Financial Instruments Traded on the Commodity Exchange

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1 Financial Instruments Traded on the Commodity Exchange Using the Financial Markets A cotton trader will almost always prefer to manage his price risk through physical positions and contracts for cotton, as this is his core business and one in which his expertise lies. However, it is not always possible for a trader to mitigate the risk through physical positions. When a trader is unable to hedge using physical back-to-back trading he can hedge his exposure using financial instruments which are traded on international commodity exchanges. In such circumstances, a trader will take a position on the financial market until such time that he is able to close the position in the physical market. For example, a trader may have purchased a significant volume of cotton at the start of a season, but is not able to find a buyer for that cotton. The trader knows that he is "long" and fears that the price of cotton will fall, leaving him with a loss. To protect against falling prices, the trader would normally either forward sell this cotton, or sell it immediately. However, being unable to sell the physical cotton due to the lack of a buyer in the physical market, he may "sell" the cotton (at today s prices) on the financial markets using a futures contract. This would, allow him to lock-in today s price for the sale. This financial contract will provide protection against any fall in the cotton price since the trader could "buy back" his contract at any time. The trader is off-setting the risk of falling prices by locking-in the sales price at today s price. Once the trader has managed to find a buyer for the physical cotton, he 126

2 will exit the financial contract. Effectively, he has used the financial instrument to take the place of a buyer, until he is been able to find a buyer for his physical cotton. Differences Between the Financial and Physical Markets The financial and physical cotton markets are very different marketplaces, each with different characteristics, purposes, processes and procedures. However, these markets also have strong linkages and are related to one another, which enable the financial marketplace to support participants operating within the physical marketplace by providing risk management solutions, as well as providing cotton pricing data. The physical marketplace involves the physical trading of cotton (buying and selling of cotton) with the cotton moving from one party to another. For example, from a producer to a trader, from a trader to a buyer, from a buyer to a roaster and from a roaster to a retailer. The financial marketplace does not generally involve real movements of physical cotton (although these do take place), but primarily exists to provide an environment that assists in pricing cotton, and in enabling cotton sector participants to manage their price risk. 127

3 Thinking in Two Markets In order to use financial markets to hedge risk, it is important to begin thinking in two markets. The first market is the market that all cotton traders know well - the local physical market for cotton (the physical market). This is where traders do business everyday buying and selling cotton from local producers/ traders and selling to buyers/ exporters. The second market - the international market for cotton (the financial market) - is also familiar to traders. Most traders already use this "second" market to determine prices when negotiating with exporters and determining local prices. It was discussed in the risk assessment section when looking at breakeven pricing and marked to market analysis. In this section we will discuss the specific dynamics of this market in more detail, and how it can be used to manage risk. Use of Futures Markets for Cotton It is very important that course participants understand the differences between the physical cotton market and the financial cotton market; the purposes of each market; and how each market is used by different cotton industry participants to manage the cotton business risks. Key differences between physical and financial markets: The financial markets have uniformed standard financial contracts for cotton, e.g. the same delivery locations, the same quality of cotton, the same export terms, the same volume of cotton and the 128

4 same units of measurement. In short, the terms and conditions for each financial contract traded on the commodity exchange are identical, with the only difference between contracts being the date (month) of delivery. The uniform nature of the financial contracts enables people trading these contracts to do so, knowing the terms and conditions of each contract are the same. In contrast, physical contracts for cotton are not standardized, and specific to each transaction in terms of volume, quality, location, etc. Comparing these characteristics of the physical market to those in the financial markets shows the main differences between the two markets: Location/Place: The physical market exists in cotton producing countries, with buyers and sellers trading physical cotton. There will also be a physical cotton market in importing countries, where physical cotton is traded between importers and cotton roasters. The financial market is a global (often electronic) exchange for financial contracts (representing different amounts of cotton for delivery in different months), rather than where physical cotton is exchanged. There are numerous physical markets where the trade in cotton takes place, but relatively few financial markets where cotton financial contracts are traded. Activities/Purpose: In the physical market, the primary activity is the buying and selling of physical cotton between businesses that earn money from trading and moving cotton. The financial markets have a very different purpose and set of activities. In the financial markets, cotton contracts are traded with very little expectation of delivery of cotton. The primary purpose of these activities is for cotton sector participants to get information on current (and future) prices for cotton, and to enable them to manage their risk through the trading of these financial instruments. Delivery location: In local physical cotton markets, delivery takes place depending on the contract terms (INCOTERMS), at the ginnery gate (EXW, FOT), at the port in the exporting country (FAS or more often FOB), at the port of destination in the importing country, or at the textile mill (DDP, etc). Contracts on the cotton futures market involve delivery to licensed warehouses in the United States. However, as will be discussed later very few of these contracts will ultimately result in actual delivery of the physical cotton. Export terms: Local traders operating in the physical market will generally have contracts based on FOB (Free on Board) export terms, whereas cotton futures market contracts are ex-warehouse in the US, and international prices are CFR (Cost and Freight). 129

5 Unit of measurement: Local markets utilize their own units of measurement (metric units kilograms or tons - or bales) whereas the futures markets work in standard bales weighing 500 pounds each. International contracts are in metric unit or in pounds. Price: Prices of physical cotton in local markets are generally in domestic currency per kg or ton, while prices in the international market and in the futures market are in U.S. cents per pound (cts/lb). 1 cent per pound is equivalent to cents per kilogram. These key differences need to be understood by traders hoping to utilize the financial markets for risk management purposes. Each of these differences will affect the basis (the differential between local contracts for physical cotton and international prices), as they each involve different costs. Often international cotton contracts (traded on commodity exchanges) will have higher prices (for the same grade cotton) than local contracts. This is primarily due to the differences in delivery conditions i.e. FOB/CFR. As all cotton traders will know, physical cotton contracts traded in local markets will contain different terms and conditions that are agreed upon and tailored to the needs of each buyer and seller when they are agreeing the contract. The main purpose of these contracts are to trade / deliver physical cotton. These significant differences between the terms of a local market contract and a financial market contract result in a price differential between the two markets in cotton prices. Usually, the international market price will be higher, as it will be based on CIF rather than FOB. The Physical Market The physical market involves traders buying cotton from producers, and exporting this cotton to buyers. At each step in the process, physical cotton moves between market participants and payments are made for the physical cotton. The producers earn money by selling the cotton that they have grown. The trader (or intermediary / exporter) earns money by buying the cotton from the producers, who process the cotton and sells it to a buyer (importer). As all traders know, the market is not really this simple. Often there will be a variety of intermediaries through whom the cotton passes, including primary and secondary cooperatives, processors, exporters, etc. However the physical market will always involve the trade in physical volumes of cotton with the ultimate purpose to deliver cotton from the producer who grows the cotton to the consumer of the cotton. Each participant in the physical cotton supply chain aims to make money from the trade in the physical cotton. 130

6 The Financial/Futures Markets The financial markets are very different from the physical market both in how they function and their purpose. Unlike the physical market, in the financial market contracts will only result in physical delivery of cotton on a limited basis. Rather, these contracts are held for financial purposes and the contracts will be sold or terminated at, or prior to, the delivery date, which will result in a financial settlement of the contract. There are various financial purposes for these contracts including risk management activities and speculation. The vast majority of contracts traded on the exchange are traded as a means of providing buyers and sellers of cotton (in the physical market) with opportunities to manage their exposure to price risk. These markets are accessed by participants from all over the world which results in numerous transactions every day. An added benefit of this liquidity is that by having so many market players trading cotton contracts in one location, the demand and supply for these contracts help buyers and sellers determine an aggregate price for cotton which is commonly known as the world price of cotton. This price, as all those in the cotton business know, is used by producers, traders, exporters, and roasters around the world as the reference price for cotton on any given day. 131

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8 Hedging with Financial Instruments Equal and Opposite We have been discussing the presence of two markets for cotton trade. The key aspect of managing risk through these markets is using one market to manage the risk on the other market. In most cases risk for traders is created in the physical markets. Managing risk involves managing the risk on the physical market by taking a position in the financial market also. Hedging is "the process of managing risk, and neutralizing a risk that is currently faced, by taking an equal and opposite position in the financial market to what is held in the physical market. Hedging can help to lock-in profits for cotton trader. The primary purpose of hedging is to reduce the volatility of a trader s profits from volatile price movements and reduce the risk of losses." 133

9 Using Financial Markets to Take an Equal and Opposite Position Risk can be avoided by taking an equal and opposite position in the financial markets to the position that is already on a trader s books. Timing Differences Risk occurs when there is a "gap" or a timing difference between when a trader purchases and when he sells his cotton. This gap is also the explanation for a trader holding a short or long trading position. Hedging can effectively remove the risk created due to the timing difference by "filling the gap", through the financial instruments. Effectively, the physical gap in timing between the sale and the purchase of cotton will exist, but the risk will have been negated by contracting an equal and opposite position on the financial markets. This is how a trader manages to reduce or eliminate the risk exposure by locking-in prices now. The objective in taking this position in the financial market is that any losses in the physical market will be offset by gains in the financial market and vice verse. Use of Physical Instruments to Manage risk Risk management can involve the use of both physical contracts and financial instruments. A hedging strategy will often use both sets of tools (physicals and financials) to protect a trader from risk. A trader does not have to use just physicals, or just financials, to manage risk, but can use a combination of both. 134

10 Hedging is Not a Guarantee of Profits The goal of hedging is simple and very straightforward. It is to minimize risk. When financial contracts are used in order to solely try and generate profits, their use is considered a speculative activity. In the cotton trading business, the use of financial instruments is recommended as a risk reduction strategy to offset the risky physical position created by the everyday business of a cotton trader. While hedging will not guarantee the trader a profit, it will lock-in an offsetting position from the existing physical cotton trading position that the trader holds on his books at a specific point in time. If the trader has been operating unprofitably, it will mean locking-in the loss of these operations, at that moment in time. If the trader has been trading profitably, it will mean locking-in the profit at that moment in time. Therefore, hedging protects the trader from accruing additional losses or losing estimated profits due to adverse price movements while the trader has exposure. The Effectiveness of Hedging Will Vary The effectiveness of hedging varies by location, market and trader: Basis, which is the differential between the price of cotton in the local contracts for physical cotton (and will be discussed in detail later in this section), and the international prices for cotton, is a major factor. 135

11 In addition, a trader will have to have an effective price risk management program in place if he wants to hedge effectively. Any mismatch in timing or pricing will reduce the protection required by the trader. The size of the physical position will also impact upon the effectiveness of hedging. The larger the traders position in terms of volume, the greater the financial impact of even small changes in price. 136

12 Hedging with Financial Instruments The Purpose of Hedging The purpose of hedging is to reduce price uncertainty and the impact of adverse cotton price movements. Effectively, a trader has the option to implement price risk management in his business by developing and implementing a hedging strategy. In order for this to occur a trader must make continuous decisions to adopt strategies that will reduce price uncertainty for the trading business and protect against potential adverse cotton price movements. Constant Monitoring and Updating of Risk A trader needs to frequently update his risk assessment and identify changes to his risk exposure. Any change to a trader s exposure will require a change in the hedging strategy. In addition, hedging strategies need to adapt not only to changes in the trader s position, but also to changes in the cotton market. For example, consider a trader who selects a strategy of back-to-back purchases and sales to manage risk. If market conditions make it impossible for that trader to find buyers for his cotton, he will need to revise his strategy and manage the price risk exposure in a different way. Therefore, a trader needs to constantly undertake risk assessments to ensure that his risk management strategy remains valid and appropriate. A trader who fails to update his risk management strategy as the environment changes risks having a strategy that fails to effectively control or manage his risk position. Requirement for a Tailored Strategy Every trader faces a different set of circumstances and will therefore require a unique and tailored strategy, reflecting his individual business and risk exposure. While many traders will see similarities between their marketing and risk management strategies, no two strategies will be exactly alike due to the existence of different risk exposures, risk preferences, and the idiosyncratic nature of many marketing opportunities. For example, a trader with strong relationships with buyers may be in a better position to utilize forward contracts. However, a trader who does not have such strong relationships may have to rely on a back-to-back physical trading strategy. Another example might be that a cotton trader with greater financial resources may be in a better financial position to utilize financial instruments, such as futures and options. In comparison, a smaller trader without similar financial resources may not be able to access the financial hedging instruments available on international commodity markets. A trader must carefully review his business and his operating environment to develop a strategy that is effective and specific to his situation. 137

13 Basis For any cotton trader doing business in the international market and selling to exporters, the concept of basis is a vital to understand. It is even more critical if a trader also wants to begin using these markets to hedge risk. Basis refers to the difference between the international cotton price (the price quoted for cotton on the financial markets) and the local physical market cotton price. Many traders know this more commonly as the "differential" between the two markets. This basis between these to markets is determined by a number of different factors. It is important for traders to know what costs and factors make up the difference between local prices and international prices. Each of these differences will affect basis. There are a variety of items that can make up this difference. These include cotton quality from one country to another, the costs of transportation, interest, and insurance. Basis can be either positive or negative. Positive basis is when the local market price for cotton is greater than the international market price, whereas negative basis is when the local market price is less than the international market price. When considering basis a simple way to think of it is: Basis Determinants Spot (Local) Price of Cotton - Futures Price = Basis 138

14 A number of factors determine the basis between international and local cotton prices factors including: Quality of cotton: Perceived quality of cotton from different countries and different regions varies significantly. This difference in perceived quality is known as the "quality differential". A country producing higher grade cotton (than the cotton traded in the exchange based contracts), will have a premium over exchange prices in terms of a positive basis. Whereas, cotton from a country with a lower grade cotton will have a negative basis, reflecting the lower grade cotton than the cotton traded on the exchange based contracts. Differences in costs: Financial contracts include storage costs, interest costs, and insurance costs. These costs are not included in the local market prices for cotton. Therefore, futures contract prices are generally higher than local market prices unless quality differentials are very marked in the local country s favor. In general local cotton prices are quoted with at the farm gate or FOB at a local port whereas international prices are quoted in CIF terms for delivery to an international destination. Seasonal or cyclical differences: Basis may also vary during the season, as local conditions "on the ground" (in one particular cotton market) move local prices more sharply, than the international price would normally suggest. Seasonal trends might be identified by comparing local and international markets over a number of historical seasons. Occasionally, clear seasonal variations appear often at the start or end of season, reflecting a trader s willingness to pay premium local prices (compared to international prices). The trader may be either starting the season or completing the season, and is racing to secure cotton volumes to complete final orders. 139

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16 Basis Basis and Risk Management How Basis Impacts Risk Management It is normal for basis to vary during a season as international and local prices do not move in a oneto-one correlation, however basis needs to be reasonably stable if commodity exchanges and exchange traded contracts are to be used by a trader for hedging. As we will discuss, financial instruments offer protection against movements in the international market price for cotton. Therefore, if they are going to be used to manage risk on the local market, it is critical that the local market follows the international market movements. Any significant movement in basis may mean that a trader (who is hedging using financial instruments) is not fully able to cover his position. In order to determine the relationship between the two markets, a trader will need to review historic local and international prices to see how stable basis is throughout a season. Only traders operating in countries that show a reasonable level of stability in basis (where local prices follow the price movements of the international markets quite closely), should consider using international markets to hedge. 141

17 Even if a trader has reviewed the historical relationship between these two markets, any trader using futures and options to hedge will need to keep a constant eye on movements in local and international prices during a season. Basis can shift during a single season even if it has been stable for a number of months or years. By watching the basis or differential closely, a trader can recognize any divergence in the usual basis between the two markets. If changes are weakening his protection, the trader will need to take action as such divergences occur. A trader who has used the futures markets to hedge will have taken an equal and opposite position on the futures market to their physical position. However as there is basis (i.e. a difference between the physical market price for cotton and the financial market price for cotton) they will have taken a basis position. The basis position is either "long the basis" (where they are long in the physical market and have gone short in the financial market), or "short the basis" (where they are short in the physical market and have gone long in the financial market). In summary: A trader using financial instruments to hedge will be hedging based on the international market price for cotton. If there is a change in basis over the course of the season, the trader may find that his financial hedge does not protect his physical position. As such, a trader must understand the stability of basis when deciding to use, or not use, the financial markets to hedge. When hedging with financial instruments, the trader must keep a close eye on local and international market prices to ensure that basis remains stable. 142

18 Basis Basis Risk For the purposes of trading, it is hoped that basis remains stable throughout the season. This will allow traders to most easily use the international market as a reference for pricing. When the relationship between the two markets is stable, traders can easily determine the effect of a change in the international price of cotton on local prices. In addition this will allow traders to use international markets to manage risk on the local market. For example, if the trader will be using financial contracts traded on the exchange to hedge, he will need to know the relationship between local and international prices, so that they can be hedged effectively. The trader will also need to understand and calculate the stability (or volatility) of the long term relationship between local and international prices. When basis changes, this can be risky to traders since it changes the relationship between the two markets and can lessen the effectiveness of using this market for pricing and risk management. The risk that basis will change over time is referred to as "basis risk". Where there is a significant amount of volatility in basis i.e. the relationship - or differential - between local and international prices varies greatly over time; basis risk is high. The greater the basis risk, the more difficult it is for a trader to use the financial markets. A significant change in the differential between the local and international price may reduce the effectiveness of the hedge. 143

19 Unusual Basis Reversals Under exceptional circumstances, the traditional relationship between local prices and international prices may reverse for short periods of time. Where normally local markets will follow the international market prices, specific local events may force unusual behavior. For example, a local cotton shortage may drive up local prices, reflecting traders purchasing cotton to fulfill their orders even at a higher price than the international market is dictating. Of course the international market will not be impacted by this local shortage, so international prices will not react. However, the rise in local prices will greatly change the basis for the local country for that period. 144

20 Basis risk will impact a hedger depending on whether they have a long basis position or a short basis position: If they have a long basis position (i.e. are long in the physical market and short in the financial market) they are at risk of basis narrowing o i.e. they are at risk from a reduction in the difference between the physical and financial market prices. If they have a short basis position (i.e. are short in the physical market and long in the futures market) they are at risk of basis widening o i.e. they are at risk from an expansion in the difference between the physical and financial market prices. 145

21 Basis Evaluating the Basis A first step for any trader considering the use of futures and options to hedge his exposure to risk, is to understand the relationship between the physical and financial cotton market prices. This will require identifying how closely the markets are correlated. The international cotton price (Cotlook A Index) is usually above the futures price, due to quality and location differentials. The differential between the world price and the futures price ( basis ) is not constant; sudden and wide fluctuations do occur. As a result, the basis risk is significant and potential changes in the basis are a major limitation to using futures markets for hedging non-us cottons. A trader can only use the futures market efficiently if the correlation between the two markets is strong. The strongest relationship between the futures market price and the physical market is for U.S. upland cottons, as those cottons are the only ones that can be physically delivered for liquidating the futures contracts. Recognizing the need for hedging instruments for non-u.s. cottons, NYCE introduced a world cotton futures contract ("World Cotton Contract") in Based on 50,000 pounds, the contract settlement price was equal to the 5-day average of the Cotlook A Index. Despite high expectations and the expertise of the New York Cotton Exchange, the world contract never took off. There were few 146

22 transactions and only small volumes during two years and trading of the contract was discontinued as soon as The main reasons for this failure were the absence of an equivalent spot physical market with well-defined quality and delivery specifications and concerns about possible tampering of the Cotlook A Index. 147

23 Hedging vs Speculation Hedging is not Speculating Often times, people confuse or misunderstand the use of financial instruments for hedging price risk and wrongly equate it with speculation. It is easy to see how this can be done, since both activities are carried out on international commodity markets using financial instruments. But, in contrast to speculation, hedging attempts to manage risk and avoid the potential negative consequences that arise due to unmitigated risk exposure. Speculation, on the other hand, is about embracing risk in an attempt to profit from such risk. Speculating Using the Futures Market Speculation involves taking a position in the market with the expectation that the market will move favorably and result in a gain or profit. If the market moves unfavorably, a loss will be generated for the speculator. For example, a person speculating in the futures market might sell a futures contract with the hope that the market would move down and that he would be able to buy back that position at a cheaper price resulting in a net gain. The speculator purchasing such a speculative futures contract would not have a physical position which he is trying to protect. Rather, he would be hoping to gain from market movements. If the market moved against him, in this case rose, he would lose money, and those losses would not be offset by gains in his physical business. 148

24 Speculating Using the Physical Cotton Market Speculating can also be done in the physical markets. Using physical markets to speculate involves purchasing cotton, without selling that cotton, and hoping that the price of cotton rises (the trader would make a gain if prices rise). Alternatively, it involves selling cotton, without buying that cotton, hoping that the price of cotton falls (the trader would make gain by buying the cotton at a lower level). Of course, such speculation will only "pay off" should the price of cotton move in the trader s favor. If the price moves against the trader, the trader will face a loss. Hedging to Reduce Risk Exposure to Price Movements Hedging is fundamentally different from speculation. Hedging involves a trader taking an equal and opposite position in the market to protect his business against adverse price movements. There is no anticipation of windfall gains or profits. Rather, the goal is to protect the business from price risk. A cotton trader may hedge with futures contracts or options contracts to offset the risk on his physical cotton position. In the case of the perfect hedge, a gain on the futures contract would be exactly offset by a corresponding loss on the sale (or purchase) of the physical cotton. Similarly, a loss on the futures contract would be exactly offset by a corresponding gain on the sale (or purchase) of the physical cotton. Any trader that uses futures markets to hedge should also be aware that they will not be profiting consistently from their activities on the market. Rather, by offsetting their exposure to risk, a gain in 149

25 either the physical or the financial market will be offset against an equivalent loss in the other market. This will allow them to lock-in a level of profit or margin on their trading activities. A trader will at times generate losses on futures contracts which will be covered by gains on his physical purchase or sale position. A trader who is hedging his price risk, will not achieve a short term windfall gain from positive cotton price movements, as any gain on one side will be offset by an equal loss on the other side. Effectively, a trader is "locking-in" prices (and profits), but giving up potential short-term windfall gains (which is the "price" for avoiding potential losses). Speculation Increases Risk Any trader who decides to speculate on futures markets (or in the physical markets) will be increasing his exposure to risk without necessarily increasing his rate of return. By speculating on cotton prices, the trader will face greater losses or gains due to a greater exposure to risk. 150

26 Summary of Module 5 - Using Financial Instruments to Hedge Risk Hedging is About Managing Risk Hedging is used by traders to protect their businesses from volatile prices, enabling them to "lock-in" profits and avoid losses that might otherwise be generated by adverse price movements. Hedging always involves a trader taking an "equal and opposite" position in the market, ensuring that, should a loss (caused by cotton price movements) occur, it will be covered by a gain in the opposite position. All traders who wish to protect themselves against price volatility are able to do so. However, hedging requires effort and time, and often involves additional financial cost. All Traders Need to Create Their Own Tailored Hedging Strategies There is no one best strategy that can be utilized by all traders. A trading firm that wishes to manage price risk will need to create a strategy which is tailored to account for their business circumstances and for the marketplace in which their business operates. A trading strategy requires constant review and updating to take account for changes in the traders position, and changes in the local cotton markets. To effectively hedge, a trader will need to frequently update his risk assessment and subsequently adapt and amend the hedging strategy, to take account of changes in the risk assessment. Hedging is Never About Speculating Hedging is never about speculating. Hedging is about managing risk and "locking-in" profits to avoid losses caused by price volatility. Any trader who speculates, may make short term gains, but will find themselves increasing their exposure to risk. Hedging is the reverse of speculation, and involves controlling and managing risk. Using Both Physical and Financial Contracts A risk management strategy may involve the use of both physical contracts and financial contracts. The exact make up of the risk management strategy will be determined by the trader s appetite for risk, the size of his business, the marketplace in which he operates, and his ability to utilize the different methods available for controlling risk in his managerial capacity. When Physical Solutions Are Not Available Traders should focus on managing risk and implementing a risk management strategy with physical contracts. Traders are experts in trading cotton; this is their core business and what they are best at. As such, a trader should focus at all times on how he can offset risk by buying and selling physical cotton. Only where it is not possible to manage risk effectively using physicals, should a trader consider using the international financial markets. The Two Markets and Basis Risk Futures and options contracts can be useful tools for traders wishing to hedge. However, the use of these instruments requires a trader to have a strong understanding of how the financial market differs from the physical market. In addition, the trader must understand the relationship between local 151

27 cotton prices and international cotton prices, i.e. basis. A trader should use the international markets only after he has confirmed that the basis risk is not too large, which would create, rather than offset, risk for the trader. 152

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