HEDGING IN THEORY AND PRACTICE

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1 HEDGING IN THEORY AND PRACTICE Ann Berg Senior Commodity Markets Development Expert USAID/FINREP-ІІ Kyiv, 2013

2 July 11 Maize contract (CME) $ 11 April $ 13 June $ 1 March US$/Tonnes $ 29 June $ 28 Jan $ 30 March $ 06 May / / / / / / /2011 2

80 $ 29 June 260 250 259.74 $ 28 Jan 264.17 $ 30 March 270.

3 What is hedging on futures market? Transfer of price risk from one market participant to another by buying or selling futures contracts to offset an underlying cash position Producers seek to protect against prices falling hedge anticipated production by selling futures contracts they are called short hedgers End users refiners/millers/feeders seek to protect against prices rising hedge anticipated physical needs by buying futures contracts they are called long hedgers Exporters may hedge risks using long or short strategies 3

position Producers seek to protect against prices falling hedge anticipated production by selling futures contracts they are called

4 Simple producer hedge in US Corn Cash price Futures price Month Cash Harvest Price [$/bushel] CME Dec Futures Price [$/bushel] June Harvest bid is 5.00 Sell 10 contracts of 5.00 [50,000 bu] November Cash sale of 4.00 is improved by futures gain of 1.00 Sell 50,000 bu to $3.50 Buy 10 contracts of 4.00 Net price realized = 5.00 = $4.50 The basis is the difference between cash price and futures price. Basis risk is always present after hedging with futures 4

00 is improved by futures gain of 1.00 Sell 50,000 bu to elevator @4.00 $3.50 Buy 10 contracts of corn @ 4.

5 Real world deals in Metric Tons One contract of corn = 5000 bushels One bushel of corn = 56 pounds One CME contract of corn = 127 MT Most contracts are 10, 50 or 100 MT lots Wheat and soybeans are heavier [60lbs/bu] One contract of wheat or soybeans is 136 MT 5

127 MT Most contracts are 10, 50 or 100 MT lots Wheat and

6 Exporter hedge Corn cash price futures price April April October China bidding $270/MT 50,000MT corn delivered C&F for November shipment Exporter sells C&F Exporter buys fob cargo from Black Sea $255 =$290 C&F [costings & frt = $35/MT CME December corn [$220/MT] Buys 400 contracts CME [50,000MT = 2m bushels = 400 contracts, each contract is 5000 bushels] Sells 400 contracts CME corn futures $6.10 [$240/MT] Calculation Loses $20/MT Gains $.50 bu [20/MT] Exporter locks in small margin by hedging on futures market. Without hedge exporter would have lost $20/MT 6

60 [$220/MT] Buys 400 contracts CME futures @$5.

7 World maize/corn export prices (fob, US$ per tonne) quotation in or $ / tonne Maize - US 3YC Gulf - $ 312 Maize - Argentina Feed Up River - $ 282 Maize - Brazil Feed Paranagua - $ no quotation Maize - Black Sea Feed - $ 285 7

8 $US/MT CBOT corn vs Ukraine fob corn prices Export tax Food Crisis US drought Export quotas /4/2008 7/4/2008 1/4/2009 7/4/2009 1/4/2010 7/4/2010 1/4/2011 7/4/2011 1/4/2012 7/4/2012 1/4/2013 Corn (CBOT) Corn (FOB) Huge range in Ukraine corn prices $110 $337 [3 x price increase] 8

00 250.00 Export quotas 200.00 150.00 100.00 50.00 0.

9 Ukrainian fob basis Food crisis US drought Ranges from large overs to large unders to CBOT corn Subject to degree of speculation in US futures [2008 and 2012] Dependent upon US S&D vs. Ukrainian S&D & ocean freight rate spreads Influenced by government interventions by both countries export restrictions and US biofuel mandates Corn (CBOT) Corn (FOB) 9

speculation in US futures [2008 and 2012] Dependent upon US S&D vs.

10 Forward curve risk extreme backwardation Corn market has been characterized by extreme backwardation this crop year Backwardation is a market structure in which the market is priced at successively lower prices along the curve Backwardation has increased close to delivery because ethanol industry has drawn corn supplies away from delivery market (along Illinois River for export) If holders of long cash position in Black Sea hedged this year in by placing shorts in near month US corn market, they would have lost additional moneys CME Forward Curves Corn FCs Dec 2012 FCs Mar

industry has drawn corn supplies away from delivery market (along Illinois River for export) If holders of long cash position in Black Sea hedged

11 What might have happened 2012 Corn cash price fob Ukraine futures price April 2012 April Last week June July cargoes offered $277/MT Exporter buys 50,000 MT cargo fob July shipment Exporter resells fob $295/MT CME July corn = [$254/MT] Basis = +$23/MT Sells 400 contracts CME July corn Buys 400 contracts CME July corn futures $7.62 [$300/MT] Basis = minus $5/MT Calculation Gains $18/MT Loses $1.17 bu [$46/MT] Exporter s net loss = $28/MT hedging on futures market. 11

futures @$6.45 = [$254/MT] Basis = +$23/MT Sells 400 contracts CME July corn futures @$6.

12 Basis Risk for Ukrainian traders is large Basis risk between Chicago and other regions has fueled growth in global commodity exchanges China, e.g. trades enormous volumes of agricultural futures. European volumes [NYSE Liffe] have increased dramatically since 2007/8 food crisis but remain light in corn. 12

European volumes [NYSE Liffe] have increased dramatically since 2007/8 food

13 Volumes of contracts traded 13

14 European grain futures & options 2011 Milling wheat : 6.9m Rapeseed: 2.3m Corn:.4m London [cocoa, coffee, sugar, feed wheat]: 11.1m = 20.7m Vol contracts MillingWht Rapeseed Corn Milling wheat comprises 72% of volume Source: nyse liffe 14

15 Basis risk would be substantially reduced by fob or domestic futures delivery contract If fob contract, freight costs, delivery allocations among ports, wait time, would determine execution costs to final destination port instead of price spread between CME and Ukraine except in case of government interference If domestic contract, transportation availability, storage, interest rate level, crop quality would determine economic effectiveness of hedging 15

instead of price spread between CME and Ukraine except in case of government interference If domestic contract,

16 Basis risk would be substantially reduced by fob or domestic futures delivery contract Several steps needed [derivatives law, electronic WHR system, training/education] to facilitate domestic futures market CME created Black Sea wheat contract $US/MT Fob delivery 3 countries, 3 wheat classes Uncertainty of load port[s] delivery adds cost/complexity necessity of foreign bank/broker excludes participation by agrarian domestic market 16

created Black Sea wheat contract $US/MT Fob delivery 3 countries, 3 wheat classes Uncertainty of load port[s]

17 Create Ukrainian fob contract: In Theory Exporter could sell corn cargo to Japan, China, et.al and hedge sale by buying Ukrainian corn futures delivered fob If futures remains cheapest execution, then exporter would remain long into delivery month and will receive notification of deliveries locations [ports] by month end Exporter charters freight and nominates vessel to load out and execute sale 17

execution, then exporter would remain long into delivery month and will receive notification of

18 In practice Exporter may prefer to buy full cargo from one load port since 3 4 load ports make cargo very expensive with daily charter rates $15,000 $20,000/day [rethink contract design for corn] Export restrictions could make load out infeasible Liquidity also an issue 18

rates $15,000 $20,000/day [rethink contract design for corn] Export

How futures markets work. Convergence between cash and futures

How futures markets work. Convergence between cash and futures How futures markets work Convergence between cash and futures Futures markets Futures markets have existed over 150 years as a means for managing price risk Futures contracts are purchase and sales agreements