Supply and Supply and Demand ChaosDemand Chaos

Early Markets in Early Markets in the USthe US

ExchangesExchanges

•Chicago Board of TradeChicago Board of Trade•Chicago Mercantile Chicago Mercantile ExchangeExchange

•Commodity Exchange Commodity Exchange IncorporatedIncorporated

ExchangesExchanges

•Kansas City Board Kansas City Board of Tradeof Trade

•New York Cocoa New York Cocoa ExchangeExchange

Characteristics of Characteristics of Commodities TradedCommodities Traded•Units homogeneousUnits homogeneous•Susceptible to Susceptible to grading and grading and standardizationstandardization

•Supply and demand Supply and demand uncertainuncertain

Characteristics of Characteristics of Commodities TradedCommodities Traded•Large supply and Large supply and demanddemand

•Supply flows naturally Supply flows naturally to marketto market

•Commodity not very Commodity not very perishableperishable

What is a futures What is a futures contract?contract?

•A transferable agreement A transferable agreement to make or take delivery to make or take delivery of a standardized amount of a standardized amount of a commodity of of a commodity of minimum quality during a minimum quality during a specific month.specific month.

Terms of a ContractTerms of a Contract

•CommoditCommodityy

•PricePrice•QuantityQuantity•QualityQuality

Terms of a ContractTerms of a Contract

•Time of deliveryTime of delivery•Place of Place of deliverydelivery

•Terms of Terms of paymentpayment

Settlement of a Settlement of a futures contractfutures contract

•DeliveryDelivery•Offsetting Offsetting transactiontransaction

Concept of Concept of Long and ShortLong and Short

•Long - BuyLong - Buy•Short - Short - SellSell

Open InterestOpen Interest

•1 long position + 1 1 long position + 1 short position = 1 short position = 1 open contractopen contract

E.g.: Open InterestE.g.: Open Interest

•A sells to BA sells to B•A-short; B-longA-short; B-long•C sells to BC sells to B•A-short; B-long 2; C-shortA-short; B-long 2; C-short•Open interest = ?Open interest = ?•Open interest = 2Open interest = 2

Margin MoniesMargin Monies

•Secure position of Secure position of tradertrader

•Solvency of Clearing Solvency of Clearing HouseHouse

Margin ExampleMargin Example

•Soybean contract Soybean contract (5000 bu)(5000 bu)

•Original margin = Original margin = $3,000$3,000

•Call point = $2,000Call point = $2,000

Margin ExampleMargin Example

•Sold soybeans @ $6Sold soybeans @ $6•Then price increases Then price increases to $6.25to $6.25

•Would you get a Would you get a margin call?margin call?

Margin ExampleMargin Example

•Calculate the Trading Calculate the Trading Result (TR)Result (TR)

•TR = (value of TR = (value of contract sold) - (value contract sold) - (value of contract that must of contract that must be bought back)be bought back)

Margin ExampleMargin Example

•TR = (5000 x $6) - TR = (5000 x $6) - (5000 x $6.25)(5000 x $6.25)

•TR = $30,000 - TR = $30,000 - $31,250 = -$1,250$31,250 = -$1,250

Margin ExampleMargin Example

•Effective Margin = Effective Margin = Original Margin +/- Original Margin +/- Trading ResultTrading Result

•EM = $3,000 - $1,250 EM = $3,000 - $1,250 = $1,750= $1,750

Speculation vs. Speculation vs. HedgingHedging

What is speculation?What is speculation?

•Taking a position in Taking a position in the market in order to the market in order to make money on the make money on the rise and fall of futures rise and fall of futures prices of certain prices of certain commodities.commodities.

SpeculationSpeculation

•Buy a contract at a Buy a contract at a low price, then turn low price, then turn around and sell the around and sell the contract at a high contract at a high price.price.

•Buy low, sell high.Buy low, sell high.

SpeculationSpeculation

•Sell a contract at a Sell a contract at a high price, then turn high price, then turn around and buy the around and buy the contract at a low contract at a low price.price.

•Sell high, buy low.Sell high, buy low.

Speculator’s RoleSpeculator’s Role•Provides risk capitalProvides risk capital•Provides volume and Provides volume and liquidityliquidity

•Keeps some markets in Keeps some markets in alignment through alignment through arbitragearbitrage

What is hedging?What is hedging?

•Taking an equal and Taking an equal and opposite position in the opposite position in the futures market to that in futures market to that in the cash market in order the cash market in order to insulate one’s business to insulate one’s business against price level against price level speculation.speculation.

Why hedge?Why hedge?

•Too much price riskToo much price risk•Highly leveragedHighly leveraged•Some banks require it Some banks require it as part of a loan as part of a loan agreementagreement

Causes of Price RiskCauses of Price Risk•Time difference between Time difference between production and marketingproduction and marketing

•Uncertain nature of farm Uncertain nature of farm productionproduction

•National or international National or international policiespolicies

The Producer’s The Producer’s HedgeHedge

The Producer’s The Producer’s HedgeHedge

•Date CashDate Cash

Mar. 1: Est. Mar. 1: Est. Price $2.60Price $2.60

Nov. 1: Nov. 1: Harvest & Harvest & sell @ $2.40sell @ $2.40

•FuturesFutures

Sell: Dec. Sell: Dec. futures @ $3futures @ $3

Buy: Dec. Buy: Dec. futures @ futures @ $2.80$2.80

The Producer’s The Producer’s HedgeHedge

•Date CashDate Cash

3/1: $2.603/1: $2.60

11/1: Sell 11/1: Sell $2.40$2.40

-$0.20-$0.20

•FuturesFutures

Sell: $3Sell: $3

Buy: $2.80Buy: $2.80

++$.020$.020

The Producer’s The Producer’s HedgeHedge

•The producer sold The producer sold crop at $2.40 in the crop at $2.40 in the market at harvest.market at harvest.

•Bought back the Bought back the futures contract for futures contract for $2.80.$2.80.

The Producer’s The Producer’s HedgeHedge

•The producer gained The producer gained $0.20 in the futures $0.20 in the futures market to add to market to add to earnings in the cash earnings in the cash market.market.

The Producer’s The Producer’s HedgeHedge

•Nov. 1 cash price = $2.40Nov. 1 cash price = $2.40

+ futures gain = + futures gain = $0.20$0.20

Total return = $2.60Total return = $2.60

•Note: Estimated return = Note: Estimated return = $2.60$2.60

The Processor’s The Processor’s HedgeHedge

The Processor’s The Processor’s HedgeHedge

•Date Date CashCash

Mar. 1: Mar. 1: Lock in Lock in $5.40$5.40

Nov. 1: Buy Nov. 1: Buy @ $7.00@ $7.00

•FuturesFutures

Buy: Mar. Buy: Mar. @ $5.70@ $5.70

Sell: Mar. Sell: Mar. @ $7.30@ $7.30

The Processor’s The Processor’s HedgeHedge

•Date CashDate Cash

3/1: $5.403/1: $5.40

11/1: Buy 11/1: Buy $7.00$7.00

•FuturesFutures

Buy: $5.70Buy: $5.70

Sell: $7.30Sell: $7.30

+$1.60+$1.60

The Processor’s The Processor’s HedgeHedge

•Processor bought grain for Processor bought grain for $7 in cash market.$7 in cash market.

•Sold futures contract for Sold futures contract for $7.30.$7.30.

•Gained $1.60 in the futures Gained $1.60 in the futures market to help cover cost of market to help cover cost of grain purchased.grain purchased.

The Processor’s The Processor’s HedgeHedge

•Nov. 1 cash price = $7.00Nov. 1 cash price = $7.00

+ futures gain = -+ futures gain = -$1.60$1.60

Net cost = Net cost = $5.40 $5.40

•Note: Estimated price = Note: Estimated price = $5.40$5.40