PNWPriceRisk-Module5

7/31/2019 PNWPriceRisk-Module5

1/18

HOW CASH PRICE AND BASIS AFFECT

HEDGING OUTCOMES

Larry D. Makus andPaul E. Patterson

University of IdahoDepartment of Agricultural

Economics & Rural Sociology


2/18


3/18

HEDGING CONCEPT (cont.)

Hedging based on idea that cash and futures markets are

related and move up and down together relationship between cash and futures is measured

by basis

Basis cash price minus the futures price basis is not a constant; can get weaker (smaller

value) or stronger (larger value)

Hedging effectiveness strongly influenced by how the actual basis

behaves relative to what is expected remember, the futures market is used only for a

temporary sale of your commodity


4/18

SHORT HEDGE EXAMPLEfor Wheat Producer

Situation Mid January; grain producer expects to harvest

30,000 busels of wheat in August; selling aboutAugust 15

appropriate futures contract month, Sept Evaluate expected hedge price using CBT

Sep wheat futures contract

"Appropriate" futures price = 335

+ Expected basis (local) = -10 (under)- Cost of hedging = - 2-= Expected hedge price = 323 cents/bu.


5/18

SHORT HEDGE EXAMPLEfor Wheat Producer (cont.)

Compare hedge to other alternatives cash forward price with options

dont price Decision is to price with a hedge

quantity to hedge: 67% of expected production, 20,000 bu.

sell 4 Sep (5000 bu. each) at 335 expected hedge price = 323 cents/bu.


6/18

WHEAT HEDGE OUTCOMESPrice Increases

Situation A mid August local price increases to 350 cents/bu. basis holds at -10 (under)

Actual

Cash Market Futures Market BasisSell wheat Sold at 335at 350 (offset) Buy at 360 -10

Loss = 25 cents/bu.

Hedge Outcome

Cash Price = 350Loss on Futures = 25 (-)Cost of Hedge = 2 (-)

Net Price = 323 cents/bu.


7/18

WHEAT HEDGE OUTCOMESPrice Decreases

Situation B mid August local price decreases to 260 cents/bu. basis holds at -10 (under)

Actual


gain = 65 cents/bu.

Hedge Outcome

Cash Price = 260Gain on Futures = 65 (+)Cost of Hedge = 2 (-)



8/18

Situation C mid August local price decreases to 260 cents/bu. basis weakens to -20 (under)

Actual


gain = 55 cents/bu.

Hedge Outcome

Cash Price = 260Gain on Futures = 55 (+)Cost of Hedge = 2 (-)

Net Price = 313 cents/bu.Note: Net price was 10 cents below the expected hedge price because of a weaker basis.

WHEAT HEDGE OUTCOMESPrice Decreases


9/18

Situation D mid August local price increases to 3.50 cents/bu. basis strengthens to 0

Actual

Cash Market Futures Market BasisSell wheat Sold at 335at 350 (offset) Buy at 350 0

Loss = 15 cents/bu.

Hedge Outcome

Cash Price = 350Loss on Futures = 15 (-)Cost of Hedge = 2 (-)-

Net Price = 333 cents/bu.Note: Net price was 10 cents above the expected hedge price because the basis strengthened by 10 cents.

WHEAT HEDGE OUTCOMESPrice Increases


10/18

PUT OPTION EXAMPLEfor Wheat Producer

Situation Mid January; grain producer expects to harvest

30,000 bushels of wheat in August, sellingabout August 15

appropriate futures contract month, Sept

Evaluate level of expected price protection:Strike price of Sep put = 330

+ Expected basis (local) = -10 (under)- Put cost (premium + fee) = 28 (-)= Expected price protection = 292 cents/bu.


11/18

Compare to other alternatives: cash forward contract

hedge with futures dont price

Decision is to buy put options for price protection

quantity to protect: 67% of expected production, or20,00 bu

number of contracts: 4(20,000 5,000)

buy 4 CBTo 330 Sep wheat put options at 28 cents

(27 cent premium + 1 cent broker fee) to obtainprotection

expected minimum price is 292 cents per bu. withpotential to benefit if price increases

Note: How many bushels of expected production to hedge will depend on

a number of factors. Avoid taking a futures position that you cant back

by grain you produce. Otherwise, youre speculating.

PUT OPTION EXAMPLEfor Wheat Producer


12/18

WHEAT PUT OUTCOMESPrice Increases

Situation A mid August local price increases to 350 cents/bu. basis holds at -10 (under)

ActualCash Market Futures Market BasisSell wheat Sept Futures price = 360at 350 330 Put premium = 0 -10

(no intrinsic value)Put expires worthless

Option Outcome

Cash Price = 350Cost of Put = 28 (-)Sale of Put = 0-Net Price = 322 cents/bu.

Note: Option is always second best choice!


13/18

WHEAT PUT OUTCOMESPrice Decreases

Situation B mid August local price decreases to 260 cents/bu. basis holds at -10 (under)

ActualCash Market Futures Market BasisSell wheat Sept Futures price = 270at 260 330 Put premium = 60 -10

(intrinsic value)Sell put for premium

Outcome

Cash Price = 260Cost of Put = 28 (-)Sale of Put = 60 (+)-Net Price = 292 cents/bu.

Note: Option is always second best choice


14/18

PUT OPTION OUTCOMESBasis Changes

Changes in basis will impact option-basedstrategies in the same manner basis changesimpact hedges:

Weakening Basis

the actual price protection will be lowerthan the expected price protection level

Strengthening Basis

the actual price protection will be higher

than the expected price protection level.


15/18

CALL OPTION EXAMPLEfor Wheat Producer

Situation mid January; grain producer has 30,000 bushels

of wheat in storage current cash price is 310 cents/bu. wants to eliminate holding costs, but believes

some potential exists for price gain betweennow and mid April appropriate contract month, May premium on out-of-the-money 300 CBT May

wheat call is 15 cents

Evaluate potential for gain:

Cost of holding cash wheat = 20Cost of buying 300 Chi May Call = 16= Minimum gain from buying call = 4 cents/bu.


16/18

Compare to other alternatives cash forward contract hedge with futures dont price

Decision is to use call option alternative

number of options: 6 (30,000 5) sell cash wheat at 310 cents/bu. buy 6 CBT 300 May wheat call options at 16

cents (15 cent premium + 1 cent broker fee)

CALL OPTION EXAMPLEfor Wheat Producer


17/18

PURCHASE WHEAT CALL OUTCOMEPrice Increases

Situation A mid April local price increases to 350 cents/bu. basis holds at -10 (under)

ActualCash Market Futures Market BasisSold wheat Sept Futures price = 360at 310 300 Call premium = 60 -10

(intrinsic value)Sell call for premium

Option Outcome

Sale of cash wheat = 310 (+)Premium paid for 300 call = 16 (-)Storage cost savings = 20 (+)Proceeds from sale of call = 60 (+)



18/18

WHEAT CALL OUTCOMEPrice Decreases

Situation B mid April local price decreases to 260 cents/bu. basis holds at -10 (under)

ActualCash Market Futures Market BasisSold wheat Sept Futures price = 270at 310 300 Call premium = 0 -10

(no intrinsic value)Call expires worthless

Option Outcome

Sale of cash wheat = 310 (+)Premium paid for 300 call = 16 (-)Storage cost savings = 20 (+)Proceeds from sale of call = 0 (+)


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PNWPriceRisk-Module5