AGEC 420, Lec 8 1

AGEC 420

• Hedging examples

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Hedging

• Expected (net forward) price:= futures + expected basis

• If basis is at the expected level– then realized price = expected price– regardless of whether the overall price level

goes up or down

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Realized Price – 2 ways to calculate it

Jan 31: July futures @ $3.20, Expected basis -$0.10.

July 1: Local price $2.90, July futures @ $3.00

A. Realized price = futures* + actual basis(i.e., = $3.20* - $0.10 = $3.10)

• The futures price when hedge was established

or

B. Realized price = Cash + Result on futuresi.e., = $2.90 (cash price) + $0.20 (profit on futures) = $3.10

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Example 2 – Basis Strengthens

• Jan 31: plan to sell 5,000bu wheat in early July • July futures @ $3.20, Expected basis -$0.10.

• Expected price = 3.20 - 0.10 = $3.10

ACTION: sell 1 July futures @ 3.20

• July 1: • Local price $2.95, July futures @ $3.00

• Basis is stronger than expected

ACTION: sell wheat @ 2.95, buy futures @ 3.00

• Realized net price is 2.95 +0.20 = $3.15

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Basis Risk

• A strengthening (or stronger than expected) basis helps the short hedger.

• It means that his local cash price is (relatively) stronger than expected.

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Example 3 – Prices Rise, Basis same

• Jan 31: plan to sell 5,000bu wheat in early July • July futures @ $3.20, Expected basis -$0.10.

• Expected price = 3.20 - 0.10 = $3.10

ACTION: sell 1 July futures @ 3.20

• July 1: • Local price $3.60, July futures @ $3.70

• Basis is as expected

ACTION: sell wheat @ 3.60, buy futures @ 3.70

• Realized net price is 3.60 -0.50 = $3.10

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Example 4 – Prices Rise, Basis weakens

• Jan 31: plan to sell 5,000bu wheat in early July • July futures @ $3.20, Expected basis -$0.10.

• Expected (net forward) price = 3.20 - 0.10 = $3.10

ACTION: sell 1 July futures @ 3.20

• July 1: • Local price $3.55, July futures @ $3.70

• Basis is weaker than expected

ACTION: sell wheat @ 3.55, buy futures @ 3.70

• Realized net price is 3.55 -0.50 = $3.05

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Stronger Basis

Basis at the expected level: realized price = expected price

Basis stronger than expected realized price above expected price stronger basis helps the short hedger.It means that cash price is (relatively) stronger

than expected.

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Weaker Basis

Basis at the expected level: realized price = expected price

Basis weaker than expected realized price above expected price stronger basis helps the short hedger.It means that cash price is (relatively) weaker

than expected.

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Example 5.

• In Feb.: plan to sell 40 fed cattle in June • June future @ $70.55/cwt, Exp. basis is +$0.25.

• Expected price = 70.55 + 0.25 = $70.80

ACTION: sell futures @ 70.55

• In June: • Local price is $64.50, June futures price is $64.45

• Basis weaker than expected, by $0.20/cwt

• Realized net price is $70.60

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Long Hedge

• An agent who will need to buy the commodity.– Would lose if prices rose

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Long Hedge – for the buyer

1st Question:What is the risk ? - or - What do you want to protect

yourself from?

Answer: a rise in price

Therefore – you want a position in futures that will make $$ if price

rises.

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Long Hedge

• An agent who will need to buy the commodity.– Would lose if prices rose

To establish the hedge – buy futures

At some future date – buy wheat in local cash market

– sell futures (to offset)

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Example 6. Long hedge

• Feb: Elevator needs to buy wheat by July.• July futures @ $3.50, Exp. basis is -$0.20

• Expected net forward price is 3.50 - 0.20 = $3.30

buy futures @ 3.50

• May: • Local price is $3.85. Futures price is $3.95

• Basis stronger than expected, by $0.10/bu

buy wheat @ 3.85, sell futures @ 3.95

• Realized price paid is $3.85-$0.45 = $3.40

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Basis risk

• Strengthening basis – helps the short hedger– works against the long hedger

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Example 4. Long Hedge

• Feb: plan to buy feeder cattle in May. • May futures @ $84.00, Exp. basis is -$0.50• Expected net forward price is 84.00 - 0.50 = $83.50buy futures @ 84.00

• May: • Local price is $85.00. Futures price is $85.75• Basis weaker than expected, by $0.25 / cwtbuy cattle locally, sell futures

• Realized net price paid is $83.25

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Hedging (summary)

• Objective: to reduce risk– works because basis risk < cash price risk

If maturity basis = expected basis

then realized price = expected price (regardless of whether prices go up or down)

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Approach to hedging problems

• identify the risk in the cash position• will money be lost if price rises or if it falls

• decide appropriate action in futures• one that makes money if there are losses in the cash

• expected price = futures + expected basis