Futures markets allow the possibility of forward pricing. Forward pricing or hedging allows decision makers pricing flexibility.

Transcription

1 II) Forward Pricing and Risk Transfer Cash market participants are price takers. Futures markets allow the possibility of forward pricing. Forward pricing or hedging allows decision makers pricing flexibility. A futures market transaction is a temporary substitute for a cash market transaction. (So does trading futures change the nature of the eminent cash market transaction?) Pricing becomes a decision. Hedgers need to learn how to make good pricing decisions and need to recognize good decisions can result in bad outcomes. AREC 412 Lec D Forward Pricing & Risk 1

2 There are two facts about cash and futures markets which make hedging effective. 1) Cash and futures prices respond to the forces of supply and demand such that the two markets move together. Cash commodities and futures contracts are assets the value of which moves in the same direction. Therefore, an opposite position in the futures market will offset changes in cash asset values. 2) As the futures contract approaches the expiration date, the cash and futures prices will converge to a predictable difference. The difference is called: basis = cash futures. This means that any futures prices can be converted to something that look like cash market prices using: futures + basis = cash. After working the examples, make sure you understand what is meant by effective. AREC 412 Lec D Forward Pricing & Risk 2

3 Perfect Conservative Hedge Example Corn producer ex) Falling prices Date Cash Futures Basis 6/1 Forward Price = Futures + Basis DEC $4.00/bu (expected) BE Price = $3.25/bu. 11/1 Sell cash $ DEC $3.00/bu (actual) Gain/Loss = $ Net Price = Cash Price + Gain or Loss in Futures AREC 412 Lec D Forward Pricing & Risk 3

4 ex) Falling prices (& this is the good 2018 & 2016 outcome) Date Cash Futures Basis 6/1 Forward Price = Futures + Basis $4.10 = BE Price = $3.25/bu. DEC $4.00/bu. Sell (expected) 11/1 Sell cash $3.10/bu. DEC $3.00/bu. Buy (actual) Gain/Loss = +$1.00/bu. Net Price = Cash Price + Gain or Loss in Futures $4.10/bu. = AREC 412 Lec D Forward Pricing & Risk 4

5 T-Account Schematic Date Cash Futures Basis 1) Decision period Forward Price = Futures + Basis 4) Opportunity 3) Futures price 5) Futures action temporary substitute for cash action 3) expected basis in outcome period 2) Outcome period 6) Cash action 6) Futures outcome 6) Gain/Loss 6) actual basis in outcome period 7) Net Price = Cash Price + Gain or Loss in Futures AREC 412 Lec D Forward Pricing & Risk 5

6 Perfect Conservative Hedge Example Corn producer ex) Rising prices Date Cash Futures Basis 6/1 Forward Price = Futures + Basis $4.10 = BE Price = $3.25/bu. DEC $4.00/bu. Sell (expected) 11/1 Sell cash $ DEC $5.75/bu. Buy (actual) Gain/Loss = Net Price = Cash Price + Gain or Loss in Futures AREC 412 Lec D Forward Pricing & Risk 6

7 ex) Rising prices (& this is the bad outcome) Date Cash Futures Basis 6/1 Forward Price = Futures + Basis $4.10 = BE Price = $3.25/bu. DEC $4.00/bu. Sell (expected) 11/1 Sell cash $5.85/bu. DEC $5.75/bu. Buy (actual) Gain/Loss = $1.75/bu. Net Price = Cash Price + Gain or Loss in Futures $4.10/bu. = AREC 412 Lec D Forward Pricing & Risk 7

8 Choosing and realizing a forward price is what is meant by effective forward pricing. Not price enhancement, not the best price, not the highest price, not above costs of production... Hedging works because losses in one market are offset by gains in the other market. The example also illustrates risk transfer. The risk of a price change is transferred to (most likely) a speculator. The hedger is protected against all price changes. Producers are still price takers but when they take price is flexible and forward pricing decisions become an opportunity. forward pricing window (months) price taking (day) forward pricing window (months) price taking (day) harvest harvest Example) What is JUL19 KC wheat trading for? What about DEC18 & DEC19 corn? (We did this! Go do it now and think about opportunities from the perspective of a producer ) AREC 412 Lec D Forward Pricing & Risk 8

9 Corn producer example, decision to hedge: falling prices good or bad? decision to hedge: rising prices good or bad? Example) Former student with $650k of margin calls in (1.69=251/148.2) Example) Suppose the corn producer in our examples sold 10 contracts 50,000 bu. and suppose the market rallied to where the producer was losing $2/bu. How much financing would be needed? From where would that money come? Margin calls, margin calls, margin calls What are you going to do when you get margin calls? What about using forward contracts? (But what about credit risk?) AREC 412 Lec D Forward Pricing & Risk 9

10 Corn producer example, decision to hedge: falling prices good or bad? decision to hedge: rising prices good or bad? Are you thinking DECISION or OUTCOME? Was the decision good or bad given the information available when the decision was made? What information and processes would it take for you to make good forward pricing decisions? Break-even Price & Costs of Production Basis Information Access to Credit Capital Budgeting Risk Assessment & Target RoR or ROI Market Outlook? Price Forecasts? Probabilistic Forecasts? (Crystal ball?) AREC 412 Lec D Forward Pricing & Risk 10

11 Where does this information go on the Cash Flow Statement? Beginning Cash Balance Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Operating Receipts Grain Livestock Futures G/L Capital Receipts... $ $ $ $ Total Cash Inflow Operating Expenses... Debt Payments... $ $ Total Cash Outflow Ending Cash Balance What is the date when the decision was made and when is the outcome realized? AREC 412 Lec D Forward Pricing & Risk 11

12 Where does this information go on the Balance Sheet? ASSETS LIABILITIES Current Assets Current Liabilities Cash assets $... Futures assets $ Futures liabilities $ Capital Assets Capital Debt $ $ $ $ Total Assets $$$ Total Liabilities $$$ EQUITY $$$ AREC 412 Lec D Forward Pricing & Risk 12

13 Perfect Conservative Hedge with Options Example Corn producer ex) Falling prices Date Cash Futures Basis 6/1 Forward Price Floor = Option Futures Price + Basis - Premium $3.75 = BE Price = $3.25/bu. DEC $4.00/bu. Right to sell DEC $4.00/bu. is $0.35/bu. Buy option (Put) (expected) 11/1 Sell cash $ DEC $3.00/bu. Right to sell DEC $4.00/bu. is $? (actual) Net Price = Cash Price + Gain or Loss in Options AREC 412 Lec D Forward Pricing & Risk 13

14 ex) Falling prices Date Cash Futures Basis 6/1 Forward Price Floor = Option Futures Price + Basis - Premium $3.75 = BE Price = $3.25/bu. DEC $4.00/bu. Right to sell DEC $4.00/bu. is $0.35/bu. Buy option (Put) (expected) 11/1 Sell cash $3.10/bu. DEC $3.00/bu. Right to sell DEC $4.00/bu. is $1.00/bu. Sell option (actual) Net Price = Cash Price + Gain or Loss in Options $3.75/bu. = AREC 412 Lec D Forward Pricing & Risk 14

15 Perfect Conservative Hedge with Options Example Corn producer ex) Rising prices Date Cash Futures Basis 6/1 Forward Price Floor = Option Futures Price + Basis - Premium $3.75 = BE Price = $3.50/bu. DEC $4.00/bu. Right to sell DEC $4.00/bu. is $0.35/bu. Buy option (Put) (expected) 11/1 Sell cash $ DEC $5.75/bu. Right to sell DEC $4.00/bu. is $? (actual) Net Price = Cash Price + Gain or Loss in Options AREC 412 Lec D Forward Pricing & Risk 15

16 ex) Rising prices Date Cash Futures Basis 6/1 Forward Price Floor = Option Futures Price + Basis - Premium $3.75 = BE Price = $3.50/bu. DEC $4.00/bu. Right to sell DEC $4.00/bu. is $0.35/bu. Buy option (Put) (expected) 11/1 Sell cash $5.85 DEC $5.75/bu. Right to sell DEC $4.00/bu. is $0.00. Option expires worthless (actual) Net Price = Cash Price + Gain or Loss in Options $5.50/bu. = AREC 412 Lec D Forward Pricing & Risk 16

17 Scenario Cash Futures Options Falling Prices Rising Prices Steady Prices First, find the prices for the different strategies under the different scenarios. Second, determine which is the best strategy? For a given scenario row which strategy column has the highest price? AREC 412 Lec D Forward Pricing & Risk 17

18 Scenario Cash Futures Options Falling Prices $3.10 $4.10 $3.75 Rising Prices $5.85 $4.10 $5.50 Steady Prices $4.10 $4.10 $3.75 Which is best? Are you thinking Decision or Outcome? Cash and Futures are always best or worst outcome. With options, the price protection is not as good as with futures. However, you are not locked into a futures position that loses money. But options are not a fix-all for the problem with a futures hedge more flexible but more costly. Options are never the best outcome are many times second best and sometimes the worst. (I did here but don t ignore commissions and interest on borrowed money.) Decision makers need a forward pricing strategy a method and information to make good pricing decisions. AREC 412 Lec D Forward Pricing & Risk 18

19 Reading Assignment USDA ERS Publication. Managing Risk in Farming: Concepts, Research, and Analysis. Ag Econ Report 774 (AER-774). AREC 412 Lec D Forward Pricing & Risk 19

20 How Do We Measure Risk? First, we have to answer How do we measure return? Then risk is like experience... frequency Ex) Enterprises A, B, & C μ A = μ B < μ C σ A < σ B < σ C Which enterprise is best? Which is worst? (See spreadsheet figure.) Price or Revenue or RoR AREC 412 Lec D Forward Pricing & Risk 20

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23 Returns are some expected value e.g., mean price, profit, or rate of return. Risk is some measure of deviation from expected value e.g., standard dev. The first batch of equations... T Return: E(x) = = x t / T or E( y t ) = = β 0 + β 1 x 1t β k x kt t=1 T T Risk: = ( x t ) 2 / (T-1) or = (y t ) 2 / (T-(k+1)) and σ = σ 2 t=1 t=1 Measures of central tendency are measures of what we can expect means or conditional means (i.e., regression predictions). Measures of dispersion are measures of departures from what we expect how spread out are the realizations. Interpret: 1) mean and 2) standard deviation? The mean is easy as it s the? Standard deviations measure dispersion or how spread-out the individual x t s are around the mean. Using σ with a Normal distribution, 68% of time what? 95% of the time what? And 99% of the time what? AREC 412 Lec D Forward Pricing & Risk 23

24 Some real-world numbers Livestock Grains Specialty Stocks Bonds T-Bills Return (μ) 5-8% 8-12% 15-25% 8-10% 5-7% 1-3% Risk (σ) 10-20% 15-30% 25-50% 15-20% 10-15% 2-4% Which enterprise is best? Which investment is best? Evaluating Investment and Other Business Decisions Using Efficient Frontier % Return A choice is efficient if has the highest return for a given risk or lowest risk for a given return. There are no wrong choices among risk-efficient choices. % Risk AREC 412 Lec D Forward Pricing & Risk 24

25 Some Ideas About Measuring Risk Deviation from what we expect... Outcome = Expectation ± Departures from expectation (Risk) Simple Expectations Yield: Y t = μ + e t Price: P t = μ + e t Alternative: P t = P t-1 + e t (Where e t is a random variable with zero mean and possibly distributed Normal.) Better (or Smarter) Expectations Yield: Price: Y t = trend + e t = β 0 + β 1 t + e t P t = β 0 + β 1 P t-1 + e t (See spreadsheet figures for yields and prices.) AREC 412 Lec D Forward Pricing & Risk 25

26 It might not be on exams but it will be on assignments Make sure you can do the following. Calculate the yield forecast, or expected dry-land corn yield, for 2018: Y t = β 0 + β 1 t + e t Y t = t + e t where t = 44 for 2018 so E(Yield 2018 ) = (44) = bu./ac. Now the unexplained variation in yields is measured by σ from the model above. Given σ = 15.1 (find that in the spreadsheet table) then calculate the probability that the dry-land corn yield is below 29.7 bushels/acre in NORM.DIST(29.7, 59.9, 15.1, true) = %. Change 29.7 above to 44.8, calculate the new probability, and interpret. The answers are on the table of corn yield and price data. Do the work above, find it on the table, and invest time in understanding the NORMDIST function in MS Excel. We are measuring risk and I think that s important. AREC 412 Lec D Forward Pricing & Risk 26

27 Similarly, on the price side, make sure you can do the following. Calculate the price forecast, or expected corn price, for 2018: P t = β 0 + β 1 P t-1 + e t P t = P t-1 + e t where P 2017 = 3.35 (price for 2017) so E(P 2018 ) = (3.35) = $ /bu. Now the unexplained variation in price is measured by σ from the model above. Given σ = 0.60 (find that in the spreadsheet table) then calculate the probability that the corn price is below $2.70/bu. in NORM.DIST(2.70, 3.30, 0.60, true) = %. Change 2.70 above to 2.11 and then to 3.25, calculate both new probabilities, and interpret. The answers are on the table of corn yield and price data. Do the work above, find it on the table, and make sure you understand the NORMDIST function in MS Excel. We are measuring price risk and I think that s yahoo-important. AREC 412 Lec D Forward Pricing & Risk 27

28 More on NORM.DIST( X, µ, σ, TRUE ) or NORM.DIST( Outcome, ExpectedValue, StandardDeviation, TRUE) X is the specific event outcome for which we want the probability, µ is the measure of central tendency or the mean or the expected value (or forecast) of the distribution, σ is the measure of dispersion or the standard deviation of or the risk in the distribution, TRUE tells the function to do the integration for us so that we get the probability of X or less happening. For example, what s the probability of corn price being $3.25 or below in 2018? We need the forecast or expected value for 2018 (think of that as µ). We need the error associated with our forecast (think of that as σ). So NORM.DIST( 3.25, µ, σ, TRUE) and we are in the ballpark. Similarly, what the probability of the corn price being above $4.50/bu? AREC 412 Lec D Forward Pricing & Risk 28

29 Back to Expectations and the Smartest Yet Using Economics Demand: P t = a + b Q t + c I t + e 1t Supply: Q t = d + f P t-1 + g X t-1 + e 2t P t = a + b ( d + f P t-1 + g X t-1 ) + c I t + e t P t = (a + bd) + bf P t-1 + bg X t-1 + c I t + e t P t = β 0 + β 1 P t-1 + β 2 X t-1 + β 3 I t + e t You can (build an econometric model especially if you need to do a short research paper to) predict this year s price with last year s price and variables that shift the supply curve and (predictions of) variables that shift the demand curve. This will work well. (The R-squared will be high and be difficult to make larger.) The bottom line is good agribusiness planners have a fact-based or experiencebased perception of what s going to happen before they act. Some use data & econometrics and some use years of experience. Outcomes are less surprising for those that are smart and plan. (But those that forward price are not surprised much.) AREC 412 Lec D Forward Pricing & Risk 29

30 Potential Forecasting Exercise: We need an expectation for (your choice commodity) this coming (your choice time). We ll use past prices... What are potential supply shifters? What are potential demand shifters? AREC 412 Lec D Forward Pricing & Risk 30

31 Better yet, let s work on that corn price forecasting econometric model. The simple regression model has been quite wrong for the past few years. So, can we change it so that it sees the big price increase and decrease coming? We used last year s price to explain this year, which is a reasonable start but what else might we use? How about this year s production or forecasted production combined with the coming year s forecasted use which results in a corn stocks forecast? P t = β 0 + β 1 P t-1 + β 2 Q t + e t P t = P t Q t + e t P t = (3.35) (0.115) = $ /bu. with an standard error (σ) of $0.55/bu & R 2 = What s the forecast for 2018 and what s the probability of $3.25/bu or lower corn? (My most complicated but simple model has an R 2 = 0.91, forecasts $3.65/bu and has σ = $0.45/bu. Bottom line: we need forecasts but they will be wrong they have risk so we need to access that risk.) AREC 412 Lec D Forward Pricing & Risk 31

32 What can we do with measures of expectations and risk? Determine efficient and inefficient choices. (Efficient frontier) Risk preferences determine best choice among efficient choices. Calculate probabilities of good and bad outcomes. Might also need to assume a distribution or we could use the histogram. Illustrates downside risks how much financing might be needed. Simulate results of different strategies. (Stochastic simulation) Dynamics or time is important. Illustrates differences in mean and variability of returns. AREC 412 Lec D Forward Pricing & Risk 32

33 Risk and Return Making Investment and Other Business Decisions Plan Return Std Dev Return A B C D 12% 8% 8% 50% 10% 2% 10% 2% Risk What are efficient Plans? What Plan can we rule out as inefficient? How to choose among remaining Plans? AREC 412 Lec D Forward Pricing & Risk 33

34 Figuring out your risk preferences... Choose a decision and flip coin for outcome. Monthly take-home pay... Decision Outcome A B C D E μ & (σ) $1000 ($100) $1100 ($250) $1200 ($400) $1000 ($250) $900 ($250) Heads $1100 $1350 $1600 $1250 $1150 Tails $900 $850 $800 $750 $650 What decision letter do you want? Are D and E efficient? Is there a best choice between A, B, and C? AREC 412 Lec D Forward Pricing & Risk 34

35 Simulation of Risky Decisions In concept: Taking a random draw from a distribution (pdf). Outcomes are more likely from the sample space of the pdf where the function is higher. pdf (See spreadsheet figure.) Return AREC 412 Lec D Forward Pricing & Risk 35

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37 In Practice: using a spreadsheet. pdf The probability is the area under curve from point to the left. Return cdf The probability can be found by reading the number off the curve the integration is already done. (See spreadsheet figures.) Return AREC 412 Lec D Forward Pricing & Risk 37

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39 Simulate investment decision outcomes. Retirement after saving $1,200 per year for 45 years. (250 replications & take average across.) (Blend: ) Decision Outcome Stocks Bonds T-Bills Blend Best $10.8 million $1.4 million $144 thou $4.6 million μ $1.9 million $509 thou $116 thou $1.1 million Worst $323 thou $190 thou $94 thou $256 thou Average-Stocks are better than Best-Bonds. Worst-Stocks are better than Best-T-Bills Worst-Bonds are better than Best-T-Bills. Best-Blend and Worst-Blend better than all but stocks. Invest, take risk, and diversify but within high-risk choices. AREC 412 Lec D Forward Pricing & Risk 39

40 Observation and Commentary The firms that succeed and grow in the commodity production and marketing businesses are the firms that: 1) Aggressively manage risk 2) and are willing to live with the smallest rate of return (RoR). Applies to cattle feeding, hog production, corn, wheat, oilseeds... Thought Example two cattle feeding firms A aggressively manages risk and willing to take $20/head profit. B wants $45/head profit and takes risk to get it. Who s still there after 10, 15, and 25 years? Who s most likely to have experienced a market event that has bankrupted, or seriously setback, the firm? Who is a better risk in the eyes of their lender? And can borrow more $? Who has grown? AREC 412 Lec D Forward Pricing & Risk 40