Risk Management with Futures and Options

1
Risk Management with Futures and Options

• Tom Clark
• Associate Director
• CME Group Commodity Products July 17, 2008

2
Introduction to CME Group

• The worlds largest and most diverse exchange
• Merger The Chicago Board of Trade (CBOT) was
  established in 1848, and the Chicago Mercantile
  Exchange (CME) in 1898.
• The Role of the Exchange
• Create products that serve an economic function
• Hedging and risk management
• Price discovery
• Price dissemination
• CME Group Clearing House All transactions
  cleared, settled, and guaranteed
• Worlds largest
• 100 years of default free performance
• Centralized Marketplace Virtual 24 hour trading
  on the CME Globex electronic trading platform

3
CME Group Products

• Widest selection of benchmark products
• Access to all major asset classes
• Traditional and alternative product choices
• Interest Rate
• Equity
• Commodity AI
• FX
• 83 of volume is electronic.

4
Commodity Products ADV (Combined CME CBOT,
incl. Weather)
18 CAGR
44
5
Market StatisticsCurrent Volume Open Interest
(6/30/08)
DefinitionsOpen Interest - The accumulated
total of all currently outstanding contracts (one
side only). Refers to unliquidated purchases and
sales. Volume -The number of contracts traded
(one side of each trade only) for each delivery
month during the trading period.
6
Market StatisticsElectronic Trade
7
Trading Information

• Livestock futures and options Trading Hours
• Floor 905 a.m. - 100 p.m. Monday Friday
• Globex

8
Lean Hog Contract Specifications
40,000 lbs
LH/HE
10th Business day of contract month
11
Jun, Jul ,Aug, Oct, Dec, Feb, Apr, May
Full-size .025/lb. or 10 per contract
Futures .03/lb. or 1,200/contract
On any day that the option is trading
1 per cwt. in first 2 contracts, 2 in others
(24 listing range)
9
Cash Settlement

• CME Lean Hog Index
• The CME Lean Hog Index is a two-day weighted
  average of national lean hog values. The data is
  collected by the USDA. The Index represents the
  most active trades in lean-value or grade and
  yield hogs.
• Detail
• The CME Lean Hog Index is a two-day weighted
  average of cash prices. For contracts through
  February 2003, these cash prices are the actual
  base costs at 51-52 lean of the hogs that were
  slaughtered that day. These prices are available
  in USDA Report LM_HG213-National Daily Base Lean
  Hog Carcass Slaughter Cost. Beginning with the
  April 2003 contract, the cash prices used in the
  Index will be the average net prices at the
  average percent lean for slaughtered hogs. These
  prices are available in USDA Report
  LM_HG201-National Daily Direct Hog Prior Day
  Report-Slaughtered Swine. Each packer reports
  this base cost and average net price, the number
  of hogs slaughtered and the average carcass
  weight to the USDA. The USDA then calculates an
  average base cost and net price, weighted by the
  number of hogs slaughtered and the average
  carcass weight. This weighting allows each price
  to be represented in proportion to the number of
  hogs sold so that the Index better represents
  production patterns and prices received by
  producers. On the day after slaughter, the USDA
  releases the weighted average base cost and
  average net price, the total number of hogs
  slaughtered and the average carcass weight.
  Because the information is reported the day
  following the actual slaughter, the Index itself
  has a lag.

10
What are Futures Options?

• Futures contracts are standardized, legally
  binding agreements to buy or sell a specific
  product or financial instrument in the future.
  The buyer and seller of a futures contract agree
  on a price today for a product to be delivered or
  settled in cash at a future date. Each contract
  specifies the quantity, quality and the time and
  location of delivery and payment.
• Options can be thought of as insurance policies.
  The option buyer pays a price for the right but
  not the obligation to buy or sell a futures
  contract within a stated period of time at a
  predetermined price.

11
Contract Trade Positions

• Futures Contract
• An obligation to buy or sell a commodity that
  meets set grades and standards on some future
  date.

Prices down
Short
Long
Prices up
Long
Short
12
How Are Prices Determined?

• Actions of hedgers and speculators looking at
• Supply
• Demand
• Political factors
• Psychological factors
• And coping with price volatility

13
Price Fluctuations

• Minimum (tick) 2 ½ cents/cwt.
• 76.025 76.05
• 76.00
• 75.975 75.95
• Each tick move 400 cwt. X .025 cwt.
• 10.00 per Lean Hog contract
• Maximum daily limit from previous days
  settlement price
• Lean Hogs 3.00 x 400 cwt. 1,200

14
Market Safeguards

• Clearing House
• All the clearing firms of the Exchange together
  stand in between every buyer and seller.
• Market-to-Market
• Funds move into or out of each trading account
  daily, based on settlement price change.
• Sell (short) one Lean Hog contract with 1.00
  price move
• 77 (400 out of account)
• 76
• 75 (400 in account)
• Vice-versa in long contracts

15
Market Safeguards - Performance Bond or Margin

• Like a Security Deposit. Must be maintained at a
  certain level while futures position held.
  Usually less than 10 of contract value.
• Live Cattle cash value vs. Futures contract
  margin example

40,000 400 cwt. 400 cwt. x 90
36,000 800/36,000 4.5
800
800
1,080
1,080
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Performance Bond Example Cattle
400
40,000
400
10.00
400
1,200
1,080
800
Trade Day
2,000
Sell LC 90.50
2,200
LC Close 90.000
.50 x 400 200
1,200
LC Close 92.50
-2.50 x 400 -1,000
LC Close 93.525
-1.025 x 400 -410
790 (MC 290)
1,880
LC Close 91.525
2.00 x 400 800
2,450
Offset LC
Buy LC 90.10
1.42 x 400 570
Trade Summary S 90.50

B 90.10 .40
x 400160
Account Summary 1,080 Initial 290 MC
1,370 Trade balance 2,000--2,450 450 160
Profit 290 MC 450
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Introduction to Hedging with Futures and Options
18
Hedging (Risk Shifting)

• Definition of Hedging
• Taking an opposite position in futures from your
  present cash position.

• Owner of inventory
• Risk in down markets

• Seller of contracts (Short)
• Gain in down markets

• User of inventory
• Risk in up markets

• Buyer of contracts (Long)
• Gain in up markets

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Market Make-Up

• Commercial Hedgers

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Market Make-Up

• Discretionary traders

21
Why Firms Use Commodity F O

• Lock in or cap input costs
• Protect inventory
• Offer customers fixed price contracts
• Reduce risk of regular seasonal moves
• Minimize damage from long-term cyclical moves
• Cover opportunity losses from forward pricing
• Control risks in other parts of business
• Capture windfall pricing opportunities

22
Price Risk and Futures Markets

• Price risk simply defined
• Procurement/ input cost risk - up markets
• And/ Or
• Inventory risk - down markets
• Taking Price Risk is Speculation!

23
Hedging with Futures and Options

• Hedging consists of defining
• Your open cash pricing risk,
• The corresponding futures contract to offset the
  risk,
• The futures contract month closest to cash risk
  production/procure period in question,
• An estimated basis in the marketing/ procure
  month in order to project a hedged price.
• Plus, firms hedge policy plans such as price
  objectives, percentages to hedge, and the offset
  policy to meet overall risk management
  objectives.
• Basic approaches to hedging price risk
• Buy (long) hedging Procurement
• Sell (short) hedging Production

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Sell Futures to Hedge Inventory
____ ____ ____ ____ ____ _______ ____ ____ ____ __
__ ____
82.50
____ ____ ____ ____ ____ _______ ____ ____ ____ __
__ ____
Opportunity loss
Price Opportunity
Start
75.00
75 /- Basis Floor
67.50
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Buy a Put to Protect a Price Level
____ ____ ____ ____ ____ _______ ____ ____ ____ __
__ ____
____ _____ ____ ____ ____ _______ ____ ____ ____ _
___ ____
82.50
Opportunity Gain
Price Opportunity
Start
Strike (-) Premium Floor
75.00
67.50
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Hedging and Basis

• Basis and Expected Hedged (target) Price
• Futures contracts are standardized as to size,
  quality, etc. thus a zero basis never exists
  because the underlying cash (spot) price varies
  based on quality (premiums discounts) and
  location factors effecting supply and demand.
• Futures prices are quoted daily. B/S Hedgers can
  convert the futures price to a hedged price
  return by adjusting for their historical basis in
  the marketing month in question.
• Actual Basis derived when hedge is lifted.

Fut./Mo./ Est. Local
Expected Price Basis
(Ave.) Hedge Price
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Lean Hog/Producer Zero Basis Risk

• Hogs hedged at _____ and zero basis projection at
  the time the hedge was initiated should equate to
  a final hedged price of ______ (/- _____)
  ______
• Sale Month __________ Historical _________
  Basis Est. _____
  
• Sell Futures _____ /- _____ Basis _______
• 
  (expected
  hedged price)

75.00
75.00
0
75.00
June
0
June
75.00
75.00
0
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Lean Hog/Producer Zero Basis Example
75.00
75.00
0
0
67.50
67.50
75.50
67.50
7.50
75.00
0
75.00
0
82.50
82.50
75.00
82.50
-7.50
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Hedging and Risk Shifting Summary

• Basis
• The difference between your price for your hogs
  and the futures price on the date the hedge is
  lifted.
• Basis Cash minus Futures
• Example -2.00 (cash under futures) 2.00 (cash
  higher than futures)
• Estimated Basis
• Based on historical cash/ futures price
  relationships
• Usually derived from 3-5 years of history
• Lean Hogs Weighted average (about 54 lean)
• Actual Basis
• Results in net hedge price when lifting hedge.
  Reflects how strong or weak the market is.
• Impacts your price

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Options and Futures Contract Price
76.00

• June Lean Hog Futures

77, 78, 79, 80
75, 74, 73, 72
76
76
75, 74, 73, 72
77, 78, 79, 80
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June Lean Hog Options
In the Money
In the Money
3.00
3.40
78.00
74.00
77.00
2.40
75.00
2.85
At Money
76.00
1.90
76.00
2.00
At Money
75.00
1.50
77.00
1.75
Out of Money
Out of Money
74.00
1.00
78.00
1.25
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Put Premium Example
76.00

• Example Buy a ____ Put when Futures are at
  ______
• Increases in value as market falls
• Decreases in value to zero as market rises

75
Premium ____ ____ ____ ____ ____ ____ ____
Strike Price ____ Put
Futures ____ ____ ____ ____ ____ ____ ____
82.50
June
0.00
Buy
1.50
76.00
75
Now
(600)
67.50
8.00
June
(3,200)
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34
Long Hedging Management Strategies

• Buy Futures
• Buy a Call
• Roll Down to Futures
• Sell a Put
• Buy a Call Sell a Put Fence

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Steps to Hedging Summary

• Know costs
• Contract specifications
• Basis
• Performance bond requirements
• Hedging costs
• Commission
• Interest
• Knowledgeable
• Broker
• Lender
• Marketing plan

36
Developing a Marketing Plan
37
Marketing Plans Are Critical To SuccessA
Seven-Step Marketing Plan

• Know your costs of production and determine your
  break-even levels
• Utilize sound market information
• Know your product
• Set target price(s)
• Evaluate pricing alternatives
• Forward contract
• Auction
• Futures/Options Hedging
• Execute when target prices are hit.
• Review results to determine what works best for
  your operation

38
Marketing Alternatives
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Trading Resources
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CME Group Website

• Visit CME Group website www.cmegroup.com
• Types of information
• Current market and exchange Information
• Contract information
• Educational material publications, tutorials,
  webinars
• Rules and regulations
• Trading information margin, fees, price limits,
  position limits etc.
• Statistical reports

41
CME Group Website - Product resources page
www.cmegroup.com/commodities
42
CME Group Webinars
43
CME Group Webinars
44
CME Group Webinars www.cmegroup.com/porkwebinars

45
CME Group Brochure Self study guide to
Hedging with Livestock F O
46
Real Time Electronic Quotes
www.cmegroup.com/elivestockquotes
47
Free Daily Commentary
Daily Livestock Report
Commodity News for Tomorrow

• Latest industry news
• Prices
• Fundamentals
• www.dailylivestockreport.com

48
2008 Moore Historical Reports

• Historical daily charts
• Cash and basis charts
• Seasonal strategies
• And other research data to help you trade

Contact thomas.clark_at_cmegroup.com
49
Other Web Resources

• USDA www.usda.gov
• NASS www.nass.usda.gov
• LMIC www.lmic.info
• NPB Pork Checkoff- www.pork.org

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Further Information

• CME Web site www.cmegroup.com
• CME commodities Web site www.cmegroup.com/commodi
  ties
• USDA reports www.nass.usda.gov, www.usda.gov
• CME contact information
• Commodity Products 312-338-2080
• Customer Service and Publications 800-331-3332
• Thomas Clark, Associate Director 312-930-4595
• Thomas.clark_at_cmegroup.com

51
Disclaimer

• Futures trading is not suitable for all
  investors, and involves the risk of loss. Futures
  are a leveraged investment, and because only a
  percentage of a contracts value is required to
  trade, it is possible to lose more than the
  amount of money deposited for a futures position.
  Therefore, traders should only use funds that
  they can afford to lose without affecting their
  lifestyles. And only a portion of those funds
  should be devoted to any one trade because they
  cannot expect to profit on every trade.
• All references to options refer to options on
  futures.
• The Globe logo, CME and CME Group are
  trademarks of Chicago Mercantile Exchange Inc. 
  CBOT and Chicago Board of Trade are trademarks
  of The Board of Trade of the City of Chicago,
  Inc.  All other trademarks are the property of
  their respective owners.
• The information within this presentation has been
  compiled by CME Group for general purposes only.
  Although every attempt has been made to ensure
  the accuracy of the information within this
  presentation, CME Group assumes no responsibility
  for any errors or omissions. Additionally, all
  examples in this presentation are hypothetical
  situations, used for explanation purposes only,
  and should not be considered investment advice or
  the results of actual market experience.
• All matters pertaining to rules and
  specifications herein are made subject to and are
  superseded by official CME, CBOT and CME Group
  rules. Current rules should be consulted in all
  cases concerning contract specifications.