commodity marketing

7/27/2019 Commodity Marketing

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Commodity Marketing

Introduction

The term commodity is commonly used in reference to basic agricultural products that areeither in their original form or have undergone only primary processing. Examples include

cereals, coffee beans, sugar, palm oil, eggs, milk, fruits, vegetables, beef, cotton and rubber.

A related characteristic is that the production methods, postharvest treatments and/or primary

processing to which they have been subjected, have not imparted any distinguishing

characteristics or attributes. Thus, within a particular grade, and with respect to a given

variety, commodities coming from different suppliers, and even different countries or

continents, are ready substitutes for one another. For example whilst two varieties of coffee

bean, such as robusta and arabica, do have differing characteristics but two robustas, albeit

from different continents, will, within the same grade band, have identical characteristics in

all important respects. Agricultural commodities are generic, undifferentiated products that,

since they have no other distinguishing and marketable characteristics, compete with one

another on the basis of price. Commodities contrast sharply with those products which have

been given a trademark or branded in order to communicate their marketable differences.

Agricultural commodity marketing system

A commodity marketing system encompasses all the participants in the production,

processing and marketing of an undifferentiated or unbranded farm product (such as cereals),

including farm input suppliers, farmers, storage operators, processors, wholesalers and

retailers involved in the flow of the commodity from initial inputs to the final consumer. The

commodity marketing system also includes all the institutions and arrangements that effect

and coordinate the successive stages of a commodity flow such as the government and its

parastatals, trade associations, cooperatives, financial partners, transport groups and

educational organisations related to the commodity. The commodity system framework

includes the major linkages that hold the system together such as transportation, contractual

coordination, vertical integration, joint ventures, tripartite marketing arrangements, and

financial arrangements. The systems approach emphasises the interdependence and inter

relatedness of all aspects of agribusiness, namely: from farm input supply to the growing,

assembling, storage, processing, distribution and ultimate consumption of the product.


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Stages in agricultural commodity marketing

The marketing systems differ widely according to the commodity, the systems of production,

the culture and traditions of the producers and the level of development of both the particular

country and the particular sector within that country. This being the case, the overview of the

structure of the selected major commodities marketed, which follows, is both broad and

general. The major commodities whose marketing systems will be discussed in this chapter

are: large grains, livestock and meat, poultry and eggs, cotton, fruit and vegetables and milk.

Table 6.1 identifies the main stages of agricultural marketing and this provides a loose

framework around which to structure the discussion of the marketing of these commodities.

This is a general model and therefore not all of the stages it describes are equally applicable

to the commodities selected for discussion. This being so, certain stages are given more or

less emphasis; and for some commodities specific stages are omitted altogether from the

discussion.

Table 4.1 Stages of agricultural commodity marketing

Stages Activity Example

Stage 1 Assembly Commodity buyers

specialising in specific

agricultural products, such

commodities as grain, cattle,

beef, oil palm, poultry and

eggs, milk.

Stage 2 Transportation Independent truckers,

trucking companies,

railroads, airlines etc.

Stage 3 Storage Grain elevators, public

refrigerated warehouse,

controlled-atmosphere

warehouses, heated

warehouses, freezer

warehouses

Stage 4 Grading and classification Commodity merchants or


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government grading officials

Stage 5 Processing Food and fibre processing

plants such as flour mills, oil

mills, rice mills, cotton mills,wool mills, and fruit and

vegetable canning or freezing

plants

Stage 6 Packaging Makers of tin cans, cardboard

boxes, film bags, and bottles

for food packaging or fibre

products for

Stage 7 Distribution and retailing Independent wholesalers

marketing products for

various processing plants to

retailers (chain retail stores

sometimes have their own

separate warehouse

distribution centres)

Characteristics of agricultural commodities

Agricultural commodities differ in nature and contents from industrial goods in the following

respects.

Agricultural commodities tend to be bulky and their weight and volume are great fortheir value in comparison with many industrial goods.

The demand on storage and transport facilities is heavier, and more specialized in caseof agricultural commodities than in the case of manufactured commodities.

Agricultural commodities are comparatively more perishable than industrial goods.Although some crops such as rice and paddy retain their quality for long time, most of

the farm products are perishable and cannot remain long on the way to the final

consumer without suffering loss and deterioration in quality.


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Most agricultural products are produced seasonally; this condition of seasonalproduction and availability is not found in the case of industrial goods.

Finally, both demand and supply of agricultural products are inelastic. A bumpercrop, without any minimum guaranteed support price from the government may spelldisaster for the farmer.

Commodity (futures) exchanges

Since the early development of agricultural markets, producers have attempted to protect

themselves against falling commodity prices at harvest time. Many producers ignored

marketing techniques and sold their commodities at harvest regardless of the price. Today,

producers have realised that a marketing strategy is equal in importance to production,capital, and labour strategies.

Forward contracts

The development of forward contracts was a major step in allowing producers to reduce

marketing risks. Forward contract is a cash market transaction in which a seller agrees to

deliver a specific cash commodity to a buyer at some point in the future. The price is

specified in a cash forward contract for a specific commodity. The forward price makes the

forward contract have no value when the contract is written. However, if the value of the

underlying commodity changes, the value of the forward contract becomes positive or

negative, depending on the position held.

Example

Before a wheat farmer plants his crop, he executes a contract with a cereal company for the

delivery and purchase of 75,000 bushels of wheat at a price of $1 per bushel. The actual

exchange of the wheat for money will, of course, not take place until after the crop is

harvested in the fall. By entering into a forward contract, both the farmer and the cereal

company reduce their respective risks. By pre-selling his crop at $1 per bushel, the farmer has

protected himself against the risk that in the fall the then-current price (orspot price) will be

lower than $1 per bushel. The cereal company, on the other hand, by pre-purchasing has

protected itself against the risk that in the fall the spot price of wheat will be greater than $1
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per bushel. Both parties to the transaction sacrifice the possibility of getting a better price for

themselves in exchange for eliminating the risk of getting a worse price.

When harvest time arrives, the spot price will either be higher or lower than $1 per bushel

depending on the normal circumstances that affect supply and demand. If the price at harvest

has risen to, say $1.35 a bushel, the farmer will undoubtedly wish that he had not entered into

the forward contract. The cereal company, however, will be quite pleased to pay a below-

market price of $1 per bushel. On the other hand, if the spot price in the fall drops to $0.75

per bushel, the farmer will be delighted to be getting the above-market price of $1. The cereal

company, of course, will not be so thrilled to have to pay $1 per bushel when the market rate

is $0.75. In this contract, as with all forward contracts, the buyer is pleased if the agreed-upon

contract price is lower than the spot price and the seller is happy if the contract price is higher

than the spot price.

Changes fr om forward contracts to fu tures contracts

Forward contracts had a lot of drawbacks. They were not standardized in terms of quality or

delivery time, and merchants and traders did not always fulfil their forward commitments.

Due to these drawbacks, steps were taken to formalize commodity trading by developing

standardized agreements called futures contracts.

Futures contracts

This is a contractual agreement, generally made on the trading floor of a futures exchange, to

buy or sell a particular commodity at a pre-determined price in the future. Futures contracts in

contrast to forward contracts were standardized as to quality, quantity, and time and location

of delivery of delivery for the commodity being traded. The only variable is price, which is

set through an auctionlike process on the trading floor of an organized exchange.

Example

A producer of wheat may be trying to secure a selling price for next season's crop, while a

bread maker may be trying to secure a buying price to determine how much bread can be

made and at what profit. So the farmer and the bread maker may enter into a futures contract

requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per

bushel. By entering into this futures contract, the farmer and the bread maker secure a price


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that both parties believe will be a fair price in June. It is this contract - and not the grain per

se - that can then be bought and sold in the futures market.

So, a futures contract is an agreement between two parties: a short position - the party who

agrees to deliver a commodity - and a long position - the party who agrees to receive a

commodity. In the above scenario, the farmer would be the holder of the short position

(agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). A

futures contract has the same general features as a forward contract but is transacted through

a futures exchange.

Unlike futures contracts (which occur on a trading floor), forward contracts are privately

negotiated and are not standardized. Further, the two parties must bear each other's credit

risk, which is not the case with a futures contract. Also, since the contracts are not exchange

traded, there is no marking to market requirement, which allows a buyer to avoid almost all

capital outflow initially (though some counterparties might set collateral requirements).

Given the lack ofstandardization in these contracts, there is very little scope for a secondary

market in forwards. Forwards are priced in a manner similar to futures. Like in the case of a

futures contract, the first step in pricing a forward is to add the spot price to the cost of carry

(interest forgone, convenience yield, storage costs and interest/dividend received on the

underlying). Unlike a futures contract though, the price may also include a premium for

counterparty credit risk, and the fact that there is not daily marking to market process to

minimize default risk. If there is no allowance for these credit risks, then the forward price

will equal the futures price.

Purpose of commodity (futures) markets

Futures exchanges, no matter how they are organized and run, exist because they provide two

vital economic functions for the marketplace: risk transfer and price discovery. Futures

markets makes it possible for those who want to manage risks-hedgers- to transfer some or

all of that risk to those who are willing to accept it speculators.

Buying futures contracts

Futures contracts are not formalized contract written by an attorney, they are legally binding

agreements, made on the trading floor of a futures exchange, to buy or sell something in the

future. That something could be corn, soybeans, wheat, tobacco, live beef or some other
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commodities. In other words, a futures contract establishes a price today for a commodity that

will be delivered later. Buyers and sellers in the futures markets look at current economic

information (supply and demand) and anticipate how it may affect the price of a commodity.

Though not written each future contract specifies the time of delivery or payment, where the

commodity should be delivered, and the quality and quantity of the item. This specificity is

what makes the futures contracts attractive to those who want to plan ahead and protect

themselves from dangerous price swings and to investors wanting to profit from market

fluctuations.

The standard features are called contract specifications. The futures exchange where the

commodity is traded usually provides contract specifications for commodity. Business

journals are one of the best sources for commodity market information.

A common example of how commodity prices may appear is given below:

Friday April 16

Corn (CBOT) 5,000 bushels, centsper bushels

Open High Low Settle Change

May 231 231 227 227 -4

July 236 237 232 233 -4

Sept 241 241 237 237 -3

Dec 246 246 242 243 -3

Name of commodity: corn

Where it is traded: Chicago board of Trade

Contract size: 5,000 bushels


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Price quote: price per bushel

Open is the first price anyone paid for corn. High is the highest price anyone paid for corn.

Settle or settlement is the last price anyone paid for corn. Change or net change is the

difference between the settlement price today, and the previous trading day.

Practice: July corn opened at.......................... and settles at............... on April 16. Thelowest price anyone paid for July corn, on April 16, was........................., and the

highest price anyone paid for July corn on that day was.................. the contract size is

..............., prices are quoted in........................, and it is traded at the ................

Determining the value of a futures contract

Suppose the settlement price for December corn futures is 200 cents a bushel: that is , $2.00 a

bushel. To calculate the dollar value of one corn contract, multiply the $2.00 settlement price

by the contract size. In the case of CBOT corn futures, each contract equals 5,000bushels of

corn, so if 1 bushel of corn is worth $2.00, then a 5,000 bushel contract is worth $10,000; $

2.00 per bushel times 5,000 bushels equals $ 10,000.

Futures contracts do not always trade in even numbers: sometimes they move in fractions.These fractions are the smallest price unit at which a futures contract trades and are called

minimum price fluctuations. in futures lingo it is referred to as ticks. The tick size of a

futures contract varies according to the commodity.

The minimum price fluctuation for a CBOT corn futures contract, for instance, is cent per

bushel, or $12.50 per contract (5,000 X $.0025).

Keeping in mind that the minimum price fluctuation for CBOT corn futures is 14 cents perbushel, the next few higher prices above corn trading at 200 cents per bushel ($2.00/bu)

would be 200 cents, 200 cents, 200 , and 201 cents. To calculate the value of a futures

contract when fractions are involved, just use the same equation of settlement price times

contract size. For example, if December corn futures are trading at 200 cents /bu. Then the

contract value is

$2.0025/bushel X 5,000 bushels = $ 10,012.50.


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Determining profit or loss on a futures contract

Suppose you read in the paper that soil moisture in the midlands was below normal for the

month of June and the forecast does not look promising for rain. Limited rainfall during the

growing season could cause the production of corn to decrease, thus increasing the price.

Anticipating higher corn prices, you buy one December corn futures contract at 250

cents/bushels. On July 1, if you were right and corn prices rise, you will make a profit.

Throughout the month of July, there is no rain in the Corn Belt. The end result is higher

prices, so you decide to offset your position on July 30 by selling one December futures

contract at $2.55/bushel.

Did you make a profit or loss? :

Calculation: Jul 1 BUY 1 Dec. Corn futures at $2.50/bushel

Jul 30 SELL 1 Dec. Corn futures at $ 2.55/bushel

Profit $ .05/ bushel

The total profit is $250 ($.05 X 5000 bushel).

** remember that brokerage fees are always subtracted from your profit.

Who participates?

There are two main categories of futures traders that utilize futures contracts. These are the

hedgers and speculators. Hedgers either now own, or will at some time own, the commodity

they are trading. Hedger may be producers, elevator owners, or any others in the agribusinessinput and outputs sectors.

Hedgers

Hedging is a tool used by producers and agribusinesses to shift some of the risk resulting

from price uncertainty to speculators who trade in the futures market. Hedgers use the futures

primarily to reduce their price risks in dealing with the cash commodity. They may speculate

to some extent on the relationship between futures prices and cash prices, but their goal is to


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avoid the substantial decline or rises in prices often encountered in the commodity market.

Hedging involves taking a position in the futures market equal but opposite to what one has

in the cash market. If prices fall, a producer who placed a hedge will be protected. This is

why hedgers willingly give up the opportunity to benefit from favourable price changes to

achieve protection from unfavourable changes.

Long (buying) and short (selling) hedgers

Two terms used to describe buying and selling are long and short. If you first buy a futures

contract, this is called going long, or going long hedge. If you first sell a futures contract, this

is called going short, or going short hedge. Hedging in the futures market is a two step

process. Depending on your cash market situation, you will either buy or sell futures as yourfirst position. For instance, if you are going to buy a commodity in the cash market at a later

time, your fist step is to buy a futures contract. In contrast, if you are going to sell a cash

commodity at a later time, your first step in the hedging process is to sell futures contracts.

The second stage in the process occurs when the cash market transaction takes place. At this

time, the futures position is no longer needed for price protection, so it should therefore be

offset (closed out). If your hedge was initially long, you would offset your position by selling

the contract back. If your hedge was initially short, you would buy back the futures contract.

Both the opening and closing positions must be for the same commodity, number of

contracts, and delivery month.

Example of a long hedge

A food processor is planning to buy 240,000 pounds of soybean oil over the next few months

to cover production needs. Currently, soybean oil is quoted at 26 cents a pound, but the

company management is concerned that prices will rise by the time it is ready to purchase

and take delivery of the oil. To take advantage of current prices, the company decides to buy

four CBOT September soybean oil futures contracts at 26 cents a pound. The standard

contract size for CBOT soy bean oil is 60, 000 pounds. The managements greatest fear

comes true. The price of soybean oil jumps to 31 cents a pound by the time the food

processor is ready to purchase it. The company offsets its futures position by selling four

CBOT September soybean oil contracts for 31 cents a pound. The companys hedging

activities result in the following:


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Cash market Futures market

June

Plans to buy 240,000 ibs. Soybean oil in the

cash market at $.26 / ib.

June

Buys 4 CBOT Sept. soybean oil futures

contracts at $.26/ib.

August

Purchases 240,000 ibs. Soybean oil in the

cash market at $.31/ib.

August

Sells 4 CBOT Sept. soybean oil futures

contracts at $ .31/ib.

Purchase price of cash soybean oil $.31/ib

Less futures gain ($.31 - $.26) $.05/ib

Net purchase price $.26/ib

By using CBOT soybean oil futures, the food processor lowered its purchase price from 31

cents to 26 cents a pound. That was exactly what the company expected to pay.

Example of a short hedge

Rather than selling for whatever price the local elevator is willing to pay come harvest time, a

producer decides to explore a variety of marketing alternatives including futures. Her

ultimate goal is to improve her bottom line. Suppose she figures that it cost her $ 2.00 to

produce one bushel of corn. When corn enters a price range of where the producer can make

a profit, she may decide to hedge a portion of her crop by selling one CBOT December corn

futures contract. (The standard contract size for one CBOT corn futures contract is 5,000

bushels)

By early may, CBOT December corn futures hit $ 2.60 a bushel. To lock in a selling price of

42.60, the grain producer sells one CBOT December corn futures contract. As it turns out,

there was a near perfect growing condition that year and corn yields are above normal,

causing prices to drop. By harvest time, corn has fallen to $1.90 a bushel. The producer

therefore offsets her futures position by purchasing one CBOT December corn futures

contract. The corn producers hedging activities result in the following:


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Cash market Futures market

May

Plans to sell 5,000 bu. Corn in the cash

market at $2.60/bu.

May

Sells one CBOT Dec. Corn futures contract

at $ 2.60/bu.

October

Sells 5,000bu. Corn in the market at $

1.90/bu.

October

Buys one CBOT Dec. Corn futures contract

at $ 1.90/bu.

Sales price of cash corn $ 1.90/bu.

Plus futures gain ($2.60-$1.90) $ 0.70/bu.

Net sales price $ 2.60/bu.

By using CBOT corn futures, the producer increased her final sale price from $1.90 to $ 2.60

a bushel. That was exactly what she wanted to receive. Better yet, the final sale price was 60

cents per bushel higher than her production expenses.

** keep in mind that these examples are simplified to give an overview of hedging.

Speculators

Speculators, in contrast, will likely never own or even see the physical commodity. They are

in the game to profit from a move up or down in the market. Agricultural producers,

commodity processors, exporters, food manufacturers, and others use the futures market to

shift market risk (the risk of adverse price movements) to someone else. The party who

assumes the risk is the speculator. They just buy and sell futures contracts and hope to make a

profit on their expectations and predictions of future price movements. The profit potential of

a speculator is proportional to the amount of risk that is assumed and the speculators skill in

forecasting price movement. Speculators always offset their positions by buying (selling)

futures contacts they originally sold (bought). Speculators take a price risk on a given product

with the hope of making a profit. The risk a speculator takes is not the same as that a gambler

takes in buying a lottery ticket. In contrast to gambling, a commodity speculator assumes a

naturally occurring risk rather than one that is deliberately created. In agribusiness, risk is


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inherent when one holds inventories of commodities. If speculators were not willing to

assume some of the risk, a producers costs would increase due to losses from adverse prices.

Instead, agribusiness firms are able to produce items at lower costs because they have shifted

some of their natural risk to commodity speculators. With this type of market, society

benefits.

Speculators can be classified by their trading methods:

A position trader: this is a public or professional trader who initiates a futures oroptions position and holds it over a period of days, weeks, or months.

A day trader: holds market positions only during the course of a single tradingsession, and rarely carries a position overnight. Most day traders are exchangemembers who execute their transactions in the trading pits.

Scalpers: trades only for themselves in the pits. Scalpers trade in minimumfluctuations, taking small profits and losses on a heavy volume of trades. Like a day

trader, a scalper rarely holds positions overnight.

Spreaders: trade on the shifting price relationships between two or more differentfutures contracts. Examples include: different delivery months for the same

commodity, the prices of the same commodity on different exchanges, products andtheir by-products, and different but related commodities.

Economic functions of futures markets

Due to the presence of speculations and hedging in futures contracts, futures markets provide

a number of very useful economic functions. They can be enumerated in terms of their role

in:

Enabling hedgers to transfer pri ce risk to speculators: without futures the process ofcommodity marketing will be more risky and inefficient. The importance of futures

can be observed if for whatever reason, futures are not operating. This might be due to

severe weather at the location of the exchange, limit moves in the contract price, etc.

At those times in the grain trade, the comment is often heard that, elevator are taking

protection. This means that being unable to hedge; they widen their margins as they

face increased price risks.


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Facil itate pri ce discovery: futures markets provide central facilities for buyers andsellers to interact and bring all the forces impinging on price formation together. In

many cases, this is a face to face confrontation of buyers and sellers in octagonal pits

or similar sites. Typically, the trading is by open outcry in a very transparent process.

The floor brokers involved are mainly representing the real buyers and sellers, who

may be from all parts of the world.

Enhancing information collection and dissemination: information needed foreffective use of futures markets is so valuable that many resources are devoted to

collection and dissemination. This involves both public and private organizations. The

ministry of agriculture, national farmers union, agricultural marketing association and

various cooperating counterparts, play a major role in providing comprehensive,

unbiased crop and livestock estimates, and market information. Private consulting

firms and specialised market news services are also prominent. Futures market

themselves collect and make available an extensive amount of data on prices, volume,

and open interest. Open position data on hedgers, small traders and large trades are

also generated and distributed.

Assisting in the coordination of economic activity: another economic function offutures market is to help coordinate economic activity. Futures price information is so

prevalent that commercial houses simply refer to cash prices in terms of their

relationships to futures. This facilitates day to day operations in moving products

through the system. With prices on products and in/or inputs locked in, a firm can

devote more energy into the production line operation and increasing efficiency.

Stabil izing markets and providing liquidity: active future markets are liquid (manybuyers and sellers are ever present either on the trading floor or linked to brokerage

offices). At times, cash markets can be a bit clumsy allowing gluts in supplies to

unduly depress prices. At other times, shortages can move markets above levels

warranted by supply-demand conditions. Some do question whether futures help

stabilise prices and cite examples of high volatility in futures at times. Research on

commodities futures trading supports the contention that futures stabilize markets.

However, in the very short time context, futures may be less stable because market

information can quickly be reflected in price moves as compared to more dispersed

and less coordinated cash markets.


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Providing fl exibil ity in forward pri cing: Also related to the transfer of risk, futuresmarkets provide commercial operators considerable flexibility in forward pricing both

products and inputs. They can choose to use futures or not and can decide what

proportion of their products and inputs to hedge, determining how much risk they are

willing to assume.

What commodities are traded, where and why?

Futures markets are worldwide. In addition to 13 exchanges in the US, 12 other nations have

futures markets. They include Australia, Brazil, Canada (four), France (three), Hong Kong,

Japan (four), Malaysia, the Netherlands, New Zealand, Singapore, Sweden, and the United

Kingdom (nine).

A wide variety of commodities are actively traded in futures markets. Among agricultural

products are grains, oilseeds, livestock and meat, milk, dairy products, tropical products such

as sugar, coffee and cocoa, frozen orange juice and cotton. A list of some of the commodities

and where they are trade is given below:

List of traded commodities

Agricultural (grains, and food and fibre)

Commodity Main Exchange Contract Size Trading Symbol

Corn CBOT 5000 bu C

Corn EURONEXT 50 tons EMA

Oats CBOT 5000 bu O

Rough Rice CBOT 2000 cwt RR

Soybeans CBOT 5000 bu S

Rapeseed EURONEXT 50 tons ECO

Soybean Meal CBOT 100 short tons SM

Soybean Oil CBOT 60,000 lb BO

Wheat CBOT 5000 bu W

Cocoa NYBOT 10 tons CC

Coffee C NYBOT 37,500 lb KC

Cotton No.2 NYBOT 50,000 lb CT

Sugar No.11 NYBOT 112,000 lb SB

Sugar No.14 NYBOT 112,000 lb SE
http://en.wikipedia.org/wiki/Bushelhttp://en.wikipedia.org/wiki/Bushel


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Livestock and meat

Commodity Contract Size Currency Main ExchangeTrading

Symbol

Lean Hogs

40,000 lb (20tons) USD ($)

Chicago MercantileExchange LH

Frozen PorkBellies

40,000 lb (20tons)

USD ($)Chicago MercantileExchange

PB

Live Cattle40,000 lb (20tons)


LC

Feeder Cattle 50,000 lb (25tons)


FC

The following agricultural products are not, at present (2008), traded on any exchange, and,

therefore, no spot or futures market where producers, consumers and traders can fix an

official or settlement price exists for these minerals. Generally the only price information that

is available is based on information from producers, consumers and traders.

Fresh Flowers, Cut Flowers, Melons,Lemons,Tung Oil,Gum Arabic, Pine Oil,Xanthan,

Milk, Tomatoes, Grapes, Eggs, Potatoes, and Figs.

Others

Commodity Unit Currency Bourse

Ethanol 29,000 US gallon(110 m)

USD ($) CBOT

Rubber 1 kg US cents ()*Singapore CommodityExchange

Palm Oil 1000 kgMalaysian Ringgit(RM)

Bursa Malaysia

Wool 1 kg AUD (p) ASX

Polypropylene 1000 kg USD ($) London Metal Exchange

Linear Low DensityPolyethylene (LL)

1000 kg USD ($) London Metal Exchange

And so many more

In reviewing the list of commodities traded in futures markets, certain common

characteristics are apparent:

1. Pri ces are volati le: volatility attracts both speculative and hedger interest. Speculatorscan profit (or lose) in a volatile market, but has little opportunity for profit in a stable
http://en.wikipedia.org/wiki/Lean_Hogshttp://en.wikipedia.org/wiki/Lean_Hogshttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/United_States_currencyhttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Pork_bellyhttp://en.wikipedia.org/wiki/Pork_bellyhttp://en.wikipedia.org/wiki/Pork_bellyhttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Cattlehttp://en.wikipedia.org/wiki/Cattlehttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/w/index.php?title=Feeder_Cattle&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Feeder_Cattle&action=edit&redlink=1http://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Flowerhttp://en.wikipedia.org/wiki/Melonhttp://en.wikipedia.org/wiki/Lemonhttp://en.wikipedia.org/wiki/Tung_Oilhttp://en.wikipedia.org/wiki/Gum_Arabichttp://en.wikipedia.org/wiki/Pine_Oilhttp://en.wikipedia.org/wiki/Xanthanhttp://en.wikipedia.org/wiki/Milkhttp://en.wikipedia.org/wiki/Tomatoeshttp://en.wikipedia.org/wiki/Grapeshttp://en.wikipedia.org/wiki/Egg_%28food%29http://en.wikipedia.org/wiki/Potatoeshttp://en.wikipedia.org/wiki/Figshttp://en.wikipedia.org/wiki/Ethanolhttp://en.wikipedia.org/wiki/Ethanolhttp://en.wikipedia.org/wiki/United_States_currencyhttp://en.wikipedia.org/wiki/United_States_currencyhttp://en.wikipedia.org/wiki/Rubberhttp://www.sicom.net/http://www.sicom.net/http://en.wikipedia.org/wiki/Palm_Oilhttp://en.wikipedia.org/wiki/Malaysian_Ringgithttp://en.wikipedia.org/wiki/Bursa_Malaysiahttp://en.wikipedia.org/wiki/Bursa_Malaysiahttp://en.wikipedia.org/wiki/Bursa_Malaysiahttp://en.wikipedia.org/wiki/Woolhttp://en.wikipedia.org/wiki/ASXhttp://en.wikipedia.org/wiki/Polypropylenehttp://en.wikipedia.org/wiki/Polypropylenehttp://en.wikipedia.org/wiki/London_Metal_Exchangehttp://en.wikipedia.org/wiki/London_Metal_Exchangehttp://en.wikipedia.org/wiki/Polyethylenehttp://en.wikipedia.org/wiki/Polyethylenehttp://en.wikipedia.org/wiki/London_Metal_Exchangehttp://en.wikipedia.org/wiki/Polypropylenehttp://en.wikipedia.org/wiki/ASXhttp://en.wikipedia.org/wiki/Woolhttp://en.wikipedia.org/wiki/Bursa_Malaysiahttp://en.wikipedia.org/wiki/Malaysian_Ringgithttp://en.wikipedia.org/wiki/Palm_Oilhttp://www.sicom.net/http://www.sicom.net/http://en.wikipedia.org/wiki/Rubberhttp://en.wikipedia.org/wiki/United_States_currencyhttp://en.wikipedia.org/wiki/Ethanolhttp://en.wikipedia.org/wiki/Figshttp://en.wikipedia.org/wiki/Potatoeshttp://en.wikipedia.org/wiki/Egg_%28food%29http://en.wikipedia.org/wiki/Grapeshttp://en.wikipedia.org/wiki/Tomatoeshttp://en.wikipedia.org/wiki/Milkhttp://en.wikipedia.org/wiki/Xanthanhttp://en.wikipedia.org/wiki/Pine_Oilhttp://en.wikipedia.org/wiki/Gum_Arabichttp://en.wikipedia.org/wiki/Tung_Oilhttp://en.wikipedia.org/wiki/Lemonhttp://en.wikipedia.org/wiki/Melonhttp://en.wikipedia.org/wiki/Flowerhttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/w/index.php?title=Feeder_Cattle&action=edit&redlink=1http://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/Cattlehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/Pork_bellyhttp://en.wikipedia.org/wiki/Pork_bellyhttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/Chicago_Mercantile_Exchangehttp://en.wikipedia.org/wiki/United_States_currencyhttp://en.wikipedia.org/wiki/Pound_%28mass%29http://en.wikipedia.org/wiki/Lean_Hogs


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market. Hedgers need protection in a volatile market, but have no need for such

protection in a stable market.

2. Products are standardized. Grading is established: because trading in futures marketsfocuses on a base grade, with the possibility of delivery, the product must have grades

and standards acceptable to the industry. This is particularly important with

agricultural commodities that are not easily produced to a particular standard.

3. Products are actively produced and marketed: products broadly produced andmarketed have a better chance of success as actively traded commodities than those

with concentrated production areas with few marketing channels. For example, live

cattle futures succeeded, but beef carcass did not, ostensibly because live cattle had a

broad production base while beef carcass production was much more concentrated.

4. Many products are storable: at one time, storability was felt to be a primeconsideration. Reasons for this related to the delivery process. However, the

continuance of live cattle, feeder cattle, and hog futures is testimony that storability is

not a necessary condition. However, very perishable products such as fresh fruits and

vegetables are not viable candidates.

Options on futures

In contrast to futures, options on futures allow investors and risk managers to define risk and

limit it to the cost of a premium paid for the right to buy and sell a futures contract. Options

provide the opportunity but not the obligation to sell or buy a commodity at a certain

price. When talking about options, the underlying commodity is a futures contract and not the

physical commodity. With an option, producers have the right, but not the obligation to buy

or sell a specific commodity within a specific period of time at a specific price. Producers can

use options contracts to establish a minimum selling price for their produce while still

retaining the right to any price increase.

Futures options are much more attractive to many hedgers and speculators than straight

futures contracts. (House example).

Example of a simplified options contract: consider a call option that conveys the right to buy

a used combine from your neighbour. You are debating whether to buy a used combine or to


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put up capital for a new combine. You convince your neighbour to sell you an option to

purchase the combine at any time before April 1. In turn, the neighbour gives you the right to

buy the used combine for $ 10,000. For this right, you pay $2,000.

In option terms, the combine is the underlying commodity, and $10,000 is the stri ke pri ce.

April 1 is the expiration date, and the $2,000 you paid for the option is the premium. At any

time before the expiration date, your option contract gives you the right to exercise your

option and purchase the combine. However, you are not obligated to buy the combine. You

may choose to not exercise your option-you can simply let your option expire. You may

offset your current position by selling your option to someone else. Whatever measure you

take, the writer(seller) of the option keeps the $2,000 premium. With options, once you

make a transaction, you can predict your maximum losses.

A call is an option that gives the option buyer the right (without obligation) to purchase a

futures contract at a certain price on or before the expiration date of the option, for a price

called the premium which is determined in open-outcry trading in pits on the trading floor.

A put is an option that gives the option buyer the right (without obligation) to sell a futures

contract at a certain price on or before the expiration date of the option.

The premium is the cost of futures options. It is the only variable in the options contract

traded on the trading floor. The premium depends on market conditions such as volatility,

time until the option expires, and other economic variables. The premium is the only element

of an option contract that is negotiated in the trading pit; all the other parts of an option

contract- such as the strike price and expiration date- are predetermined or standardized by

the trading board.

Factors affecting premiums

Intrinsic value: the intrinsic value of an option is the positive difference between thestrike price and the underlying futures price.

For a put, the intrinsic value is the amount that the strike price exceeds the futures

price. For example, when the July corn futures price is $2.50, a July corn put with a

strike price of $2.70 has an intrinsic value of 20 cents a bushel. If the futures price


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increases to $2.60, the options intrinsic value declines to 10 cents a bushel. If the

strike for a put is below the futures, the intrinsic value is zero, not negative.

For a call, the intrinsic value is the amount that the strike price is below the futures

price. For example, when the December corn futures price is $2.50, a December corn

call with a strike price of $2.20 has an intrinsic value of 30 cents a bushel. If the

futures price increases to $2.60, the options intrinsic value increases to 40 cents a

bushel. If the futures price declines to $2.40, the intrinsic value declines to 20 cents a

bushel

Time value: time value originates from the fact that the longer the time untilexpiration, the more the opportunity for buyers and sellers to profit. Time value-

sometimes called extrinsic value- reflects the amount of money that buyers are willing

to pay hoping that an option will be worth exercising at or before expiration. For

example, if July corn futures are at $2.16 and a July corn call with a strike price of $2

is selling for 18 cents, then the intrinsic value equals 16 cents (the difference between

the strike price and futures price) and the time value equals 2 cents (difference

between the total premium and the intrinsic value).

The time value of an option declines as the expiration date of the option approach.

The option will have no time value at expiration, and any remaining premium will

consist entirely of intrinsic value. Major factors affecting time value include the

following:

Time remain ing until expir ation: the greater the number of days remaininguntil expiration, the greater the time value of an option will be. This occurs

because option sellers will demand a higher price because it is more likely that

the option will eventually be worth exercising

Market volatili ty: time value also increases as market volatility increases.Again, option sellers will demand a higher premium because the more volatile

or variable a market is, the more likely it is that the option will be worth

exercising.

I nterest rate:although the effect is minimal, interest rates affect the timevalue of an option: as interest rates increases, time value decreases.


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Determining option classification

Call option Put option

Inthemoney Futures price > strike price Futures price > strike price

Atthemoney Futures price = strike price Futures price = strike price

Outofthe - money Futures price < strike price Futures price > strike price

Ways to exit a futures option position

Once an option has been traded, there are three ways you can get out of a position: exercise

the option, offset the option, or let the option expire.

Exercise: only the option buyer can decide whether to exercise the option. When anoption position is exercised, both the buyers and the seller of the option are assigned a

futures position. The option buyer first notifies his/her broker, who then submits an

exercise notice to the board of trade clearing corporation. The exercise is carried out

that night. The clearing corporation creates a new futures position at the strike price to

a randomly selected customer who sold the same option. The entire procedure is

carried out before trading opens on the following business day.

Offsetting: offsetting is the most common method of closing out an option position.You do this by purchasing a put or call identical to the put or call you originally sold:

or by selling a put or call identical to the one you originally bought. Offsetting an

option before expiration is the only way you can recover any remaining time value.

Offsetting also precludes the risk of being assigned a futures position if you originally

sold an option and want to avoid the possibility of being exercised against. Your net

profit or loss, after a commission is deducted, is the difference between the premium

you paid to buy the option and the premium you receive when you offset the option.

Market participants always face the risk that there may not be an active market for

their particular options at the time they choose to offset, especially if the option is out

of the money or the expiration date is near.

Expiration: the other choice you have is to let the option expire by simply doingnothing. In fact, the right to hold the option up until the final day for exercise is one of

the features that make options attractive to investors. Therefore, if the change in price

initially moves in the opposite direction, you have the assurance that the most you canlose is the premium you paid for the option.


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Group Assignment

1. Some say speculating is the same as gambling. Others say that speculating is acalculated business decision. Which view do you favour? Write an essay defending

your position.

2. If you decided to trade futures commodities as either a hedger or a speculator, wouldyou trade futures contracts or futures options? Defend your choice.

This group assignment will be presented to the class along with other students, in the form of

a debate.

commodity marketing

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