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Evaluating Risk Management Tools

Evaluating Risk Management Tools. John D. Lawrence Extension Livestock Economist Iowa State University. Tools. Futures Forward contracts Options Livestock Revenue Protection Livestock Gross Margin Option combinations. Y-axis is the net price received. Cash is a 45 o line.

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Evaluating Risk Management Tools

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  1. Evaluating Risk Management Tools John D. Lawrence Extension Livestock Economist Iowa State University

  2. Tools • Futures • Forward contracts • Options • Livestock Revenue Protection • Livestock Gross Margin • Option combinations

  3. Y-axis is the net price received Cash is a 45o line X-axis is possible futures prices at end of contract

  4. Futures and Options Data

  5. Establishes a flat price with basis risk around it. • If Futures fall to $80: Cattle are worth $80.56 + Futures gain of $5.80 – Com of $.12 • If Futures rise to $90: Cattle are worth $90.56 – Futures loss of $4.20 – Com of $.12 • In either case the net price is $86.24 +/- the change in basis from expected

  6. Forward Contract v. Futures • They look the same on the graph • Flat price • Difference: Forward contact • Contract with buyer • Must deliver commodity (deliver specs) • Basis is known and no basis risk • No margin calls • Typically flexible sizes

  7. Establishes a floor price, but not a ceiling and has basis risk • At Futures prices below SP: Net price is the Floor Price because the futures gains off set cash price decline, but subtract premium and commission. • At Futures prices above SP: Net price is the cash price minus the premium and commission that have already been paid.

  8. P+C Corner at intersection of Strike and Floor Prices

  9. Compare Futures hedge to ATM Put 45o line so rise/run = 1. “Rise” is P+C is also “Run” from current futures to the futures price where the lines cross Futures has higher net price until the lines cross

  10. Livestock Revenue Protection • Looks like buying put option on graph • Floor price with upside potential • Difference: LRP • Is both through insurance agent • Flexible size of contract • Expiration time is fixed • Cannot be resold • Basis is slightly different as is basis risk

  11. Livestock Gross Margin • Protect a “margin” • Revenue – feed cost – feeder cost • Budgeted quantities and weights • Uses futures prices • Focus on profits not price • Flexible size • Purchased from insurance agents

  12. Combination Option Strategies • Buy one option and sell another • Income from option sold raises the floor • Get premium, but give up something else • Option sellers • Must establish an margin account and will get margin calls if futures price moves against you

  13. Buy 82 Put @ $3.88 Sell 90 Call @ $3.35

  14. Buy 88 put at $6.60 Sell 82 Put at $3.88 This not a floor. It is a shelf There is down side risk, but no ceiling and higher over range of prices.

  15. Summary • Tools are available to include into a well developed marketing plan • Tools have different strengths and weaknesses to achieve different objectives • Understand the math and basis first • Marketing clubs are good ways to learn

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