PRICE FIXING STRATEGIES INTRO TO HEDGING

Transcription

1 PRICE FIXING STRATEGIES INTRO TO HEDGING

2 QuickTime and a decompressor are needed to see this picture. Why manage risk? The business of a cotton producer is to grow and market cotton at a profitable price. The business of a cotton ginner is to buy, process and sell cotton at a profitable price. The business of a cotton trader is to buy and sell cotton at a profitable price. Profit uncertainty for cotton producers, ginners and traders arises from volatility in the costs of production and of, above all, cotton prices. PLAY AT YOUR OWN RISK C A U T I O N

3 RISK MANAGEMENT (Hedging) Strategies thru Physical Trading Financial Instruments Back to Back Operations Structured Operations Back to Back Operations Structured Operations Forward Contracts Spots/ Forwards Options on Trading 1. Minimum price Options forward on Physical contracts Trading 2. Price to be fixed contracts 3. Long term forward contracts Futures contracts Options on Futures Back to Back Operations imply that whatever is being sold is simultaneously being covered thru an opposite transaction involving either physical trading or futures contracts Structured Operations are tailor made and designed with the sole purpose of generating further possibilities for favorable prices A combination of these strategies can be used to manage price risk these involve strategic planning of sales and purchases of cotton

4 QuickTime and a decompressor are needed to see this picture. The Concept of Hedging Hedging is the use of physical trading, futures and options contracts to manage physical price risk. Hedging can help by locking in the price of cotton at times when price certainty and/or price protection is needed. Prices of cotton are established in different markets: 1. the SPOT markets, where the physical cotton is traded; 2. the FUTURES market which trades contracts for future delivery and PLAY AT YOUR OWN RISK C A U T I O N 3. The OPTIONS market which trades options on futures.

5 QuickTime and a decompressor are needed to see this picture. The Concept of Hedging Hedging involves taking a position in the financial market that is equal and opposite to that which is held in the physical market, with the objective of minimising the adverse affects of cotton price swings on the value of your physical product. Timing differences between purchases and sales can be hedged. Hedging is complementary to the use of physicals when managing price risk. Hedging aims to lock in prices and is not a guarantee of profits. PLAY AT YOUR OWN RISK C A U T I O N The effectiveness of hedging will depend on the level of basis risk, the volume of physical position risk and the effectiveness of a traders price risk management program.

6 The Concept of Hedging Many cotton trading businesses should primarily rely on physical trading to manage their price risk exposure as physicals are their core business. Where physical trading is not sufficient to effectively manage the price risk, cotton sector businesses may consider the use of financial strategies (futures & options). In all cases, strategies undertaken will have to be continuously reviewed and amended. Appropriate strategies (and selection of strategies) will vary across firms. The purpose of HEDGING is to REDUCE price uncertainty and the impact of adverse cotton price movements.

7 Hedging vs. Speculation Hedging is not about speculating. Futures speculating involves taking out a futures contract without a corresponding opposite position in the physical cotton market. Hedging involves taking positions that reduce a traders exposure to price risk. Futures speculators, in the long run, should not expect to make profits, therefore: Speculating on futures increases risk without increasing expected rates of return. Hedgers should expect their futures positions to reduce risk but should not expect to profit consistently from their futures transactions.

8 Hedging with Financial Instruments The use of Commodity Exchange for Cotton Whenever a physical BACK TO BACK operation is not possible the trader then goes to the Commodity Exchange for cotton and uses it as a Financial counterparty until he finds a Physical counterparty for his physical operation. The financial and physical markets are very different market places: The financial marketplace provides a platform for pricing and price risk management. The physical market involves goods physically moving from one person to another in course of regular physical trade.

9 Physical and Financial Markets Physical contracts for cotton are not standardized, and specific to each transaction (volume, quality, location, etc). Financial markets have uniformed standard contracts: Location/Place. Activities/Purpose Delivery location. Delivery terms. Unit of measurement. Price.

10 Basis Difference between physical price and price in the financial market: Basis = Physical Price of Cotton minus Futures Price Basis determinants: - Quality of cotton - Differences in costs (location) - Seasonal or cyclical differences

11 Cotlook A Index & New York Futures US Cents per pound Cotlook A Index NY Nearby futures contract janv-00 janv-02 janv-04 janv-06 janv-08 janv-10 Sources: Cotton Outlook, ICE Futures U.S. 11

12 Basis Fluctuations Cotlook A Index minus NY nearby futures (US cents per pound) Average = +5, j-00 j-02 j-04 j-06 j-08 j-10 Sources: Cotton Outlook, ICE Futures U.S. 12

13 Basis Definition The basis is above ( ON ) or below ( OFF ) a given futures contract month (for example : 300 OFF December ). The basis widens when the spot price increases more (or declines less) than the futures contract price. The basis narrows when the spot price increases less (or declines more) or than the futures contract price. 13

14 Hedging BASIS RISK Futures and physical prices do NOT always move together in 1:1 correlation. Financial instruments offer protection against falls on the futures market price. Financial instruments do not protect against falls in the physical market price that are not related to falls in the futures market price. Basis risk increases when the relationship between physical and financial prices change over time When there is a low correlation between the two markets hedging is less effective and may even be risky.

15 Basis Risk Basis = differential between the spot price and the futures contract price of a commodity. Covering a physical position by an equal and opposite position in the futures market creates a basis position : - long the basis = long physical + short futures - short the basis = short physical + long futures 15

16 Basis Risk Long basis position = long physical + short futures: - Exposure to risk of basis narrowing Short basis position = short physical + long futures: - Exposure to risk of basis widening 16

17 Hedging Hedging is not a guarantee of profits; it s goal is to minimize risk. The effectiveness of hedging will vary. Hedging is not speculating; speculation increases risk.

18 Speculating Speculating using the futures market 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. Speculating using the physical cotton market involves: - Purchasing cotton, without selling that cotton, hoping that the price of cotton will rise. - Selling cotton, without buying that cotton, hoping that the price of cotton will fall.