1

FRE 501 2013Lab 9 (Nov 5th)

1. Overview of Palm Oil2. Plantation Economics and Policy3. Corporate Behaviour - Hedging

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Mission Statement

Understand how commodity futures markets work, Formulate and refine trading and hedging strategies,

Learn and practice risk management,In preparation for future professional roles

3

Palm Oil Overview

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We all eat palm, some of you put it on your face

Yihai Kerry brands in ChinaBrands in China Icon Products

Arawana “金龙鱼” Edible oils, rice and flour

Koufu “口福” Edible oils and soy milk powder

Wonder Farm “香满园” Edible oils, rice,

flour and grains

Gold Ingots “元宝” Soybean oil, rice and flour

Orchid “胡姬花” Peanut oil and blended oil

Fengyuan “丰苑” Feed meals

Jin Li “金鸝” Specialty fats

Huaqi “花旗” Edible oils, flour and specialty fats

Reyland “銳龍” Oleochemicals

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

05

101520253035404550

Rapeseed Oil

Palm OilSoybean Oil

Million Metric Tons

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Palm Oil’s place: Top 3 Veg Oils World Supply

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Palm Oil cultivation

Oil Palm tree is originally from Nigeria, Africa – brought to Malaysia by the BritishOver 90% of cultivated Oil Palm today is in Malaysia and Indonesia

Africans generally eat it unprocessedCultivation hasn’t taken off in a big way in South America – Palm Trees there plagued by ‘bud rot’ – has killed off entire plantations in as little as 2 years

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Rainforest->Logged->Oil Palm

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10

Palm – Friend or Foe?

Oil Palm is now closer to 13 mil ha – 5 mil ha in Malaysia8 mil ha in Indonesia

Total US: ~360 mil ha

This chart might

shock you

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Amazon Deforestation

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Palm is a long-lived perennialPalm Oil Yield with Age (FFB and Oil)

0 2 4 6 8 10

12 14

16 18

20 22

24 26

28 30

0

5

10

15

20

25

30 FFB YieldOil Equiv

Year from Planting

Mt / year The fruits have ~ 23.5% Oil content

So why does yield drop with age?

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Harvesting Palm is “high”ly skilled joband a “tall” order

At ~ 6-7 years of age (prime)

At~ 15-20 years of age

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Oil Palm is perennial but still exhibits SeasonalityCorn and Soybeans are ‘annuals’

J F M A M J J A S O N D -

10,000

20,000

30,000

40,000

50,000

60,000

2011

2010

2009

Mt/monthRainy Season‘Dry’ Season

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Applying Storage TheoryBased on your understanding of commodity storage – should palm oil ‘normally’ be in backwardation or contango?

BackwardationThere’s always more coming next month

Contagos are rare, and great hedging opportunities

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Plantation Economics and Policy

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A brief history of palm (prices)

Jan-01

Aug-01

Mar-02Oct-

02

May-03

Dec-03Jul-0

4

Feb-05

Sep-05

Apr-06

Nov-06Jun-07

Jan-08

Aug-08

Mar-09Oct-

09

May-10

Dec-10Jul-1

1

Feb-12

Sep-12

Apr-13

0

200

400

600

800

1000

1200

1400USD/mt

Peak of commodity speculation

Financial Crisis trough, Crude oil at $30

Following crude oil up

Biofuel policies begin

Change in EU biofuel stance

$750

Plantation Cashflow –long-term30 year investments

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FY 2

010

FY 2

011

FY 2

012

FY 2

013

FY 2

014

FY 2

015

FY 2

016

FY 2

017

FY 2

018

FY 2

019

FY 2

020

FY 2

021

FY 2

022

FY 2

023

FY 2

024

FY 2

025

FY 2

026

FY 2

027

FY 2

028

FY 2

029

FY 2

030

FY 2

031

FY 2

032

FY 2

033

FY 2

034

FY 2

035

FY 2

036

FY 2

037

FY 2

038

FY 2

039

FY 2

040

(4,000) (3,000) (2,000) (1,000)

- 1,000 2,000 3,000 4,000 5,000

-

50

100

150

200

250

300

350

Cashflow (CPO=$1100) Payback = 8.5 yrsCashflow (CPO = $600) Payback = 12 yrsCost of Production

Cash Flow USD/ha MC

Average cost of ~$250/mt. Current prices ~ $800 >60% Ebitda margin : One of the most profitable cash crops in the world

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Financial modeling and forecasting – with array formulasyield matrix upgrade (practice your quant skills)

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 202019 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7

2003 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2004 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2005 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2006 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2007 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2008 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2009 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2010 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2011 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2012 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2013 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2014 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2015 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2016 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2017 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2018 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2019 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2020 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - - 2021 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - - 2022 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 - 2023 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 5.9 2024 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 9.9 2025 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 13.8 2026 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 17.8 2027 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 22.7 2028 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 24.7 2029 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 24.7 2030 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 24.7 2031 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 24.7 2032 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 24.7 2033 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 24.7 2034 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 23.7 2035 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 23.7 2036 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 22.7 2037 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 21.7 2038 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 21.7 2039 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 20.7 2040 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 19.7 2041 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 18.8 2042 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8 17.8 2043 13.4 13.9 14.4 14.9 15.3 15.8 16.8 16.8

Year projected

Year of planting

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Export Tax Structure Complexity

No Uraian

Export tax rate CPO Prices (CIF Rotterdam) 1 2 3 4 5 6 7 8 9 10 11 12 ≤ $750 750-800 800-850 850-900 900-950 950-1000 1000-1050 1050-1100 1100-1150 1150-1200 1200-1250 > $1250

CIF ROTT > than $750 $750 $800 $850 $900 $950 $1,000 $1,050 $1,100 $1,150 $1,200 $1,250 1 Buah dan Kernel Kelapa Sawit 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%2 Bungkil Kelapa Sawit 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%3 Crude Palm Oil (CPO) 0.0% 0.0% 7.5% 9.0% 10.5% 12.0% 13.5% 15.0% 16.5% 18.0% 19.5% 21.0% 22.5%4 Crude Palm Kernel Oil (CPKO) 0.0% 0.0% 7.5% 9.0% 10.5% 12.0% 13.5% 15.0% 16.5% 18.0% 19.5% 21.0% 22.5%5 Crude Palm Olein 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%6 Crude Palm Stearin 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%7 Crude Palm Kernel Olein 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%8 Crude Palm Kernel Stearin 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%9 Palm Fatty Acid Distillate (PFAD) 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%

10 Hydrogenated Palm Oil (Bulk) >20 kg 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%11 Hydrogenated Palm Kernel Oil (Bulk) >20 kg 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%12 Hydrogenated Palm Olein (Bulk) >20 kg 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%

13 Hydrogenated Palm Kernel Olein (Bulk) >20 kg 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%

14 Hydrogenated Palm Kernel Stearin (Bulk) >20 kg 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%

15 Hydrogenated Palm Stearin (Bulk) >20 kg 0.0% 0.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.5% 12.0% 13.5% 15.0%16 RBD Palm Olein 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.5% 13.0%17 RBD Palm Oil 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%18 RBD Palm Kernel Oil 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%19 RBD Palm Kernel Olein 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%20 RBD Palm Kernel Stearin 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%21 RBD Palm Stearin 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%22 Hydrogenated RBD Palm Olein 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 11.5% 13.0%23 Hydrogenated RBD Palm Oil 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%24 Hydrogenated RBD Palm Kernel Oil 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%25 Hydrogenated RBD Palm Kernel Olein 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%26 Hydrogenated RBD Palm Kernel Stearin 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%27 Hydrogenated RBD Palm Stearin 0.0% 0.0% 0.0% 0.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%28 RBD Palm Olein (dalam kemasan) 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2.0% 2.0% 2.0% 3.0% 4.0% 5.0% 6.0%29 Biodiesel dari Minyak Sawit 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2.0% 2.0% 2.0% 2.0% 5.0% 5.0% 7.5%

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Main Features of tax structure

• Collect Rents• Keep domestic food prices low• Support development of downstream industry – the tax

differential is in effect, a processing subsidy that isn’t an export subsidy and hence doesn’t violate WTO rules

Main Goals of tax structure

• Progressive tax structure• Differentiated across refined products

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Other countries’ response• India protects its own processing industry with

very high import tariffs for the refined product• China doesn’t mind importing refined product

– it blends it with soybeans and rapeseed. China protects its crushing processing though

• Malaysian refineries have been the largest losers because of Indonesian tax structure – Malaysia introduced similar tax structure this year to help refiners compete

23

Palm – Friend or Foe?

Oil Palm is now closer to 13 mil ha – 5 mil ha in Malaysia8 mil ha in Indonesia

Total US: ~360 mil ha

This chart might

shock you

24

25

Hedging

Hedging an annual crop is a one year cashflow optimization problem – Planting decisions reset every year

Economics of perennial crops differ from Economics of annual crops

How So?

Hedging perennials (any trees or plantations) is a multi-year cashflow optimization problem

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Largest plantations in Msia/Indonesia(total 13 mil ha planted) – quite fragmented

• Sime Darby- 531,000 ha (<4% total)• Golden Agri - 464,000 ha• Astra Agro- 270,000 ha• Wilmar – 255,000 ha• Indofood Agri - 230,000 ha• IOI Corp - 160,000 ha• First Resources- 160,000 ha (1.2% of mkt)

about 12 x RichmondsRichmond is about 130 km² or 13,000 ha

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First Resources160,000 ha and increasing: produced ~ 600 kt / year in 2012, increasing to ~ 1 mil mt /year in 2020

At $800/mt, this is approximately US$500 mil revenues / year increasing to $800 million in 2020

To hedge 5 years: > $2.5 bn of salesA lot of hedging to do

Plantation Share Prices vs. Commodity Price 2010-2013

60%80%

100%120%140%160%180%200%220%

4005006007008009001000110012001300

GGR-I FR-I AA-I CPO PriceShare Price

Index CPO USD/mt

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Hedging MattersQtrly EBITDA: FR vs GGR

1Q2010

2Q2010

3Q2010

4Q2010

1Q2011

2Q2011

3Q2011

4Q2011

1Q2012

2Q2012

3Q2012

4Q2012

1Q2013 -

50

100

150

200

250

300

350

FR GGR GGR: 50% decline in EBITDA

FR: very consistent EBITDA

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2012 2013 2014 (200)

(100)

-

100

200

300

400 USD mil

EBITDA

CAPEX

NET CASH FLOW

Maximum CPO Price:US $ 1400 / MT

Minimum CPO Price:US $ 400 / MT

UNHEDGED

Range of Outcomes given Commodity Price volatility

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Tiered Hedges help protect Company’s cashflow

2012 2013 2014 (100)

(50)

-

50

100

150

200

250

300

350

EBITDA

CAPEX

NET CASH FLOW

Minimum CPO Price

400 USD

1400 USDMaximum CPO Price

75 % HEDG

E

50 % HEDGE 25 %

HEDGE

HEDGES$1000 $950 $900

31

32

Ideal Hedge RatiosA function of:• Protecting Price or Profit?• Cash-flow commitments (such as capex, loan

repayments, etc)• Availability of instruments• Availability of counter-parties• Liquidity

EBITDA per mt with varying Hedge levels Does anything look odd?

$600 $650

$700 $750

$800 $850

$900 $950

$1,000

$1,050

$1,100

$1,150

$1,200

$1,250

$1,300

$1,350

$1,400 $200

$300

$400

$500

$600

$700

$800

Unhedged EBITDA50% hedge100% hedge

CPO Price at Settlement

EBITDA per ton CPO

33

34

Plantation ebitda per mt CPO: Hedged with a 50% Swap

$300

$3

30

$360

$3

90

$420

$4

50

$480

$5

10

$540

$5

70

$600

$6

30

$660

$6

90

$720

$7

50

$780

$8

10

$840

$8

70

$900

$9

30

$960

$9

90

$1,0

20

$1,0

50

$1,0

80

$1,1

10

$1,1

40

$1,1

70

$1,2

00

$1,2

30

$1,2

60

$1,2

90

$1,3

20

$1,3

50

$1,3

80

$1,4

10

$1,4

40

$1,4

70

$1,5

00

$1,5

30

$1,5

60

$1,5

90 $0

$200

$400

$600

$800

$1,000

$1,200

$1,400 EBITDA (No Export Tax, Unhedged)

EBITDA (w Export Tax, Unhedged)

EBITDA (w 50% swap hedge @ $1000)

CPO Price

EBITDA

35

Commodity SwapsA Swap is simply a promise between two parties to exchange cashflows – think of this as a series of futures contracts that auto-terminate

A commodity swap usually has a ‘fixed price’ leg and a ‘floating’ price leg

The difference is cash-settled at the end (no delivery)

The simplest commodity swap is essentially like a futures contract that auto-closes at an agreed termination date.

36

Options

• Commodity Options give the buyer the right to purchase (vs futures which give the buyer the obligation to purchase)

• Options can be combined many different ways• Collar is a sold call and bought put (or vice

versa) – a collar pair of options at the same strike price is essentially a swap

37

Why use derivatives like swaps and collars instead of just futures, or OTC contracts

• Leveraging the banks’ cheaper cost of capital– Will need to negotiate ISDAs and CSAs

• Reduces the need to micromanage futures, execution, reduce market impact. Usually did ‘asianing’ swaps – average price over the month

• Swaps are fungible and can be novated to reduce counter-party risk

• Derivatives can more effectively protect the cash-flow needs of the business, at economically sensitive price points

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Plantation ebitda per mt CPO: Hedged with a 75% Collar

$300

$3

40

$380

$4

20

$460

$5

00

$540

$5

80

$620

$6

60

$700

$7

40

$780

$8

20

$860

$9

00

$940

$9

80

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,

$1,$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000 EBITDA (w Export Tax, Unhedged)EBITDA (w 75% collar: bought put @ 800 and sold call @ 1200)

Sell a call and Buy a Put

39

Economics vs. Statistics• In a historical linear world, statistical

techniques such as normal distributions and regressions work well for forecasting

• In our current complex world, understanding the economics is far more important: what happens if biofuel mandates go away?

• Bank pricing models often use versions of black scholes model to price futures options – what’s wrong with this?

40

41

List of derivative examples:• Swaps• Collars• 3-way collars: – Sold two put options, bought one call option

based on supply curve and food demand, probability of prices falling below $600 virtually negligible

• Extendible swaps, extendible collars• Spread options

42

Refinery Spread-Options• In 2011, the first oil palm plantation/refinery business

to sell PO-GO spread options, made over US$5 mil without refining a drop of oil

• The biodiesel refinery is essentially a physical option on the PO-GO spread. When Palm Oil gets very cheap relative to diesel, the refinery can convert it into biodiesel and sell at the higher price

• This doesn’t work the other way – biodiesel cannot be converted into food

43

Concluding Remarks• Understanding the microeconomics is key to

understanding policy repercussions• The spread of Oil Palm and deforestation is

scary, but what’s the root cause? (FRE 540)

• Perennials vs. Annuals economics differ• Taxes can also act like subsidies• Learn to hedge with a variety of instruments,

counter-parties • All ‘structured’ products can be broken down

into basic elements of swaps and options