HEDGING
IN THEORY AND PRACTICE
Ann Berg
Senior Commodity Markets Development Expert USAID/FINREP-ІІ
Kyiv, 2013
230 240 250 260 270 280 290 300 310 320
01/2011 02/2011 03/2011 04/2011 05/2011 06/2011 07/2011
US$/Tonnes
July 11 Maize contract (CME)
259.74 $ 28 Jan
291.44 $ 1 March
264.17 $ 30 March
307.58 $ 11 April
270.18 $ 06 May
308.07 $ 13 June
274.80 $ 29 June
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
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 corn
@ 5.00 [50,000 bu]
November Sell 50,000 bu to
elevator @4.00
Buy 10 contracts of corn
@ 4.00
Cash sale of corn @ 4.00 is improved by futures gain of 1.00
Net price realized = 5.00
$3.50
= $4.50
The basis is the difference between cash price and futures price. Basis risk is always present after hedging with futures
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
Exporter hedge
Corn cash price futures price
April
China bidding $270/MT 50,000MT corn delivered C&F
for November shipment
CME December corn futures
@$5.60 [$220/MT]
April
Exporter sells C&F cargo @$270/MT Buys 400 contracts CME futures
@$5.60 [50,000MT = 2m bushels
= 400 contracts, each contract is 5000 bushels]
October Exporter buys fob cargo from Black Sea port @ $255
=$290 C&F [costings & frt =
$35/MT
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 $20/MT
World maize/corn export prices (fob, US$ per tonne)
125 175 225 275 325 375
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
0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00
1/4/2008 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)
CBOT corn vs Ukraine fob corn prices
$US/MT
Huge range in Ukraine corn prices ‐ $110 ‐ $337 [3 x price increase]
Export quotas
Export tax US drought
Food Crisis
Ukrainian fob basis
• 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
0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00
Corn (CBOT) Corn (FOB)
US drought Food
crisis
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
FCs Dec 2012 FCs Mar 2013
CME Forward Curves ‐ Corn
What might have happened ‐2012
Corn cash price fob Ukraine futures price
April 2012
July 10‐30 cargoes offered
$277/MT
CME July corn futures @$6.45
= [$254/MT]
Basis = +$23/MT
April
Exporter buys 50,000 MT cargo fob Odessa @$277/MT July 10‐30 shipment
Sells 400 contracts CME July corn futures @$6.45
Last week June Exporter resells fob cargo @
$295/MT
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.
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.
Volumes of contracts traded
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
14
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
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
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
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
