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A Beginner's Guide to a Simple Hedging Procedure1 P.J. van Blokland2 1. This is EDIS document FE 277, a publication of the Department of Food and Resource Economics, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL. Published March 2001. Please visit EDIS at http://edis.ifas.ufl.edu. 2. P.J. van Blokland, professor, Department of Food and Resource Economics, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL. The Institute of Food and Agricultural Sciences is an equal opportunity/affirmative action employer authorized to provide research, educational information and other services only to individuals and institutions that function without regard to race, color, sex, age, handicap, or national origin. For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative Extension Service/Institute of Food and Agricultural Sciences/University of Florida/Christine Taylor Waddill, Dean. Purpose The purpose of this paper is to provide a quick and easy introduction to hedging in the futures market. It is therefore succinct and confined to essentials. Readers are assumed to have some familiarity with markets. Assumptions It is January 22, 2001, and a potential hedger is planning to grow twits. The expected yield is 400 boxes of twits per acre. Twits are harvested in February 2002. The futures contract for twits is 20,000 boxes per contract. Step 1. Looking at the prices of contracts Before you can calculate the asking price for twits, you must first look at the contract prices for twits. For example: The March 2002 twit contract in Chicago closed at $6.10 per box on January 22, 2001. This contract was chosen because it was the nearest to harvest. The hedger must decide if this is a good or bad price. The decision rests on the asking price for twits. Step 2. Calculating the asking price The "asking price" is the sum of all the production costs and management costs. To calculate: Estimate the total production costs (costs per acre): Production costs plus harvest costs equals total costs [$1,200 + $800 = $2,000]. Therefore, the estimated total costs are $2,000 per acre ($2,000/400) or $5.00 per box. Estimate the management costs (ROI): Management costs for a firm should include return-to-investing (ROI); in other words, what the investor may expect from investing. ROI is a standard accounting measure showing what is left to pay salaries for owners, to invest for firm growth and to pay principal.
A Beginner's Guide to a Simple Hedging Procedure 2 There are several ways to calculate ROI: 1. Opportunity costs (the cost of investing in the next best alternative to twit production). 2. Recording managerial time at a predetermined cost-per-hour. 3. Comparative analysis (standard market returns). Since the S&P 500 Index has averaged around 10% annually for over 70 years, it would be reasonable to see if investing in twits would bring a similar return. For example, if a 10% ROI of $5.00 per box equals $0.50 [$5.00 x 10% = $0.50], then the asking price should equal $5.50 [$5.00 + $0.50 = $5.50]. Therefore, the potential hedger would be content with $5.50 per box because this would cover total production and management costs. The next question to be considered would be: what is the market offering? Step 3. Determining markets and basis The answer to "what is the market offering?" lies in understanding the concept of basis. Basis is the difference between two prices. Here it is the difference between the expected cash price of twits in the local market and the futures contract for the selected months. In other words, cash price minus futures price equals basis [$5.50 $6.10 = $0.60]. This means that the cash price in the local market in February minus the futures price in March is expected to be 60 cents "under" (less than) the corresponding futures price. This is because the commodity at the local market is not in the time, place or form of the commodity traded in the futures exchange. There must be some value added to the local commodity to convert it to the specifications on the futures contract. The value added may include functions such as transportation; grading; handling; loading and processing to match the time, place and form required. This specific value added is expected to cost 60 cents. If the costs of any of these functions change, so will the value added or the basis. Basis reduces the risk of hedging. This is because hedgers operate in two markets, namely cash and futures, rather than in just one market. Basis reduces risk because cash and futures prices move together. They do not move simultaneously, nor do they move equally, but they do eventually move in the same direction. For example, 1. Suppose OPEC reduced its exports to the USA 30% in March 2001. The price of the March 2001 futures contract for unleaded petrol ($0.84 cents per gallon in January 2001) would rise. The local Gainesville, Florida, petrol price ($1.50 per gallon in January 2001) also would rise in order to ration supplies between January and March. 2. Suppose in March 2001, the futures contract price for unleaded petrol price increased 22 cents (26%), and the Gainesville unleaded petrol price inceased 25 cents (17%). These are large increases, but the basis would reduce the risk for hedgers 4%. [Was $1.50 $0.84 = $0.66; Now is $1.75 $1.06 = $0.69] One way to understand the specificity of basis is that if there is a change in the local market, or in the local market's marketing month or in the futures contract month, there will be a change in basis. You can use basis to determine what the market is offering by obtaining: Basis numbers and charts from hedgers' historical records, brokers, firms adding value (marketing that commodity) or local markets. Futures prices through the media and internet web pages. Once you know basis and futures, the real calculation is to estimate the cash price. Assume that year in, year out, the typical basis for twits in the local market in February, with respect to the March twit in Chicago, is $0.45 cents under. In other words, cash minus futures equals basis [cash $6.10 = $0.45].
A Beginner's Guide to a Simple Hedging Procedure 3 Therefore the expected local cash price (ELCP) in February is $5.65 per box [$6.10 $0.45 = $5.65]. A hedger must know the following about basis before hedging: What the local basis is before hedging. That he will rarely end up with the expected basis because basis changes, but it will be pretty close to the expected basis (in this case, $0.45 under). That basis is used in planning to estimate the expected local cash price and to compare it with the asking price. That he will probably not end up with the Expected Local Cash Price (ELCP) because basis changes, but it should be close to the anticipated price. Hedgers, perhaps unknowingly, use basis, not to lock in a price but to lock in a price range. Step 4. Anticipating hedges If the asking price is $5.50 per box and the market (if the hedge is placed) is offering $5.65 per box, then this is a good hedge. How much of the anticipated production should be hedged? This decision should be guided solely by past experience. If the yield is generally much less than 10% from the estimated yields over time, then hedge around 90% of the expected yield. If a disaster occurs, hedges can be lifted before delivery. Transaction costs are very cheap. For example, assume that you have 500 acres of twits with an average yield of 400 boxes per acre for 500 acres of twits and a contract for 20,000 boxes, it would be best to hedge 9 contracts. Step 5. Placing hedges To place a hedge, you would contact the broker to short nine March 2002 contracts with a market order, and then post the margin ($1,000 per contract). Table 1 illustrates this transaction. Step 6. Watching the market To watch the market simply means that the hedger has essentially ensured a profitable situation, assuming a normal season for twits. Therefore, this hedger should sleep soundly and not panic by following real time prices for twits daily. Looking at printed market closes for March 2002 twits two or three a week is probably sufficient. If there is a catastrophe and twit prices soar, then stay with the position for two margin calls only, and offset if price movements suggest a third. For this hedge, assume things are normal, and that offseting will not occur until cash twits are sold in the local market. Remember that cash and futures prices move together. So in all simple hedges like this one, hedgers will win in one market and lose in the other. Hedgers cannot win in both markets because this is the purpose of hedging. Likewise, hedgers cannot lose in both markets. Perhaps the most important thing is that hedgers will not win and lose equally in both markets. Hedgers win when basis moves in their favor and lose if it moves against them. If basis narrows, hedgers will win in the futures market when they are short and basis is under. Step 7. Offsetting (lifting) hedges Assume the following for offsetting (lifting) the hedge: It is February 2002, and the twits are all harvested. The hedger sells the twits to the local market for cash. It has been a good season; yields are high so prices are down a bit. Assume the cash price is $5.45 per box. The hedger, unfortunately, has a legally binding document called a futures contract, which states that the hedger has agreed to deliver twits to a specific delivery point designated by the Chicago Exchange by the end of March. So what happens now? The hedger cancels the legally binding document by offsetting the contracts. Offsetting means taking
A Beginner's Guide to a Simple Hedging Procedure 4 an equal-and-opposite position in the futures market to the original position. Thus the nine March 2002 transaction can be offset by going long nine in the March 2002 contracts. Now the hedger has no futures position. All that remains is to pay the broker, who is only paid on the round-turn. If the local cash price is lower than expected, it is reasonable to assume that futures prices will fall. Suppose the March 2002 price was $5.85 when the transaction was offset, the hedger would gain $0.25 in the futures market and lose $0.20 in the cash market, coming out ahead $0.05 per box overall. (Note that this $0.05 is the same as the $0.05 change in basis.) In this case, basis narrowed and moved in favor of the hedger. [Table 2 illustrates the transaction.] Conclusion In the end: The hedger received $5.45 from the local market and $0.25 from the broker, or a total of $5.70 per box overall in cash. The hedger's ROI was $0.70 per box [$5.70 $5.00], which is a 14% return. (Production costs were $5.00 per box.) Without hedging, the producer would have received $5.45 from the cash market, or an ROI of $0.45 per box, which is a 9% return. These calculations ignore the cost of posting $1,000 per box in margin, and the commission, which is probably around $20 per round-turn per contract. These are not significant costs. Using the futures market is cheap. Perhaps the main advantage of futures is that it keeps producers aware of prices. Producers can and should profit from price movements.
A Beginner's Guide to a Simple Hedging Procedure 5 Table 1. Hedge Transaction. Date Event Cash Market Futures Basis January 22, 2001Short 9 Mar 2002 6.10 ELCP Feb 2002 5.65 Table 2. Offsetting hedge transaction. Date Event Cash Market Futures Basis January 22, 2001Short 9 Mar 2002 6.10 ELCP Feb 2002 5.65 (0.45) February 14, 2002Long 9 Mar 2002 5.85 ALCP Feb 2002 5.45 (0.40) Totals (0.200 0.25 0.05