Khon Kaen University International College

Business in the Greater Mekong Sub-region 

Course number 050 451 - Second semester 2013

Wednesdays at 9:00 in room 823

 Lecturer: Michael Cooke

office room 817E-mail: Michco@kku.ac.thWeb: KKU.AC.TH/Michco

GMS Projects Find a successful industry in GMS, or one which shows potential

to be successful (13 Nov) Explore reasons the industry located in GMS What is the nature of the business (capital or labor intensive, etc) Any spillover effects? What was the mode of entry for the businesses?

Study a GMS country in which the industry is successful (4 Dec) What are the strengths of that country from a business perspective? What are the weaknesses? Look for barriers to further business success in the country

How do you see the business evolving (5 Feb) Effect of ASEAN or other alliances (trade, labor mobility, etc) Relevant demographic, economic, trade projections Infrastructure, education, and other changes as a result of government

or business initiatives Advice you would give to government units to encourage industry growth

Mekong Watershed36% of the River’s Volume is from Laos

Mekong River Commission Secretariat

Resources• JETRO (Japan External Trade Organization) established 1958 helps small to 

medium size Japanese firms maximize their global export potential • JETRO-Institute of Developing Economies (IDE) Bangkok Research Center links

– http://www.ide.go.jp/English/Links/southeast_asia.html– Good for links to government and university sites for the GMS countries

• Institute of Developing Economies (IDE) Bangkok Research Center publications– http://www.ide.go.jp/English/Publish/Download/Brc/– Relevant and relatively recent research reports– Examples:

• "Five Triangle Areas in the Greater Mekong Subregion" Edited by ISHIDA Masami / Published in 2013• "Economic Reforms in Myanmar: Pathways and Prospects" Edited by HANK LIM and YASUHIRO YAMADA / Published 2013• "Cause and Consequence of FIRMS' FTA Utilization in Asia" Edited by HAYAKAWA Kazunobu / Published in 2012 • "Emerging Economic Corridors in the Mekong Region" Edited by ISHIDA Masami / Published in 2012 • "Industrial Readjustment in the Mekong River Basin Countries: Toward the AEC" Edited by Yasushi UEKI AND TEERANA 

BHONGMAKAPAT / Published in 2012• "Investment Climate of Major Cities in CLMV Countries" Edited by ISHIDA Masami / Published in 2010 • "Economic Relations of China, Japan and Korea with the Mekong River Basin Countries (MRBCs)" Edited by KAGAMI 

Mitsuhiro / Published in 2010 • "Major Industries and Business Chance in CLMV Countries" Edited by UCHIKAWA Shuji / Published in 2009 • "A China-Japan Comparison of Economic Relationships with the Mekong River Basin Countries" Edited by KAGAMI 

MItsuhiro / Published in 2009 

• Mekong Institute (on the KKU Campus) http://www.mekonginstitute.org/

Mekong Institute Focus on Labor• http://www.mekonginstitute.org/images/abook_file/policy_bri

ef_labour_supply.pdf• From a study of a Laos SEZ: “The breakdown in occupational skills indicate 

mismatches in supply and demand for specific  skills areas such as IT/computer operators, maintenance mechanics, welders, sewers/dressmakers, gem lapicides, and others. On the other hand, majority of students at TVET schools enroll in accountancy and Business management courses.”

• From a study of a Cambodian SEZ: “The new SEZs that have been set up in the border areas with Thailand and Vietnam have reduced the pull factor to migrate to Phnom Penh for work. The preference of students for enrolling in academic courses such as management and accounting due to the perception that vocational training will lead to a career of hard labor and low wages in factories. In Laos, many prefer to migrate to Thailand where they can earn more even without the necessary educational credentials.”

GMS Corridor Map – East-West

GMS Corridors – High Level

Source: Chiang Mai UniversityUSER 2007

SE AsiaTrade routes from East Asia to South Asia, the Middle East, and the Suez Canal pass through the Straits of Malacca, northwest of Singapore. The area is a haven for pirates. In November two large tankers were hijacked there. The East-West corridor would connect East Asia to the Indian Ocean well north of the Straits.

Why did floods in Bangkok affect a company based in Minnesota?And why are we talking about this small American company again?

Thailand is the 2nd largest producer of hard drives; producing over 25% of total drives made. An ecosystem of component suppliers has formed near the assembly operations of companies like Seagate and Western Digital. 

Nidec makes HDD motors and other small electric motors at 10 factories in Thailand.

Indigenous Firms as Suppliers http://www.ide.go.jp/English/Publish/Download/Brc/pdf/12_10.pdf

• Foreign firms experience the highest added productivity when buying from suppliers of the same nationality in the host country– An American HDD maker will tend to buy from an American supplier in Thailand– The HDD supplier, such as Hutchinson, may employ local managers

• Purchasing supplies from indigenous firms adds less value in part due to quality issues – on average across many developing markets, foreign firms are better performers

• Host country firms must raise quality of their output to the level of foreign firms– When indigenous firms raise skills and quality, more foreign firms will invest– This results in positive spillovers to the host country– Older overseas affiliates of foreign firms may have higher indigenous firm content due to 

better knowledge of local suppliers– Weak local currency tends to promote higher indigenous content due to price advantages, 

especially for firms that intend to export from the host country• Over time spillovers from foreign firms to indigenous firms occurs

– Imitating superior products and technologies– Direct skills and technologies transfer – Competition from foreign firms causes indigenous firms to raise standards– Indigenous firms learn how to penetrate export markets

Venezuela’s New President• Venezuela’s President Nicolas Maduro recently jailed more than 100 “bourgeois” 

businessmen, in what he calls an “economic war” on alleged unfair pricing.– In early November, the president sent soldiers to seize electronic stores he has accused of 

unjustified price rises, hoarding and speculation– Bargain hunters then flooded the shops and some looting was reported. – Inspectors have been dispatched to about 1,400 other businesses. Mr Maduro picked out 

US manufacturer Goodyear, demanding price reductions.• Promising to step up an “economic offensive”, Mr Maduro said that he would set 

caps on business profit margins and extend controls to establish “fair” prices. “They are barbaric, these capitalist parasites,” he said.

• Mr Maduro inherited economic problems from Hugo Chávez. – Policy paralysis has led to dwindling hard currency reserves and galloping inflation of 54 

per cent. – There are rampant shortages of food and goods, which economists attribute to currency 

market distortions.– Price controls and strict currency exchange restrictions have generated a scarcity of 

dollars to pay for imports in the oil-rich nation, with – Venezuelans use the black market for dollars, which cost nearly 10 times the official rate 

• Would businesses have similar risks in the GMS?

Financial Times, Nov 15th, 2013

A carry trade is a strategy in which an investor borrows at a low interest rate to invest in an asset that is likely to provide a higher return.

In the foreign exchange market an investor sells a currency with a relatively low interest rate and invests in a different currency with a higher interest rate. ◦ A person using this strategy attempts to capture the difference between the interest rates, and often magnifies

the difference with leverage used.◦ Prior to 2007, low interest rates in Japan were a source of carry trade flows◦ Destinations for carry trade flows were Australia and NZ (where interest rates were high)◦ When global interest rates converged in 2008 the yen appreciated and the trade diminished

An example of a "yen carry trade": ◦ Borrow 1,000 Japanese yen from a Japanese bank. ◦ Convert the funds into U.S. dollars and buy a bond for the equivalent amount.

If the bond pays 4.5% and the Japanese interest rate is set at 0% you make a profit of 4.5% as long as the exchange rate between the countries does not change.

Professional traders (and Japanese housewives) use this trade because the gains can become very large with leverage. If the trader in this example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The risk in a carry trade is the uncertainty of exchange rates. ◦ Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader

would run the risk of losing money. ◦ When the transactions are done with leverage a small movement in exchange rates can result in huge losses. ◦ From the perspective of a target country borrower, carry trade money is ‘hot money’

A risk for many SE Asian countries is a rise of US interest rates – and the resulting flows

Definition and illustration from: http://www.investopedia.com/terms/c/currencycarrytrade.asp and the Financial Times 15

'Currency Carry Trade'

Stock Exchange in Cambodia The Cambodia Securities Exchange (CSX) opened in April, 2012

Money had been banned under the Khmer Rouge regime that tore Cambodia apart between 1975 and 1979

After a $20MM IPO, Phnom Penh Water Supply Authority shares (PPWSA), rose 50 percent in the inaugural session (six months later the shares were back to the IPO price)

The launch of the new stock market is similar to that Laos The Laos exchange started in 2011 with two listed firms Both exchanges are operated as joint ventures with Korea Exchange, Asia's fourth-largest operator

Vietnam launched their first stock exchange in 2000 Potential investors see huge risks in frontier emerging markets

The Cambodian market, with one listed firm, lacks liquidity If you want to sell, you may not be able to move large positions," said Morten Kvammen,

director of underwriter SBI Royal Securities Some investors remain concerned about corruption, an unclear regulatory framework and the

use of the riel currency for trading on the bourse Ninety percent of deposits and credits in Cambodia's banking system are in dollars, so investors

worry about bureaucratic delays and currency fluctuation between transactions and payments Bangkok-based director of frontier market fund Dragon Capital, likes the transparency and

management of PPWSA, the first listed firm "If Cambodia will continue on its same growth path, will continue to modernize and create

wealth then the capital market will expand and the market's liquidity risk will diminish," the director told Reuters

In November 2012 Cambodia had 4,000 investor accounts at licensed brokerages, about a third held by foreigners

From Reuters, April 18th, 2012

SET Becomes the Top ASEAN Exchange The Stock Exchange of Thailand (SET) attracted a record number of listings in 2013

Average daily trading volume overtook SGX, the Singapore exchangeThe SET is now the largest exchange in ASEAN by volume, according to the World

Federation of Exchanges The value of total share trading in the first 11 months of 2013 was $320bn on the SET,

ahead of the SGX which notched up $265bn. Bursa Malaysia was third most active with $138bn in average daily volume

The SET plans to change its rules to allow foreign companies to list in BangkokThe change shows how exchanges in SE Asia are starting to compete as they outgrow

their domestic markets and seek to capitalize on business from within the ASEANThe exchange will focus on expanding to Cambodia, Laos, Myanmar and Vietnam,

because they have high growth potential and high need for fundsThe EVP in charge of listings at the SET said the exchange would allow any foreign

company to list under the new rules, including those from China and Australia He said “We feel that Thai growth will probably stagnate one of these days. The expansion

in our neighboring countries is huge and they are growing at a much faster rate than us” The move by SET appears aimed at attracting companies that might prefer to list on an

exchange with deeper liquidity, modern trading systems and proven corporate governance principles.

Cambodia and Laos each have a stock-exchange. Vietnam has two. According to the FT, Myanmar has accepted assistance from the Japanese to develop a stock exchange.

Financial Times 23 December, 2013

A New Cambodian Commodities Exchange

Som Yen, director of Malai Trading Co, a Cambodian agricultural products brokerage for Thai ethanol and flour said that the new commodities exchange would help promote agricultural produce and sustain prices.“At the moment, our agricultural produce such as corn and cassava is sold

[to Thailand] at about 30 percent below the market price,” said Som Yen, who collected about 25,000 tonnes of cassava and corn for export to Thailand last year.

“If this company realizes this initiative, I believe that farmers will benefit from it and will gain broader markets for their agricultural produce.”

Trading in commodities on an official, standardized exchange offers further evidence that the economy is finally maturing as well as integrating to global markets.

Thailand’s TFEX and AFET (Ag Futures Exchange of Thailand) have been in operation since 2004 with focus on SET index futures, gold, and silver; and rice, rubber, tapioca, and canned pineappleTFEX a subsidiary of SET – offers a broader range of products to local

investorsAFET issues with rubber subsidies

Unrest in Thailand and Cambodia

Thailand’s tourism industry accounts for 7% of economic activityIn the past, Thailand earned the nickname Teflon ThailandMastercard International predicts Bangkok will become the world’s

most visited city, while Instagram reports Siam Paragon is the most photographed location in the world

Planned protests aim to shut down the city January 13thSingapore Airlines announces it will cancel 19 flights to Bangkok

beginning January 14th

First quarter hotel occupancy is predicted to fall 5-10% below the norm (80%) for this time of year

Airport arrivals fell 15% in early December when protests beganThe Thai Chamber of Commerce recommended that member

businesses stockpile goods outside of the cityMultinationals also fear delays in export-import paperwork

Meanwhile in Cambodia tens of thousands of textile workers have gone on strike across the nation to seek higher minimum wage

Wall Street Journal 6-1-2014

How Does Unrest in Cambodia Affect Apparel Business?

Most of the 600 garment factories in Cambodia reopened this week They had been shut since due to strikes since Dec. 24th

Strikers have been seeking a doubling of the minimum wage to $160 per month About 60% returned to work this past Monday (January 6th) after the police action against strikers

Garment manufacturing is Cambodia’s biggest export business Primary customers are US and European apparel firms About 600K workers are employed in 800 factories (about 17% of the non-agriculture workforce) Apparel exports grew 22% last year Strikes are frequent because of low wages, poor enforcement of labor laws, and working conditions

Many factories have temporarily shifted production out of Cambodia while others may be considering a longer-term relocation

According to McKinsey Consultants in 2011 the most likely destination for apparel buyers concerned with increasing costs in China was Bangladesh They cited prices and capacity as Bangladesh’s key advantages versus gaps in infrastructure

and compliance The 2013 survey lists labor costs as the biggest advantage of sourcing in

Bangladesh, with nearly all thinking costs in Bangladesh will increase A 2013 report listed other countries expected to grow in importance as Vietnam, India, Myanmar,

and Cambodia (in that order) Bangladesh has capacity, productivity, and supplier capabilities, and trade agreements that ensure

it will remain the top alternative to China for the next five years

1) Wall Street Journal 7-1-2014; 2) www.mckinsey.de/sites/mck_files/files/2013mckinsey_apparelcposurvey.pdf

Apparel Sourcing in Practice

Bruce Rockowitz, chief executive of Li & Fung (NY Times 7 Aug 2013)

-Li & Fung is the world’s largest logistics and sourcing company. It matches poor countries’ factories and affluent countries’ vendors. It finds the lowest-cost workers, negotiates prices and manages the logistics for roughly a third of the biggest retailers found in a typical shopping mall. -Li and Fung is based in Hong Kong. It owns no clothing factories, no sewing machines and no fabric mills. Its chief asset is the 15,000 suppliers in over 60 countries that make up a network so sprawling that a massive order for skirts that once took six months from drawing board to store shelf now takes six weeks at a much lower price. (NY Times 7 Aug 2013)-Sourcing companies find low-cost factories for clients, and also monitor factory safety standards. The scale of Li & Fung’s operations and the speed at which it shifts production from one site to another give owners little incentive to improve their factories.

“We definitely are a part of bringing the prices down, there’s no question about that, because we are arbitraging factories and countries all the time,” Bruce Rockowitz said. “But it has to be a safe factory.”

The Environment in Which Apparel Sourcing Companies Operate Li and Fung’s Chairman said Bangladesh still has some of the cheapest labor in the

world, he pointed out. For factories to get safer, clothing prices would have to go up, he said. “So far,” he added, “consumers have just not been willing to accept higher costs.” *

Factories, which often consist of just sewing machines on tables, can appear and disappear overnight.

“Li & Fung is your insurance policy for when logistics go wrong,” said Mr. Hertzman, of Sourcing Journal. * When street protests delay a shipment of khakis bound for Gap and the factory says it

cannot afford to move the items by air, it is companies like Li & Fung that will have to cover the cost of the plane, he said.

Li & Fung and other sourcing companies track harvesting schedules because many factories rely on migrant workers. They watch weather reports to advise drivers.

In Dhaka, Bangladesh’s capital, sourcing agents check in daily with political and labor officials who can offer warnings about demonstrations that could shut down production.

They send undercover informants into factories to check for blocked fire exits, for example, or arrive early for scheduled factory inspections to check for child labor violations.

Sourcing companies also insulate retailers from reputation risks when bad things happen After more than 280 workers vomited and fainted in a three-day period in 2011 at the King

Fashion Garment Company factory in Phnom Penh, Cambodia, Li & Fung asked the plant to upgrade ventilation and improve wastewater drainage.

Clients with brand equity, such as H&M, were insulated from the bad press* (NY Times 7 Aug 2013)

7-23

Measuring Risk

Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.

Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”

Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.” Much of the variation of most stocks is from systemic causes.

Performance of Harvard’s Endowment FundOctober, 2009: Endowment Value Declines 29.5% as Investment Return Is -

27.3% (S&P 500 = -24.3% dividends reinvested)

Endowment Value ($billions)

Annual rate of return on investments

2007 $34.9 23.0%2008 $36.9 8.6%2009  $26.0 (27.3)%

Source: Harvard University Financial Report. FY June.

Component Performance Harvard Endowment  2008- 2009

HMC Benchmark Relative Public equities (1/3) (28.3)% (28.5)%  0.2%Private equities (31.6) (23.9) (7.7)Hedge funds  (18.6) (13.2) (5.4)Real assets (1/4) (37.7) (38.5) 0.8Fixed income (1/8) ( 4.1) ( 3.4) (0.7)TOTAL HMC (27.3) (25.2) (2.1)

Note: Mohamed A. El-Erian was CEO of Harvard Management Company from 2005-2007

Harvard’s Explanation• The “policy portfolio,” the model that HMC uses to diversify 

its assets, returned negative 25.2 percent as measured by the investment benchmarks for each asset class—2.1 percent better than HMC’s actual performance. *

• During the depths of the financial crisis and then recession last autumn and winter, Harvard’s managers worried that losses in private-equity and real-estate investments might drive even deeper declines in the endowment overall.

• Among investment factors, the internally managed domestic fixed-income portfolio, had exposure to some of the less-tradable structured credit securities that were most impacted as the market imploded.

* Investments portfolios are often compared to returns on similar classes of assets

Toward Liquidity• At the end of 2008, HMC had $11 billion of commitments to outside managers. 

– Many outside managers impose holding periods on the investments they make, creating the problem of “strategies with long holding periods” among even liquid asset classes.

– Harvard had a lack of ready liquidity in the portfolio to meet obligations  as private-equity, hedge-fund, and other asset managers slowed or stopped distributions of funds back to HMC. 

– The University had its own credit problems in late 2008—necessitating sales of liquid assets at a time when HMC might have preferred not to do so.

• Changes to address the problems.– Increase the flexibility and control Harvard has in managing the funds– Greater concentration “in areas where HMC has unique competitive strengths” (note: 

value of expertise)– Harvard is looking to increase the share of internally managed assets under the right conditions. 

• Control advantages and feel for the market realized through internal money-management expertise • HMC personnel managed about 30 percent of the portfolio in 2009, down from 70 percent early in 

the decade – Reduce leverage (keep cash on hand appropriate to circumstances)

• The policy portfolio for years called for a negative 5 percent cash position (borrowing to boost investment returns). 

• That allocation is now modeled as positive 2 percent

Harvard Magazine October 2009

The Lessons for Us• Harvard’s portfolio was fully diversified and in many 

instances hedged– You can not diversify away systemic risk– Hedges are imperfect and normally have high cost

• Harvard faced liquidity problems when they needed liquidity– Be wary of leverage, especially when macro conditions change– Understand your ability to raise cash or exit markets when 

conditions change• Expertise in investment categories has value independent of 

diversification• Remember Warren Buffett’s words about the value of 

expertise

Ch 5 -28

Hedge Fund Performance• A recent analysis conducted by Goldman Sachs shows that the typical hedge 

fund has returned just 4 percent this year through August 9 — poor compared to the 20 percent return on the S&P 500 (including dividends). – Last year hedge funds returned 8 percent return compared to a 16 percent total return 

for the S&P 500  – The time-tested message is clear: hedging produces underwhelming results during 

long market rallies.• Hedge funds typically try to compensate for possible losses on long positions by 

taking counter-balancing short positions. This strategy can produce superior results during periods of market uncertainty when equity valuations are volatile. – However stock valuations have pretty much done nothing but go up since the financial 

crisis. – This has heaped rewards on those with long positions, and punished those with 

aggressive short positions, including many hedge funds.• The Goldman Sachs report shows that fewer than 5 percent of hedge funds 

have managed to outperform the S&P 500 this year to date, and 25 of them have actually posted losses.

• Talent moves from fund to fund, and over time strategies are copied.

Global Diversification• In the early 1990s Japanese stocks had negative beta• Beta changes over time (beta is a measure of market risk)• Worldwide, stock markets now share similar patterns

– The MSCI is an index of 23 developed country stock markets• From 1997-2006 the USA had beta of .98 relative to the MSCI• Japan had beta of .86 relative to the MSCI• The beta of German stocks relative to MSCI was .65

– In 2008 the MSCI was down 40% including dividend reinvestment

– The US NASDAQ was down 40%– The S&P 500 was down 37% including dividend reinvestment– Emerging markets did not ‘decouple’ in 2008

Ch 5 -30

International Diversification

EME  is emerging markets, EAFE is developed markets excl North America 

Some Basic Concepts 

• Options – the right but not the obligation to buy or to sell at a specified price on or before a specified date– Call option – right to buy an asset at a specified exercise price on or before a 

specified exercise date– Put option – right to sell an asset at a specified exercise price on or before a 

specified exercise date– Price of an option is determined by volatility and time to maturity; stock price 

and exercise price– Options written on volatile assets are worth more than those written on safe 

assets (the opposite of capital investments)• Forward contract – a commitment between two parties (to buy and to 

sell). These involve counterparty risk.• Futures contract – a standardized commitment to buy a security or a 

commodity at a price that is fixed today. Traded on an exchange.  • Employee Stock Options – compensation in the form of stock options 

on volatile shares is worth more than on stable shares

26-33

Risk Reduction

Risks to a business– Cash shortfalls– Financial distress– Agency costs– Variable costs– Currency fluctuations– Political instability– Weather changes

26-34

Insurance

Most businesses face the possibility of a hazard that can bankrupt the company in an instant.

These risks are neither financial or business and can not be diversified.

The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk.

26-35

Insurance

ExampleAn offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.

? How can the cost of this hazard be shared

26-36

InsuranceExample - cont

An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.

? How can the cost of this hazard be shared

AnswerA large number of companies with similar risks can each

contribute pay into a fund that is set aside to pay the cost should a member of this risk sharing group experience the 1 in 10,000 loss. The other 9,999 firms may not experience a loss, but also avoided the risk of not being compensated should a loss have occurred.

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Insurance

Example - contAn offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.

? What would the cost to each group member be for this protection.

Answer

000,100$000,10

000,000,000,1

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InsuranceWhy would an insurance company not

offer a policy on this oil platform for $100,000?– Administrative costs – such as legal fees– Adverse selection – bad risks are most eager to

take insurance– Moral hazard(owner may be less careful to

take precautions when insured)

Insurance• The loss of an oil platform by a storm may be 1 in 

10,000.  The risk, however, is larger for an insurance company since all the platforms in the same area may be insured, thus if a storm damages one in may damage all in the same area.  The result is a much larger risk to the insurer

•  Reinsurance is transferring portions of risk portfolios to other parties in order to reduce the likelihood of having to pay a large insurance claim. The reinsurer gets some portion of the premiums in return for accepting part of the risk.

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Reducing Risk with Options

How options protected Mexico against a fall in oil prices.

a. Sell 330 million barrels of oil at market price = $23.1BB revenue

Price per barrel

Rev

enue

, $b

illio

ns

$70

23.1

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Reducing Risk with Options

How options protected Mexico against a fall in oil prices.

b. Buy put options with $70 exercise price. Payoff rises as oil prices falls below $70 (right to sell at $70).

Price per barrel

Rev

enue

, $b

illio

ns

$70

23.1

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Reducing Risk with OptionsHow options protected Mexico against a fall in oil prices.

c. Lock in minimum price of $70 a barrel. For each $1 oil price rise above $70/barrel, revenue rises $330MM. This “put” cost about $1.5BB (6.4%)

Price per barrel

Rev

enue

, $b

illio

ns

$70

23.1

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Hedging with Forwards and Futures

Ex - Kellogg produces cereal. A major component and cost factor is sugar.

Forecasted income & sales volume is set by using a fixed selling price.

Changes in cost can impact these forecasts. To fix your sugar costs, you would ideally like to purchase all

your sugar today, since you like today’s price, and made your forecasts based on it. But, you can not.

You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today.

This contract is called a “Futures Contract.” This technique of managing your sugar costs is called

“Hedging.”

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Hedging with Forwards and Futures1- Spot Contract - A contract for immediate sale & delivery of

an asset. 2- Forward Contract - A contract between two people for the

delivery of an asset at a negotiated price on a set date in the future.

3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.

The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & “provides” a secondary market for the speculation of Futures.

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Types of Futures

Commodity Futures-Sugar -Corn -Orange Juice-Wheat -Soy beans -Pork bellies

Financial Futures-T-bills -Yen-Stocks -Eurodollars

Index Futures -S&P 500 -Value Line Index-Vanguard Index

SUGAR

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Commodity Futures

26-47

Financial Futures

26-48

Futures Contract Concepts

Not an actual sale – price is fixed but payment made laterMargin - post partial amount as assurance of ability to payNo counterparty risk –exchange guarantees paymentAlways a winner & a loser (unlike stocks)Contracts are “settled” every day. (Marked to Market)Hedge - Contracts used to eliminate risk by locking in pricesSpeculation - Contracts used to gambleHog K = 30,000 lbsT-bill K = $1.0 milValue line Index contract = $index x 500

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Ex - Settlement & SpeculateExample - You are speculating in Hog Futures. You think that the

Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?

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Ex - Settlement & SpeculateExample - You are speculating in Hog Futures. You think that the

Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?

30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss

Since you must settle your account every day, you must give your broker $510.00

50.63 50.80-

$510

cents per lbs

26-51

Hedging

Hypothetical plot of past changes in the price of the farmer’s wheat against changes in the price of Kansas City wheat futures. A 1% change in the futures price implies, on average, an .8% change in the price of the farmer’s wheat.

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Commodity HedgeIn June, farmer John Smith expects to harvest 10,000 bushels of

corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.

Show the transactions if the Sept spot price drops to $2.80.

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Commodity HedgeIn June, farmer John Smith expects to harvest 10,000 bushels of

corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.

Show the transactions if the Sept spot price drops to $2.80.

Revenue from Crop: 10,000 x 2.80 28,000

June: Short 2K @ 2.94 = 29,400

Sept: Long 2K @ 2.80 = 28,000 .

Gain on Position------------------------------- 1,400

Total Revenue $ 29,400

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Commodity Hedge

In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.

Show the transactions if the Sept spot price rises to $3.05.

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Commodity HedgeIn June, farmer John Smith expects to harvest 10,000 bushels of

corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.

Show the transactions if the Sept spot price rises to $3.05.

Revenue from Crop: 10,000 x 3.05 30,500

June: Short 2K @ 2.94 = 29,400

Sept: Long 2K @ 3.05 = 30,500 .

Loss on Position------------------------------- ( 1,100 )

Total Revenue $ 29,400

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Commodity Speculation

Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290

Loss of 10.23 % = - 5,130

You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?

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Margin

The amount (percentage) of a Futures Contract Value that must be on deposit with a broker.

Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin.

CME margin requirements are 15%Thus, you can control $100,000 of assets

with only $15,000.

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Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290

Loss = - 5,130

Loss 5130 5130

Margin 50160 x.15 7524 ------------ = -------------------- = ------------ = 68% loss

You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?

Commodity Speculation with margin

What is the Difference Between Hedging, Speculation, and Arbitrage? 

Hedging consists of utilizing financial instruments or contracts to reduce or eliminate the risk from fluctuating interest rates, exchange rates, and/or prices.

The purpose of speculation is to profit from a change in future rate or price.

Arbitrage is the process of buying in one market and simultaneously selling in another market in order to earn a risk-free profit.

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Web Resources

Click to access web sitesInternet connection required

www.cme.com

www.nymex.com

www.lme.com

www.eurexchange.com

www.euronext.com

www.bis.org

www.commoditytrader.net

www.isda.org