AGEC 420, Lec 9 1

AGEC 420

• Review Quiz 1

• Hedging examples

• Types of Orders

• Quiz 2

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Hedging (summary)

• Objective: to reduce risk– works because basis risk < cash price risk

If maturity basis = expected basis

then realized price = expected price (regardless of whether prices go up or down)

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Approach to hedging problems

• identify the risk in the cash position• will money be lost if price rises or if it falls

• decide appropriate action in futures• one that makes money if there are losses on the cash

side

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Expected and Realized Price

Expected price = futures + expected basis

Realized price = futures + actual basis

= expected price + change in basis

= cash + result on futures

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Example 7 - Long Hedge

• Feb: plan to buy feeder cattle in May. • May futures @ $84.00, Exp. basis is +$0.50

• Expected price is $84.00 + $0.50 = $84.50

Action: buy May futures @ 84.00• May:

• Local price is $87.00. Futures price is $87.25

• Basis weaker than expected, by $0.75 / cwt

Action: buy feeder cattle, sell futures• Realized net price is $83.75

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Example 8 - Long Hedge

Feb 7: Elevator is short cash wheat, needs to buy before March.

March futures @ $3.50/bu., Exp. basis is -$0.40

Buy March futures. Expected Price = $3.50 – $0.40 = $3.10

Late Feb: Local price is $4.50. March futures @ $5.10

Basis = -$0.60, 20c weaker than expected.

Realized net price paid is: $4.50 – $1.60 = $2.90

i.e. 20c less than expected due to weaker basis

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Hedging with futures

• Advantages– Reduce exposure to price risk

• Disadvantages– Lose the opportunity to gain from favorable

price move– Margin calls

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Placing an Order

• Purcell & Koontz text, Appendix 4A, p162

• Different types of Orders– Market order– Limit order– Stop order– MIT

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Market Order

An order to take a position “at the market”executes immediately at the best available price

Example“sell 1 July wheat at the market”

Advantage – guaranteed fill (usually?)

Disadvantage – no control over fill price

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Limit Order

An order to take a position at a specified price or “better”“Better” = lower if buying, higher if selling

Example“sell 1 July wheat at 2.98”

Advantage –control over priceDisadvantage – may not be filled

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Market if Touched (MIT)

• A condition that converts a limit order to a market order

• Example – July wheat at 2.97– Order - “sell 1 July wheat at $2.98 MIT”– If price reaches $2.98 – order becomes a market order

Advantage – some control over priceDisadvantage – may not be filled