standardized Cocoa Quality The exchanges also publish firm rules on the quality of the cocoa underlying each contract. Each commodity exchange will have rules on what cocoa is deliverable and how it is graded and ranked. Information on quality standards is provided in Module 7 of this course. Standardized Time and Place of Delivery Each contract will have specific requirements as to when and where delivery must be made. This is vital as parties can only buy or sell a contract, if they know the underlying conditions and requirements for that contract. Futures contracts always specify delivery in Exchange Licensed Warehouses. These may be in a variety of locations. The NYSE Liffe allows delivery to warehouses in both Europe and the US, while the ICE only allows delivery to warehouses in the US. To Ensure a Reliable Counterpart The exchange ensures both a large number of potential contract counterparts, and also removes counterparty risk. Parties using the exchange have to commit to fulfilling their obligations on the contracts. They will be required to make payments when entering into futures contracts and as the price moves. These will be considered later when we discuss "margins" and "margin calls". To Ensure Fair and Transparent Pricing The more liquid a market, the greater the volume of contracts traded and the greater the number of different parties using the market. This also makes it harder for a market to be manipulated. It is difficult for any one party to influence the price of the contract. The exchange does not set the price of the cocoa contracts, but rather it facilitates the cumulative buying and selling of contracts between buyers and sellers that in turn sets the price. While it is possible that one group could try and influence the market by purchasing or selling large volumes of contracts, for a 186 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

16 gain, this is unlikely due to the large volumes of contracts traded, and the rules and oversight of the exchange. The transparency and volume requirements on the exchange mean that a small trader can purchase contracts at the same price as any other trader. 187 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

17 Accessing Global Financial Markets Accessing the Markets It is not possible for a trader to directly access the commodity exchanges. He will need to contact a commodity broker, who is licensed and approved by the exchange. Brokers charge their clients a commission for providing this access to the exchanges. The brokers also provide guidance and advice to their clients. Selecting a broker depends on the preference of a trader and the location of the trader. Some countries with a large cocoa industry will have a number of brokers offering brokerage services to their traders in their area, while others may have a very small selection. In some countries local legislation may prevent futures and derivatives brokers from operating. A trader can choose to either use a local broker (if available), or an international broker located in a different country. Selecting a broker should be based on a combination of factors including the commission that they charge, additional services that they offer (for example advice and guidance, provision of research on cocoa markets, real time pricing of cocoa futures), and preferably one with whom they can build a strong relationship. 188 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

18 A broker may also have rules and policies to deal only with clients who trade a certain volume of cocoa. Therefore, a trader will need to be aware of how much (or how little) cocoa they are likely to trade, and discuss this with each broker that they approach. A trader wishing to get started on selecting a broker should talk to other traders in their region, to find out who they are using for brokerage services. They should also call a number of potential brokers and describe their requirements to ask what services they offer. Eventually they can select a broker that they feel best fits their requirements. 189 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

19 Novation and Counterparty Risk A Forward Contract Between a Cocoa Buyer and Seller Counterparty Risk Exists A cocoa trader that has agreed to deliver physical cocoa at a point in the future, always faces an element of risk that the buyer may not honour the contract should market conditions change and prices fall. The buyer in turn faces the risk that the trader may not deliver if prices rise. This risk is known as counterparty or performance risk. A trader can minimize such counterparty risk by knowing their buyer well, checking on their reputation, selecting a buyer that is financially sound - however while these will reduce the likelihood of default they can not eliminate the risk of such a default. A Futures Contract Between A and B on the Commodity Exchange The exchange on the other hand has processes and procedures for managing clients using the exchange and, should a party default on their commitments then the exchange will honour the contract. As such a trader using a commodity exchange does not have to worry about counterparty risk because he is, in fact, selling to or buying from the Clearing House. 190 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

20 In terms of hedging using physical forward contracts it is obvious therefore that the physical business always includes counterparty risk, whereas forward hedging on the futures markets does not. But of course there are other aspects to the use of futures that need to be considered carefully, like margin calls. 191 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

21 Hedging With Futures enabling Back to Back Operations Hedging with Futures - Back to Back Operations A trader who is unable to secure an immediate sale of his cocoa, or enter into a physical forward contract, can still achieve the same "back to back" effect by selling an equivalent amount at the price quoted on the futures market. As such futures contracts can be a useful tool for undertaking back to back operations even when such operations are not possible in the physical market. Futures Markets Trade Contracts for Future Delivery Futures markets trade contracts for future delivery of cocoa at prices set on the exchange today. These contracts specify quality, place of delivery and quantity of cocoa to be delivered. These contracts may be traded repeatedly up until the delivery specified in the contract. Prices will vary as cocoa prices move reflecting changes in international demand and supply. 192 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

22 Every futures contract traded will have two parties involved a seller and a buyer. Both deal through the Clearing House that acts as their counterpart. As such neither party knows the identity of the other. Very few futures contracts will ultimately result in actual physical delivery. The parties have clear obligations when taking on a contract and will have to make good any gain or loss in price of the cocoa, during the period that they hold that contract. Futures Contracts are Contractual In Nature A number of participants trading futures contracts will not be involved in the cocoa supply chain, but will be trading speculatively, buying and selling contracts to gain from market price movements. These additional market actors (non-cocoa businesses), add liquidity to the marketplace by providing additional counterparties with which to trade. This liquidity provides near certainty that a trader needing to hedge with futures, will be able to place their order and find a counterpart to transact with. 193 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

23 Hedging With Futures enabling Back to Back Operations Futures Contracts Explained Futures Contract and Back to Back Operations - The Principles Once a Hedge is in Place, Price Movements on Physicals are Offset by Movements on the Futures Position The whole purpose of back to back operations is to avoid price risk by having an equal and opposite position in place, to negate any price risk exposure. As prices in general move, any gain or loss on the physical position, will be reflected with a more or less equal and opposite loss or gain on the financial market. Back to Back Hedging Requires HIGHLY Correlated Prices between Domestic and International Cocoa Markets (Basis Risk) For back to back operations to be effective, and for using futures contracts to offset a position in the physical market, it is vital for the basis between local markets and futures contracts on commodity exchanges to be relatively stable. If basis risk is high and price differentials vary significantly over time between local and international markets, it is 194 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

24 possible that a movement in the price of one market will not be replicated by an equivalent movement in the other. This will mean that a loss in one market will not be offset by an equivalent gain in the other market. Where basis risk is high, hedging with futures will not be an effective means of managing risk, as losses and gains over time on each side of the equation will not be equal. Put differently: Price risk generally can be hedged but basis risk cannot. Futures Exchanges Supply a Counterparty Ideally a trader would not need to use futures to hedge, but would be able to use forward contracts with buyers (in the physical market) to hedge and eliminate their exposure. However, where a trader is not able to find a buyer to agree a suitable physical forward contract, futures provide a means of achieving the same goal. The global nature of the exchange ensures liquidity, and means that a trader can always find a counterpart when required. Terminating the Hedge on the Commodity Exchange For effective hedging, it is vital that a trader terminates (or "lifts") his futures position at the same time as he closes his position in the physical market. A physical position is closed when the trader sells the cocoa that he holding. If a trader fails to simultaneously lift or close his futures position, he will become exposed to risk from adverse price movements in the futures market that now are no longer offset by his position in the physical market. The futures position should be closed out when the physical cocoa is sold. 195 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

25 Using Futures Contracts to Hedge Hedging with Futures Long or Short Position Long Position A long position in the commodity market, involves a trader buying futures contracts. These contracts specify that the buyer of the contract will receive delivery of the stated amount of cocoa, on the date specified on the contract. A trader that has bought a futures contract will, on contract expiry, receive delivery of the contracted quantity and quality of cocoa at the price determined when he purchased the futures contract. Short Position A short position in the commodity market, involves a trader selling futures contracts. These contracts specify that the seller of the contract will deliver a stated amount of cocoa, on the date specified on the contract. 196 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

26 A trader that has sold a futures contract will, on contract expiry, deliver the contracted quantity and quality of cocoa at the price determined when he sold the futures contract. Futures Contract Held for Hedging Should Never Result in Delivery In both cases (buying or selling futures contract) a trader using futures contracts is unlikely to hold the contract up until the expiry date as they will close down the futures position the moment they close their physical position. Very few organizations using the commodity exchanges will actually be aiming to deliver or receive physical cocoa: the vast majority of futures contracts are closed out before expiry by offsetting equivalent sales or purchases. The position taken by a cocoa trader on the commodity exchange will depend on his position in the physical market. If a cocoa trader in the physical market is "short" i.e. has sold more cocoa than he have bought, he will then take a "long position" on the commodity market by buying futures contracts. If a cocoa trader in the physical market is "long" i.e. has bought more cocoa than he has sold, he will take a "short position" on the commodity market by selling future contracts. The following pages provide examples of hedging when short and long. 197 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

27 Using Futures Contracts to Hedge Futures Contracts - Short Hedge Explained Futures Contracts - Short Hedge Example In the above slide, we consider a cocoa trader with a long position in the physical cocoa market. In this example, the cocoa trader will enter into a "short hedge" in the financial markets, to offset his long physical market position. Once he has closed his position in the physical market, he will also close his futures position. Stage 1 In October cocoa trader has bought cocoa at 1715/MT in his local market (with a - 5 differential) to the international market. He intends to sell this cocoa in December. The cocoa trader is therefore at risk of cocoa prices falling. If cocoa prices fall between October and December, he will lose money when he sells his cocoa. To protect against cocoa prices falling between October and December, the cocoa trader will (via a commodity exchange broker) place a short hedge, by selling future contracts: 198 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

28 Sell futures contract (s) equal to the amount of the cocoa that he bought in October and plans to sell in December Sell the futures at 1720/MT, which represents the international market price at the moment in time. Stage 2 In December, when the cocoa trader sells the physical cocoa to his buyer(s), cocoa is trading on the international markets at 1750/MT. Physical Market Transaction The cocoa trader sells the physical cocoa at the equivalent local market price of 1745/MT. This reflects the international market price minus the 5/MT differential, and results in a gain of 30/MT. Financial Market Transaction The cocoa trader also closes his hedge on the financial cocoa market at the same time. In order to close his existing position in the futures market, he will buy the futures contract back in December at 1750/ MT as futures prices have risen by 30/MT. In this scenario, the trader will make a loss on the futures contract of 30/MT which is the difference between the price at which he sold in October and the buy back price now. Overall Position The rise in cocoa prices between October and December, results in a gain of 30/MT on the physical cocoa sales. However, the futures hedge has resulted in an equal and opposite loss of 30/MT. The net result is neutral for the cocoa trader. By entering the hedge in the financial market to hedge a physical position, the trader effectively gave up the gain from rising prices in exchange for zero risk. NB: Of course an exact match between profit and loss is unlikely there will always be some differences. 199 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

29 Using Futures Contracts to Hedge Futures Contracts - Long Hedge Explained Futures Contracts - Long Hedge Example In the above slide, we consider a cocoa trader with a short position in the physical cocoa market. In this example, the cocoa trader will enter into a "long hedge" in the financial markets, to offset his short physical market position. Once he has closed his position in the physical market, he will also close his futures position. Stage 1 A cocoa trader in October sells cocoa at 1715/MT for delivery in December ( -5/MT differential). He intends to buy this cocoa in December. The cocoa trader is therefore at risk of cocoa prices rising. If cocoa prices rise between October and December, he will lose money when he buys his cocoa to fulfil the forward sale. To protect against cocoa prices rising between October and December, the cocoa trader will (via a commodity exchange broker) place a long hedge, by buying futures contracts: 200 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

30 Buy futures contracts equal to the amount of the cocoa that he sold forward in October and plans to buy in December Buy the futures at 1720/MT price. In this example the trader buys futures in October at 1720/MT, which shows a 5/MT difference between the local market price and the futures price, i.e. the basis or differential. Stage 2 In December, when the cocoa trader buys the physicals from his producer(s), cocoa is trading on the international markets at 1750/MT. Physical Market Transaction The cocoa trader buys the physical cocoa at the local market price of 1745/MT. This results in a loss of -30/MT. Financial Market Transaction The cocoa trader closes his futures position at the same time by selling his futures at 1750/MT as cocoa prices have risen by 30/MT. In this scenario, the trader will make a gain on the futures of 30/MT as he bought them in October at 1720/MT. Overall Position The rise in cocoa prices between October and December, results in a loss of 30/MT on the physical cocoa sale. However, the hedge has resulted in an equal and equivalent gain of 30/MT on the futures. The net result is neutral for the cocoa trader. By using futures to hedge a physical position, the trader effectively gave up the gain on the futures contract in exchange for zero risk on the physicals he sold short. NB: Of course an exact match between profit and loss is unlikely there will always be some differences. 201 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

31 Using Futures Contracts to Hedge Types of Futures Contracts Futures Contracts - Types of Orders There are a number of ways for a trader to place an order (to buy or sell futures contracts) with the exchange through a broker: Market Orders Market orders are orders placed with brokers to be executed on the market, at the best price currently available. These can be both for the purchase or sale of cocoa futures contracts. It is likely that this is the kind of contract that a cocoa trader wishing to use futures to hedge would use. They enable the trader to speedily offset a physical position with a futures contract. A reduced period of time between physical and futures activity should ensure that prices remain aligned, and hence the trader s objective will be to "lock in" his profitability. Of course traders can also place fixed rice orders but restricting the broker to a certain price can mean the order may not be executed, thereby defeating the hedging objective. 202 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

32 Limit Orders Limit orders involve a customer setting a limit on price or time for the execution of a trade, or both. For example, a "buy limit" order is placed at a price below the current market price. A "sell limit" order is placed at a price above the current market price. A sell limit is executed only at the limit price or higher (better), while the buy limit is executed only at the limit price or lower (better). Stop-Loss Orders Stop-Loss orders become market orders once a certain price level is reached. These orders are often placed with the purpose of limiting losses, if market prices move significantly against a trader s position. This enables the trader to "cap" his losses, rather than risk having the price move even further against his position. Buy-stop orders are placed at a price above the current market price. The aim is to only come into force if the market price for cocoa reaches or exceeds this limit, thereby preventing further losses for the trader who is short cocoa. Sell-stop orders are placed below the current market price. They come into force only if prices fall to or below this limit, thereby limiting a long holder s losses in the event of a sharply falling market. Good till Cancelled Orders (or "GTC" Orders) The purpose of such orders would be to buy or sell cocoa at a price that is currently not available on the market. The trader might hope to catch a sharp movement in prices and benefit from getting the order placed, without having to carefully monitor the market on an ongoing basis. However the use of GTC orders for hedging is quite limited, as most traders using futures or options to hedge, will want to fix a contract in parallel to activities and trades within their physical business. Cocoa traders wishing to hedge their exposure through back to back operations (i.e. creating risk through their physical cocoa trades, and then immediately controlling this risk by taking an equal and opposite position on the futures market), will rely on market orders that correspond to their activities in the physical market. However, larger scale multi-nationals and expert trading businesses may frequently use combinations of the above order types, as part of a complex risk management or trading strategy. A GTC order is an order placed with a broker to buy or sell a cocoa futures contract at a set price. The broker will only execute (or fulfil) this order if the price is reached. The order will stay active until it is either cancelled (by the trader) or fulfilled. Therefore, anyone placing a GTC order should keep this under constant review and not forget it was placed. 203 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

33 Using Futures Contracts to Hedge Placing & Lifting a Hedge Futures Contracts - Placing & Lifting Hedges Gain / Loss determined by the price difference between sale and purchase Any gain or loss on the futures trades will be realized once the contract has been liquidated and will be determined by the price movement between establishing the futures position and liquidating it. The trader who has hedged physicals with futures should expect the loss or gain on one side of the hedge to be offset by a more or less equivalent loss or gain on the other, always assuming there has not been a major shift in the basis or differential. Bearing in mind the volatility of cocoa prices, it is of the utmost importance that a trader lifts their hedge the moment they have closed their position in the physical cocoa market. Leaving a futures position in place after the physicals position has been closed is pure speculation and may result in serious loss if the market moves against one. 204 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

34 Using Futures Contracts to Hedge Futures Contracts - Placing & Lifting a Hedge Futures Contracts - Placing & Lifting Hedges Placing a Hedge This refers to a cocoa trader either selling or purchasing futures contracts on the commodity exchange to offset a position in physical cocoa. Lifting a Hedge This refers to a cocoa trader closing a position on the commodity exchange, following a change in the cocoa trader s physical position. Lifting a hedge is done in one of two ways: A trader who had sold a futures contract would need to purchase a futures contract (at the current market price) that would offset and negate the contract previously sold. OR 205 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

35 A trader who had bought a futures contract would need to sell a futures contract (at the current market price) that would offset and negate the contract previously bought. 206 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

36 Using Futures Contracts to Hedge Margins 207 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

37 Futures Contracts - Margins Futures contracts require deposits from the trader at the point of entering into a futures contract (buying or selling a futures contract), and potentially also during the period of holding the contract in the form of margin requirements. These payments are deposits and are repaid when the hedge is lifted. While futures are a low cost means of hedging, the need to provide margins can make their use problematic for traders who do not have either adequate cash, or credit facilities, to fund margins. There are two types of margins on futures contracts: Initial or Original Margins Initial margin (also called "Original Margin") is the amount of money that a person must deposit with his broker, when buying or selling a futures contract. As noted above, the amount will vary by exchange and by contract as well as by broker. Initial margins are basically "good faith deposits" showing the commitment of the user of the contracts, to meet any losses on the contracts caused by adverse price movements. Variation or Maintenance Margins As the price of cocoa rises and falls, profits and losses will be generated on the futures contract each day. These gains or losses are the difference between the agreed price of 208 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

38 the cocoa in the futures contract, and the prevailing market prices that vary from day to day. These gains or losses will be paid in and out of the trader s margin account. The broker has an obligation to ensure that this margin account always holds the minimum margin requirement. If a series of adverse price movements occur, the broker may have to request the client to top-up the margin account. The position of the contracts will be marked to market daily (i.e. gains or losses are calculated). In volatile price periods, this may lead to regular margin calls. As such a holder of a futures contract may need to make regular additional payments to his broker in order to maintain the minimum margin requirements. The reason for having margin accounts is to protect the Clearing House against counter party risk. The funds held in margin accounts rise and fall, as prices of the commodity rise and fall. This ensures that there should always be sufficient money held by the Clearing House to cover losses in case of default by a trader. Implication of Margins The requirement to provide an initial margin (approx. 10% of the contract value) and to potentially make top-up's to the margin account, has significant implications for a cocoa trader using futures to hedge his physical exposure. A trader will need to have significant amounts of cash (or bank facilities in place), to both meet the initial margin requirements and to subsequently make top-up's to an account, if markets move against the futures contract. Each cocoa trader will need to consider whether his financial position will allow him to meet such requirements. Traders will most likely have to agree to a facility with their bank, which provides credit to fund initial margins and meet potential margin calls. A trader using futures contracts who can not meet margin calls, will find his positions closed down by the broker and the exchange. He will lose both the initial deposits as well as the protection that the hedge provided for his business. Traders may also discover that the ability to secure an open credit-line with a bank to meet margin calls can be difficult. In cases where the bank is not knowledgeable about the use of futures contracts to hedge exposure, the trader may be required to spend time and effort educating his bankers regarding the benefits of hedging in terms of reduction in risk. Also, in some countries foreign exchange regulations or other legislation may impede easy access to international commodity exchanges. Covering Losses It is possible that traders may be dissuaded from considering the use of futures due to having to provide margins and the fear of generating losses on futures contracts. However traders should also consider that any loss on futures (requiring margin calls) will be made up for in the physical market (once all trades will be equal and opposite, meanings that a loss on the futures contract will have an equivalent gain on the physical 209 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

39 trade). As such, as long as the trader has adequately assessed that basis risk is acceptable, has conducted back to back operations in a timely manner and can meet any margin calls until the date that their physical position is unwound,they will find themselves netting off any losses on the futures markets with an equivalent gain in the physical market. 210 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

40 Using Futures Contracts to Hedge Futures Contracts - Advantages and Limitations for use in Hedging Hedging with Futures - Advantages and Limitations Advantages For traders that can't cover their positions adequately with physicals, futures contracts can enable them to conduct back-to-back operations and protect their business from adverse price volatility. Other advantages, specific to futures contracts as a tool for hedging include: 1. Common platform for all traders Futures contracts traded on commodity exchanges are standardized and clear contracts available to any trader or any business. This commonality ensures that everyone dealing on the market has the same advantages and freedom to benefit and act. 211 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

41 2. Price transparency Futures markets ensure that prices are fully transparent to all participants. Unlike the physical market, where contracts are negotiated between traders and buyers in confidential discussions, the futures marketplace publishes all pricing details. This enables a trader to know that the contract they are establishing is at the best price possible. 3. Lower Transaction Costs Futures markets are incredibly efficient and low cost to use. Hedging, using futures involves low costs for a cocoa trader ( brokerage and exchange fees and commissions), making it affordable for hedging. 4. Absence of counterparty risk Hedging with futures contracts, to all extents and purposes, eliminates counterparty risk. A cocoa trader hedging with futures will know confidently that their contract will be honoured. This is very different from hedging with physical contracts where at times of great price volatility counterparties may renege on, or demand to renegotiate, contracts. 5. Market prices available to the wider world All actors within the cocoa industry, not just traders, benefit from transparent pricing. The setting of a benchmark price helps all actors determine their pricing and business strategies. 6. Liquid Market A trader wishing to hedge with physical contracts will not always be able to find a suitable buyer willing to provide him with a contract that meets his needs in terms of price, delivery dates, volume, etcetera. The futures market overcomes this barrier. A cocoa trader wishing to hedge will be able to find a counterparty on the exchange, when they need to do so. This is almost guaranteed by the vast number of organizations trading cocoa futures contracts making this market incredibly liquid. In addition, should a trader wish to "lift a hedge" following a change in his physical position, he will very quickly be able to do so, as he will easily be able to find a buyer or a seller in the market. 7. Standardized contract size Cocoa futures contracts have standardized sizes each contract is for 10 MT. This enables simple trading of standard amounts of cocoa, which is often not the case with physical contracts that can vary in size contract by contract. 212 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

42 8. Competitively priced compared to OTC contracts Exchange traded futures contracts are more cost effective for hedging than Over the Counter (OTC) contracts. Although OTC contracts can be tailored to a traders exact requirements (volume, dates, etc). Limitations of Using Futures The main limitations of using futures that a trader needs to consider include: 1. Basis or Differential Risk The relationship between the price of cocoa on the international market (where futures are traded and priced) and a trader s local market has to be stable. Hedging with futures will only work when there is a strong correlation between cocoa prices on both markets. Every trader that is considering hedging with futures will need to undertake some significant research, to test the strength of the relationship between the prices on both markets. He has to be confident that the correlation is stable. Where there are significant variances during a season in basis, a trader should not use futures to hedge. Where there is strong correlation over time and within seasons, then futures can be utilized. 2. Physical Volume Risk Hedging with futures will not protect against local market problems when physical cocoa collection and delivery is interrupted. This may happen when a trader has used futures to protect against anticipated physical market activities, but then finds that his hedge is inappropriate (or less appropriate), as changes in the local market for physical cocoa occur. For example, a trader who has sold short forward physical cocoa, and has hedged by purchasing a futures contract to offset this risk, will find this protection inappropriate should he be unable to obtain that cocoa in the physical market. 3. Imperfect - a mismatch between gains and losses No one local cocoa market will have a perfect correlation with the international market price for cocoa. The international price is set by global supply and demand, while local prices are driven by both international price movements and local market considerations (local market supply and demand). As such, futures are imperfect and gains in one market will not be perfectly matched by losses in another. Traders hedging in the futures market may therefore find a mismatch between gains and losses. However, as long as the local market and the international market are highly correlated the mismatch should not be too large, and still justify the use of futures for hedging. 213 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

43 4. Finance required to meet margins Summary For many traders the need for upfront margins, can make the use of futures very difficult, especially when they have very limited cash reserves and limited access to borrowing from their banking partners. Only traders that can fully meet both initial and ongoing margin requirements should consider using futures. There are clearly good opportunities for traders wishing to hedge using futures, as the futures market offers the potential to hedge exposure in a cost effective, practical and timely manner. However there are clearly limitations and hurdles to consider before using futures. Each trader will need to assess his own business model, the local cocoa market and his business as well as his financial requirements, before being able to assess whether the use of futures for hedging is appropriate to his particular circumstances. 214 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t

44 Summary of Hedging with Futures Contracts Futures Contracts - Summary We have seen that: Futures can be used by cocoa traders to hedge their exposure to adverse price movements. Futures enable a trader, who can not use the physical market to adequately hedge exposure, to use the financial markets to hedge. He can do so until such time that he is able to close down his position in the physical market, or access contracts in the physical market that offset his physical risk position. By taking positions on the futures market that are equal and opposite to the position in the physical market, a trader is able to "lock in" profitability and avoid losses that might be caused by adverse price movements. Futures are not a total solution and have some significant limitations. These are primarily the issues of basis risk and the need to have adequate financing in place for margin requirements. 215 M o d u l e 4 B C o c o a P r i c e R i s k M a n a g e m e n t