USING RISK MANAGEMENT TOOLS: A LIVESTOCK APPLICATION John Michael Riley AssistantExtension Professor Assistant Extension Professor Department of Agricultural Economics 1
Price Risk: Introduction Commodity producers are price takers Prices i are essentially unpredictable Prices change as information (i.e., on supply and demand conditions) changes Information changes in a largely unpredictable fashion The inherent difficulty in predicting prices and the inability ofcommodity producers to set prices for their product should influence the goal of any commodity marketing program Typical Marketing Goals To consistently it tl net the highest h price available though h the year (or at least a big part of the year). Realistic Avoid discounts Get the best price available for my type of cattle when those cattle are ready to sell Manage price risk effectively to avoid situations where the health (or even survivability) of the operation could be compromised by a decline in price 2
Approaching Marketing Goals Avoid discounts Highlights g the relationship between production and marketing. Get the best price available for my type of cattle when those cattle are ready to sell May mean using non traditional marketing channels to get what your cattle are worth. Manage price risk effectively to avoid situations where the health (or even survivability) of the operation could be compromised by a decline in price Marketing strategy should consider your willingness and ability to withstand risk. Marketing problem is very different for one with equity to absorb a $100/head loss than for one who would be ruined by a $40/head loss (financial risk). TOOLS AVAILABLE: FORWARD CONTRACTS FUTURES CONTRACTS OPTIONS INSURANCE 3
Forward Contracting All details are determined between the buyer and seller Allows for very individual specifications Price is typically linked to futures, but negotiable Quantity is negotiated Quality characteristics are negotiated Date of delivery is negotiated Board Sales: Forward Contracting Cattle are sold in advance for a future specified delivery date Quantity = Truck load lots Price is determined on the sale date Slide is used 4
Futures vs Forwards With Futures: All specifications are pre set except for price Actual delivery on futures is not common All trades are backed by the exchange Back to Board Sale example Futures Contracts On sale date, you sell cattle for future delivery Futures are similar sell cattle today for future delivery Again, delivery seldom happens on the futures contract Why? When cattle are sold transaction is shifted from futures market to cash market 5
Hedging Managing Price Risk w/ Futures Having opposite positions in two different markets If prices move together, gains in one market will offset losses in the other If you take a futures position that is not opposite your cash market position, you are not hedging Futures vs Cash $130 $120 OKC Feeder Cattle $110 $100 $90 Feeder Cattle Futures $80 $70 $60 6
FC Price Volatility Perspective Over a typical backgrounding window, feeder cattle prices are not nearly as variable ibl as over a multi year period, but they are still variable enough to cost you a lot of money For example, average range in price for April FC over the 5 months prior to expiration is $10.51/cwt about $75/head A way to enhance profits What is Hedging NOT? Focus is on managing risk, not increasing returns A way to eliminate risk completely Hedging addresses price risk only. Other sources of risk are still present 7
Short hedge Basic Terminology Initiated by selling a futures contract Used by producers of a commodity Long Hedge Initiated by buying a futures contract Usedby consumers ofa commodity o E.g., livestock producer hedging corn purchases Basis = Cash price Futures price Basis If basis for a particular sale period (e.g., April) is fairly stable from year to year, hedging will work pretty well Stable basis indicates that cash and futures prices are pretty reliably moving together 8
Example Hedge Hedge to lock in fed cattle price of $95/cwt. Jul 15 Cash Market Send feeder calves to feedlot Futures Market Sell Aug LC futures @ $95 Dec 1 Sell fed cattle for Buy Aug LC futures @ $101 $101 Net Price = $101 cash $6 futures loss = $95/cwt Example Hedge (w/ basis) Hedge to lock in fed cattle price of $96/cwt. Jul 15 Cash Market Send feeder calves to feedlot Futures Market Sell Aug LC futures @ $95 (expect +$1 basis) Dec 1 Sell fed cattle for Buy Aug LC futures @ $101 $100 Net Price = $101 cash $5 futures loss = $96/cwt 9
Hedging and Basis As noted, if basis is consistent, hedging works very well Cash and futures markets are moving together Hedging amounts to trading price risk for basis risk Basis With short hedge, if basis weakens (cash price declines relative lti to the futures price), the hedge won t work as well as expected With a short hedge, if basis strengthens (cash price improves relative to futures price), the hedge will work better than expected 10
Example Hedge (stronger basis) Hedge to lock in fed cattle price of $96/cwt. Jul 15 Cash Market Send feeder calves to feedlot Futures Market Sell Aug LC futures @ $95 (expect +$1 basis) Dec 1 Sell fed cattle for Buy Aug LC futures @ $101 $98 Net Price = $101 cash $3 futures loss = Basis changed from $98/cwt +$1 (expected) to +$3 (actual) Example Hedge (weaker basis) Hedge to lock in fed cattle price of $96/cwt. Jul 15 Cash Market Send feeder calves to feedlot Futures Market Sell Aug LC futures @ $95 (expect +$1 basis) Dec 1 Sell fed cattle for Buy Aug LC futures @ $101 $103 Net Price = $101 cash $8 futures loss = Basis changed from $93/cwt +$1 (expected) to $2 (actual) 11
FC Basis in the Southeast Feeder cattle basis in the Southeast tends to be fairly wide but in recent years has been reasonably consistent on feeder steers Seasonality in basis may be a problem for hedgers o In GA data, Mar and Nov basis were the most variable of the year On cattle not conforming to feeder contract specifications, basis can be highly variable Suggests that feeder cattle futures may be used to hedge 7 8 wt steers fairly effectively but may be questionable on other classes of calves FC Basis in MS MS Basis (Cash Futures) for 650 700 lb #1 2 M&L Steers $ 15 Jan 15 Feb 15 Mar 15 Apr 15 May 15 Jun 15 Jul 15 Aug 15 Sep 15 Oct 15 Nov $(2.00) 2010 2006 2008 2007 2009 $(4.00) $(6.00) $(8.00) $(10.00) $(12.00) $(14.00) $(16.00) $(18.00) $(20.00) 12
FC Basis in MS MS Basis (Cash Futures) for 650 700 lb #1 2 M&L Steers $ 15 Jan 15 Feb 15 Mar 15 Apr 15 May 15 Jun 15 Jul 15 Aug 15 Sep 15 Oct 15 Nov $(2.00) 2010 2006 2008 2007 2009 $(4.00) $(6.00) $(8.00) $(10.00) $(12.00) $(14.00) $(16.00) $(18.00) $(20.00) Long Hedge Example Hedge to lock in corn price of $4.15/bu. Cash Market Futures Market Jul 15 Dec 1 Send feeder calves to feedlot Buy Dec C futures @ $4.15 (expect -$0.30 basis) Sell fed cattle: Sell Dec C futures @ corn cost = $5.50/bu $5.75 Net Price = $5.50 cash - $1.60 futures gain = $3.90/bu 13
Points about Futures Provide an effective tool for managing price risk ikon fd fed cattle and, potentially ti on some feeder cattle Basis variability on stocker classes can be a problem Require q margin funds Don t allow up side price benefit Hedging Outcomes Short hedge @ $85. 14
Options Give the holder the right but not the obligation to buy or sell a futures contract tat a specified price on or before a certain expiration date Two types: Put Call Options Terminology Put gives the buyer of the option the right, but not the obligation, to SELL the underlying futures contract at a specified ( strike ) price Call Gives the buyer of the option the right, but not the obligation, to BUY the underlying futures contract at a specified ( strike ) price 15
Options Terminology Strike Price price at which the option gives the holder the right htto buy or sell the underlying futures contract Premium amount paid for an option Exercise converting the option into a futures contract Put & Call options These are two totally different contracts Not the opposite sides of the same trade In other words, you can not offset a put with a call and v.v. For every PUT, there is a buyer and a seller For every CALL, there is a buyer and a seller 32 16
The right, but not the obligation This means that the option does not have to be exercised You can just throw it away If the option strike price is more favorable than the underlying futures price the option should be exercised 33 How much does an option cost? The buyer of an option pays a premium to have this right How much is the premium? Premium is effected by: o Relationship between the strike price & futures price o Time remaining until the option expires o Volatility of the underlying futures contract price o Interest rates (very small effect) 34 17
In the money In Out & At the money The option strike tik price currently has value o Strike Price > Current Futures Price : for a call o Strike Price < Current Futures Price : for a put Out of the money The option strike price currently has zero value At the money strike price = current futures price 35 Hedging with Options Options allow a producer to manage price risk using the futures market without actually holding a futures market position allows producer to take advantage of futures market price changes avoid margin calls (typically not an issue with cattle feeders since cattle stand for the margin) Individuals that will be selling the cash product will use puts Individuals that will be buying the cash product will use calls 18
Options Hedge Example June LC Put Option Hedge: Futures Price $98 Expected Basis -$2 Option Strategy 1 Option Strategy 2 Put Strike Price $96 $100 Premium $2.50 $5.80 'Protected' Price $96 - $2.50 - $2 = $91.50 $100 - $4.80 - $2 = $93.20 Price Floor $92.50 $93.20 Options Hedge Application Futures Price $98.00 Expected Basis $2.00 Expected Cash Price $96.00 Strike Price $96.00 Premium $2.50 Protected Price (Floor) 1 $91.50 Futures Price @ Expiration $88.00 Actual Basis $2.00 Cash Market Price 2 $86.00 Options Gain Gi 3 $8.00 Cash Revenue + Futures Profit/Loss $94.00 1) Strike Price Premium Trading fees + Basis 2 ) Futures Price + Basis 3 ) Strike Futures @ Expiration Premium Trading fees 19
Options Hedge Application Futures Price $98.00 Expected Basis $2.00 Expected Cash Price $96.00 Strike Price $96.00 Premium $2.50 Protected Price (Floor) 1 $91.50 Futures Price @ Expiration $105.00 Actual Basis $2.00 Cash Market Price 2 $103.00 Options Gain Gi 3 $2.50 Cash Revenue + Futures Profit/Loss $100.50 1) Strike Price Premium Trading fees + Basis 2 ) Futures Price + Basis 3 ) Strike Futures @ Expiration Premium Trading fees Hedging Outcomes Realized Price $110 $105 $100 $95 $90 $85 $80 $75 $70 $65 $60 No Hedge Actual Price 20
Hedging Outcomes Realized Price $110 $105 $100 $95 $90 $85 $80 $75 $70 $65 $60 Short hedge @ expected price = $85 No Hedge Futures Hd Hedge Actual Price Hedging Outcomes Realized Price $110 $105 $100 $95 $90 $85 $80 $75 $70 $65 $60 Short hedge @ expected price = $85 Put @ $85strike strike, $2.50 50premium No Hedge Futures Hedge Put Option Hedge Actual Price 21
Points about Buying Options No margin required Keep the up side open Full premium paid up front Tend to be quite expensive during periods of market volatility (i.e., NOW) Always give a second best outcome Receive the premium Option sellers Required to take the opposite position once the option has value Must deposit a margin for the futures contract and be responsible for possible margin calls 44 22
Option sellers Required to take the opposite position of the option onceoption option hasvalue Example: If you sell a put option for May corn with a strike price of $6.50 o Have the right, but not the obligation to SELL a May corn futures contract 2 months go by and now the price of the May corn contract is $6.51 You are entered into a long May corn futures position at $6.50 45 Insurance Essentially the same as a put option but Offered at a discount Allows for more flexibility on time, quantity and quality Varying dates are availaible Not locked into truck load lots Can hedge heifers, Brahman influence, dairy type 23
Buy Put (at the money) Sell Call (out of the money) Reduces cost of the Put Option Strategies Call is likely not going to be exercised Risk: market moves way higher, must go long futures (because ofthe call) and possible margin calls Vertical Spread (VS) Buy and sell an option with the same expiration month with different strike prices Bull VS buy option with a low strike & sell option with a high strike Bear VS buy option with a high strike & sell option with a low strike 48 24
Horizontal Spread Buying and selling an option with different expiration months at relatively the same strike price 49 Long Straddle buy a PUT & buy a CALL at same dli delivery month Option Straddle Short Straddle sell a PUT & sell a CALL at same delivery month 50 25
Questions? Avg. Range in FC Futures in 5 Months Prior to Expiration: 1994 2008 Expiration Month Jan Mar Apr May Aug Sep Oct Nov Mean 11.20 9.82 10.51 11.61 11.98 11.24 11.34 11.30 Min 5.22 3.15 2.37 4.40 4.40 4.55 3.93 4.25 Max 22.93 19.15 17.63 23.25 31.03 18.58 24.53 25.33 26
$ Per Steer 260 AVERAGE RETURNS TO CATTLE FEEDERS Feeding 725 Lb. Steers, S. Plains, Monthly 160 Latest Data: December 2008 60-40 -140-240 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 C-P-22 01/16/09 Livestock Marketing Information Center 27