agec 420, lec 8 1 agec 420 hedging examples agec 420, lec 8 2 hedging expected (net forward) price:...
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AGEC 420, Lec 8 1
AGEC 420
• Hedging examples
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Hedging
• Expected (net forward) price:= futures + expected basis
• If basis is at the expected level– then realized price = expected price– regardless of whether the overall price level
goes up or down
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Realized Price – 2 ways to calculate it
Jan 31: July futures @ $3.20, Expected basis -$0.10.
July 1: Local price $2.90, July futures @ $3.00
A. Realized price = futures* + actual basis(i.e., = $3.20* - $0.10 = $3.10)
• The futures price when hedge was established
or
B. Realized price = Cash + Result on futuresi.e., = $2.90 (cash price) + $0.20 (profit on futures) = $3.10
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Example 2 – Basis Strengthens
• Jan 31: plan to sell 5,000bu wheat in early July • July futures @ $3.20, Expected basis -$0.10.
• Expected price = 3.20 - 0.10 = $3.10
ACTION: sell 1 July futures @ 3.20
• July 1: • Local price $2.95, July futures @ $3.00
• Basis is stronger than expected
ACTION: sell wheat @ 2.95, buy futures @ 3.00
• Realized net price is 2.95 +0.20 = $3.15
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Basis Risk
• A strengthening (or stronger than expected) basis helps the short hedger.
• It means that his local cash price is (relatively) stronger than expected.
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Example 3 – Prices Rise, Basis same
• Jan 31: plan to sell 5,000bu wheat in early July • July futures @ $3.20, Expected basis -$0.10.
• Expected price = 3.20 - 0.10 = $3.10
ACTION: sell 1 July futures @ 3.20
• July 1: • Local price $3.60, July futures @ $3.70
• Basis is as expected
ACTION: sell wheat @ 3.60, buy futures @ 3.70
• Realized net price is 3.60 -0.50 = $3.10
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Example 4 – Prices Rise, Basis weakens
• Jan 31: plan to sell 5,000bu wheat in early July • July futures @ $3.20, Expected basis -$0.10.
• Expected (net forward) price = 3.20 - 0.10 = $3.10
ACTION: sell 1 July futures @ 3.20
• July 1: • Local price $3.55, July futures @ $3.70
• Basis is weaker than expected
ACTION: sell wheat @ 3.55, buy futures @ 3.70
• Realized net price is 3.55 -0.50 = $3.05
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Stronger Basis
Basis at the expected level: realized price = expected price
Basis stronger than expected realized price above expected price stronger basis helps the short hedger.It means that cash price is (relatively) stronger
than expected.
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Weaker Basis
Basis at the expected level: realized price = expected price
Basis weaker than expected realized price above expected price stronger basis helps the short hedger.It means that cash price is (relatively) weaker
than expected.
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Example 5.
• In Feb.: plan to sell 40 fed cattle in June • June future @ $70.55/cwt, Exp. basis is +$0.25.
• Expected price = 70.55 + 0.25 = $70.80
ACTION: sell futures @ 70.55
• In June: • Local price is $64.50, June futures price is $64.45
• Basis weaker than expected, by $0.20/cwt
• Realized net price is $70.60
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Long Hedge
• An agent who will need to buy the commodity.– Would lose if prices rose
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Long Hedge – for the buyer
1st Question:What is the risk ? - or - What do you want to protect
yourself from?
Answer: a rise in price
Therefore – you want a position in futures that will make $$ if price
rises.
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Long Hedge
• An agent who will need to buy the commodity.– Would lose if prices rose
To establish the hedge – buy futures
At some future date – buy wheat in local cash market
– sell futures (to offset)
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Example 6. Long hedge
• Feb: Elevator needs to buy wheat by July.• July futures @ $3.50, Exp. basis is -$0.20
• Expected net forward price is 3.50 - 0.20 = $3.30
buy futures @ 3.50
• May: • Local price is $3.85. Futures price is $3.95
• Basis stronger than expected, by $0.10/bu
buy wheat @ 3.85, sell futures @ 3.95
• Realized price paid is $3.85-$0.45 = $3.40
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Basis risk
• Strengthening basis – helps the short hedger– works against the long hedger
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Example 4. Long Hedge
• Feb: plan to buy feeder cattle in May. • May futures @ $84.00, Exp. basis is -$0.50• Expected net forward price is 84.00 - 0.50 = $83.50buy futures @ 84.00
• May: • Local price is $85.00. Futures price is $85.75• Basis weaker than expected, by $0.25 / cwtbuy cattle locally, sell futures
• Realized net price paid is $83.25
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Hedging (summary)
• Objective: to reduce risk– works because basis risk < cash price risk
If maturity basis = expected basis
then realized price = expected price (regardless of whether prices go up or down)
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Approach to hedging problems
• identify the risk in the cash position• will money be lost if price rises or if it falls
• decide appropriate action in futures• one that makes money if there are losses in the cash
• expected price = futures + expected basis