ECON 339X:

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ECON 339X Agricultural Marketing

Chad Hart Assistant Professor/Grain
Markets Specialist chart_at_iastate.edu 515-294-9911
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Todays Topic

• Risk Management Tools
• Price Risk
• Futures, Options

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Iowa Corn Yields
Source USDA, NASS
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Iowa Corn Prices
Source USDA, NASS
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Iowa Corn Revenues
Source USDA, NASS
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Corn Futures Prices
Corn users are worried about this
Corn suppliers are worried about this
Source CME Group
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Crop Price Variability
Price distributions for corn based on March
prices for the following July futures
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Futures and Options

• Market tools to help manage (share) price risks
• Mechanisms to establish commodity trades among
  participants at a future time
• Available from commodity exchanges / futures
  markets

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Futures Markets
A market where contracts for physical commodities
are traded, the contracts set the terms of
quantity, quality, and delivery

• Chicago Corn, soybeans, wheat (soft red), oats,
  rice
• Along with the livestock complex
• Kansas City Wheat (hard red winter)
• Minneapolis Wheat (hard red spring)
• Tokyo Corn, soybeans, coffee, sugar
• Has a market for Non-GMO soybeans
• Other markets in Argentina, Brazil, China, and
  Europe

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Agricultural Futures Markets

• Has some unique features due to the nature of the
  grain business
• Supply comes online once (or twice) a year
• So at harvest, supply spikes, then diminishes
  until the next harvest
• Production decisions are based price forecasts
• Planting decisions can be made a full year (or
  more) before the crop price is realized
• Users provide year-round demand
• Livestock feeding, biofuel production, food demand

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Futures Market Exchanges

• Competitive markets
• Open out-cry and electronic trading
• Centralized pricing
• Buyers and sellers are both in the market
• Relevant information is conveyed through the bids
  and offers for the trades
• Bid the price at which a trader would buy the
  commodity
• Offer the price at which a trader would sell
  the commodity

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The View from the Corn Pit
Source M. Spencer Green, AP Photo
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Options

• What are options?
• An option is the right, but not the obligation,
  to buy or sell an item at a predetermined price
  within a specific time period.
• Options on futures are the right to buy or sell a
  specific futures contract.
• Option buyers pay a price (premium) for the
  rights contained in the option.

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Option Types

• Two types of options Puts and Calls
• A put option contains the right to sell a futures
  contract.
• A call option contains the right to buy a futures
  contract.
• Puts and calls are not opposite positions in the
  same market. They do not offset each other.
  They are different markets.

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Put Option

• The Buyer pays the premium and has the right, but
  not the obligation, to sell a futures contract at
  the strike price.
• The Seller receives the premium and is obligated
  to buy a futures contract at the strike price if
  the Buyer uses their right.

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Call Option

• The Buyer pays a premium and has the right, but
  not the obligation, to buy a futures contract at
  the strike price.
• The Seller receives the premium but is obligated
  to sell a futures contract at the strike price if
  the Buyer uses their right.

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Options as Price Insurance

• The person wanting price protection (the buyer)
  pays the option premium.
• If damage occurs (price moves in the wrong
  direction), the buyer is reimbursed for damages.
• The seller keeps the premium, but must pay for
  damages.

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Options as Price Insurance

• The option buyer has unlimited upside and limited
  downside risk.
• If prices moves in their favor, the option buyer
  can take full advantage.
• If prices moves against them, the option seller
  compensates them.
• The option seller has limited upside and
  unlimited downside risk.
• The seller gets the option premium.

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Option Issues and Choices

• The option may or may not have value at the end
• The right to buy at 4.00 has no value if the
  market is below 4.00.
• The buyer can choose to offset, exercise, or let
  the option expire.
• The seller can only offset the option or wait for
  the buyer to choose.

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Strike Prices

• The predetermined prices for the trade of the
  futures in the options
• They set the level of price insurance
• Range of strike prices determined by the futures
  exchange

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Options Premiums

• Determined by trading in the marketplace
• Different premiums
• For puts and calls
• For each contract month
• For each strike price
• Depends on five variables
• Strike price
• Price of underlying futures contract
• Volatility of underlying futures
• Time to maturity
• Interest rate

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Option References

• In-the-money
• If the option expired today, it would have value
• Put futures price below strike price
• Call futures price above strike price
• At-the-money
• Options with strike prices nearest the future
  price
• Out-of-the-money
• If the option expired today, it would have no
  value
• Put futures price above strike price
• Call futures price below strike price

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Options Premiums
In-the-money
Dec. 2010 Corn Futures 3.85 per bushel
Out-of-the-money
Source CME Group, 3/26/10
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Options Premiums
Out-of-the-money
Dec. 2010 Corn Futures 3.85 per bushel
In-the-money
Source CME Group, 3/26/10
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Setting a Floor Price

• Short hedger
• Buy put option
• Floor Price Strike Price Basis
  Premium Commission
• At maturity
• If futures lt strike, then Net Price Floor Price
• If futures gt strike, then Net Price Cash
  Premium Commission

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Put Option Graph
Put Option Dec. 2010 Corn _at_ 3.90 Premium 0.43
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Out-of-the-Money Put
Put Option Dec. 2010 Corn _at_ 3.00 Premium 0.07
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In-the-Money Put
Put Option Dec. 2010 Corn _at_ 5.00 Premium 1.26
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Setting a Ceiling Price

• Long hedger
• Buy call option
• Ceiling Price Strike Price Basis
  Premium Commission
• At maturity
• If futures lt strike, then Net Price Cash
  Premium Commission
• If futures gt strike, then Net Price Ceiling
  Price

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Call Option Graph
Call Option Dec. 2010 Corn _at_ 3.90 Premium 0.38
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Combination Strategies

• Option fence
• Buy put and sell call
• Higher floor, but you now have a ceiling
• Put spread
• Buy At-the-money put and sell Out-of-the-money
  put
• Higher middle and higher prices, but no floor
  below Out-of-the-money strike price

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Fence
Buy Put Option Dec. 2010 Corn _at_ 3.40 Premium
0.18
Sell Call Option Dec. 2010 Corn _at_ 4.40 Premium
0.23
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Summary on Options

• Buyer
• Pays premium, has limited risk and unlimited
  potential
• Seller
• Receives premium, has limited potential and
  unlimited risk
• Buying puts
• Establish minimum prices
• Buying calls
• Establish maximum prices

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Class web sitehttp//www.econ.iastate.edu/classe
s/econ339/hart-lawrence/