Price protection?

As an Australian grain producer I have always had the attitude I’m hard done by, my price has never been good enough and I want $5 more than the market was paying. Heck, my wheat is special….it’s mine!

The reality is my wheat isn’t special; my neighbours can replace mine.

I now accept my lot in life. The price is the price and the penny has dropped, when the price is in a range I am profitable it’s a sell, and when it’s not I have to develop a strategy to achieve a profitable price. Simple hey!

Today’s farmer is armed with a range of products to price their physical grain. These include over the counter (OTC) products such as swaps (or futures) and options, or physical sales. Buying an option gives the owner the right, but not the obligation to exercise their option. Owning a put option is the right but not the obligation to put the grain into the market at the strike price and a call option the right to call for the grain at the strike price. It is akin to an insurance policy.

In a country such as Australia there is always production risk so pricing more than one produces is always a concern. The most essential element to pricing grain (as a seller or buyer) is knowing at what price you are profitable. Once established you can develop a pricing strategy.

In the last two decades (1988-2007) yields have flat lined in Victoria at approximately 1.7t/ha for wheat and barley (combined). In the same period the standard deviation of yield has risen from 0.4t/ha (88-97) to 0.72t/ha (98-07). For a state that’s production is in equilibrium for supply and demand this represents opportunity or risk. For a grain grower in eastern SA this offers opportunity to supply a short market. For a dairy farmer in Victoria this is an increased risk.

Today there are several ways (other than pricing physical) to create a price for grain. Swaps or futures pricing gives a flat price and leaves the owner of the position liable for daily margin calls. In the case of an OTC product the final margin call is the only position that incurs a cost, but the cost of this is rolled into the products cost to client.

For futures and options positions offered via Chicago Board of Trade brokers charge a flat fee, half on the opening of the position and half on the closing of the position. For futures, margin calls are covered daily and sufficient funds must be kept in a trading account to cover positions. There is an opportunity cost on these funds.

Options are purchased at a flat charge and there is also an opportunity cost on this money.

To demonstrate the practicality of an options trade I will use data from the CBOT Dec 13 flat pricing to
estimate a Dec 13 call options position. Call options are used by consumers of grain to protect against upside price risk.

The Dec 13 futures contract price bottomed at 680c in Dec 2011. It peaked at 910c in Nov 2012. January to May 2012 it bounced around in a range of 700-740c, generally between 700 and 720c.

The cost of an at the money call option is around 74c/bu. Contract size is a standard 5000 bushels (136 metric tonnes).

Let’s use the following assumptions to demonstrate what could have been an actual trade. Of course, hind sight is a wonderful thing.

Assumptions:

Strike price of call: 700c

Exercise price of call: 840c (the July peak)

Cost of call option: $3700 (74c/bu)

Total consumption is 1500t and two thirds will be hedged (8 contracts)

No brokerage fees will be added to the cost, or opportunity cost for the funds

Basis remains constant – $0.00 and all quotes are in USD

Equation:

Initial cost: 8 contracts (40 000bu) at $3700 (74c/bu) = $29 600.00 The call option owner now has the right to call 8 wheat contracts at the strike price of 700c/bu (US$257.20/t).

In July 2012 we get lucky and exercise our option, in this case we call our right for the seller of the option to provide us with 8 flat priced futures contracts at 840c/bu. We then go to the market and sell them at this price.

Return: sell 8 contracts at 840c/bu ($308.64). Our return is a margin of 140c/bu, less our initial cost of 74c/bu.  Selling 40 000bu at 66c (profit) results in a nett gain of $26 400.00 or $24.20t

Whatever happened to the price of grain, in the physical market, we now have $26 400 extra to purchase our required tonnage.

If the CBOT price had dropped by 40c ($14.70) to 660c the only cost would have been the initial cost. But the cost of the overall grain parcel (1500t) would have reduced by $22 046.00, an overall cost of $7554.00. The break even reduction in futures pricing, for this scenario, would have been ~647c/bu.

Basis will never remain constant and there will be brokerage fees. Basis is currently plus $20. A rising basis makes an options trade riskier and Australian grain more expensive relative to US grain. FX fluctuations also add another parameter to the equation.

This exercise demonstrates that if ones cost of production is known there are ways of pricing grain for sale, or purchase, without taking on the risk of a physical position. For a consumer the call options cost could be seen as the opportunity cost (for a year) of a storage system invested into an insurance policy to cap their grain price. You may not need the insurance every year.

Nothing in this blog is a recommendation, it is a scenario using hind sight.

 

 

 

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