SUMMER INTERNSHIP (MAY-JULY2009)
A PROJECT REPORT ON
Hedging Agricultural Commodities with Futures
SUBMITTED Page 1 of 56
BY Av !a" D#$e% ROLL NO&2' (M&M&S& II)
Table of Contents S.no. Particulars. 1. 2. 3. 4. &. +. Company Overview Dynamics of Potato storage a!or mar"ets Problems face$ by commercial col$ storages Derievatives' Definition()ariants(*orwar$s(*utures. ,e$ging' -ntro$uction(Corporate ,e$ging Process( .gri. commo$ity ,e$ging. /. #. ,ow ,e$ging can 0elp Col$ Storages1ware0ousing in$ustry2 Tentative ,e$ging strategy for Col$ Storages1ware0ousing in$ustry2
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Pg no. 3 4 # 1% 11 2%
23 3%
3. 1%.
Conclusion 4ibliograp0y
32 33
Company Overview'
S 5 .gro Pro$ucts'
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SMJ Agro Products was formed in 1996 with the purpose of providing Cold Storage facility for the potato farmers of the region. he company is also engaged in Potato farming on its own and contract farming of potatoes. he company has a cold storage at !anau"i #$ttar Pradesh% with a storage capacity of &'''' metric tonnes.Modus (perandi) Post *arvest+ the farmers ,ring their potato produce to the cold storage for storing intending to sell it at higher rates in the offseason. -armers are given loans against the potato they store in the cold storage. .uring off season/ as the prices go north/ the farmers pay the loan with interest and also the storage costs per pac0et #1' 0g% and get their produce unloaded for selling it off in the near,y Mar0ets #minds%. he company is also engaged in trading Potato where,y the farmers sell off their produce to the cold storage and the company sells the potatoes in whole sale mar0ets of $P and 2ihar #through commission agents%. he earnings of the company are dependent on the prices of potato in the mar0et and there is a su,stantial ris0 involved which results in high varia,ility in the earnings.
Dynamics of Potato Storage'
STO6.789
3t has ,een noticed that over the years/ production of potato has increased manifold which led to glut situation in the mar0et. he practice of storage helps to sta,ili4e the prices in the mar0et. Storing potatoes for longer period in normal temperature is not possi,le as it is a living material and through respiration/ the changes occurs due to heat/ resulting in loss of dry matter and
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ultimate deterioration of 5uality of tu,ers. At optimum condition/ the 5uality of potatoes remains good in storage for 6)1 wee0s. potatoes are as follows7 he ,est temperature and humidity condition for storage of
Sprouting in stored potato is always a serious pro,lem. o avoid sprout inhi,ition/ suppressant li0e 3sopropyl 8)Chloroprene Car,onate #CP3C%/ 8C2/ and M* are used. he irradiation
process has also ,een found effective for sprout inhi,ition. he condition and health of the tu,er while in storage is important coupled with good management during storage also plays an important role.
4enefits9
i% Minimum losses occurred due to tu,er rotting disease. ii% Preserve appearance ,y inhi,iting development of surface ,lemishes. iii% Minimi4e moisture loss and softening. iv% Minimi4e losses during sprouting. v% Prevent damages. vi% Colour 9oss.
Storage Structures9
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-2 Tra$itional Storage9
a2 -n situ storage9 3n this system/ farmers do not harvest the tu,ers and allow it to remain in soil. his method is used for short term storage of &)6 months only in upland and lowland areas of 8orth eastern states b2 ,eap storage9 3n this method/ potatoes are heaped under the shade of trees/ where 6)6' tonnes of potatoes can ,e stored. he heaps are covered with a layer of availa,le straw material #a,out 6'cm thic0%. his is a popular storage method practiced in $.P/ Maharashtra and !arnata0a. c2 Pit storage9 his is a traditional method of storage. 3n this storage system/ two types of pits are prepared i.e. 0etches and puc0 pits. !etches pit is rectangular in shape measures :.1 met. #9ength% ; 6.6 met. #<idth% ; 1: met.#depth%: whereas puce pit is normally circular in shape with a diameter of a,out :.& met. All the pits are covered with '.6 met. thic0 availa,le straw material #wheat/ paddy%. 3t is a popular storage method in Madhya Pradesh. $2 ;oo$en storage structure9 3n this system/ small wooden rooms li0e stores a,out 1' ft. heights are ,uilt in the field or near residential area. he walls of the store are ,uilt ,y hori4ontally fi;ed overlapping wooden plan0s which help in preventing seepage in store and running off the rain water. he roof of the store is covered with tin sheet and a gap is left ,etween roof and wall for aeration purpose. e2 Storage in rooms9
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3n this method/ farmers used to store potatoes in small rooms ,uilt of ,ric0 = stones = cement at the ground floor of their residence. he potatoes are stored in this storage either in heaps/ gunny ,ags or in ,am,oo ,as0ets. f2 Storage in bas"ets9 3n 8orth >astern states/ potatoes are stored in ,am,oo ,as0ets 0nown as ?polo@ which provides ,etter aeration to the tu,ers. he ,as0ets are made of different si4es. he smallest si4e holds 1' )1& 0egs and the largest si4e one 5uintal potatoes. Smaller ,as0ets are suita,le for use as they are convenient to carry to the fields. g2 Storage in layers9 he method is not very common ,ut popular where platforms of ,am,oo or wooden plan0s are constructed ,y the support of the store wall on one side and ,am,oo on the other side. 3t provides ,etter space utili4ation and helps to minimi4e rotting of potato.
ii2 -mprove$ Storage9
a2 Storage at low temperature9 he low temperature #at &)
C and A)1'oC% is the most common method for potato storage. he following recommendations are adopted in this type of storage9 Store seed potatoes at &)C as no sprouting ta0es place at this temperature and meta,olic process goes down. 2esides/ low temperature/ sweetening is of little importance in case of seed potatoes. Store potatoes for e;port and processing purposes at A)1'oC/ will not only save a lot of energy ,ut also ma0e the potatoes more suita,le for consumption/ processing and e;port. b2 Storage at 1%'12oC9
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his storage method is suita,le for potatoes for processing and e;port.
Storage *acilities9
a2 *armer<s storage9
-armers generally use indigenous in)situ storage system of without harvesting the tu,ers and to allow them remaining in the soil and also the e
situ system where the farmers used to store potatoes in pits/ ,as0ets/ wooden structures or in heaps or layers in room.
b2 Private = Co'operative = Public Storage9
3n Private = Co)operative = Pu,lic Storage sectors/ potatoes are stored in cold storages at low temperature situated throughout the country. he state)wise distri,utions of Potato cold storage in a,ove sectors are furnished on the ne;t page)
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a!or
ar"ets'
.ssembling9
Assem,ling is the first step in mar0eting of farm produce. 3t involves collection of small surpluses from num,er of small farms scattered over large areas and ,ul0ing the same for su,se5uent distri,ution in volume.
he agencies engaged in the assem,ling of potato are as ,elow 9
a% Producers ,% Billage Merchants c% 3tinerant Merchants d% <holesale Merchants e% Commission Agent f% Producers Co)operative Societies
a!or' .ssembling
ar"ets 9
he ma"or assem,ling mar0ets are located in $ttar Pradesh/ Pun"a,/ <est 2engal in which the assem,ling of potato is done along with other commodities. Some ma"or assem,ling mar0ets in ma"or producing states in the country are listed ,elow7
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Problems face$ by commercial storage owners 1S 5 .gro Pro$ucts2'
1. Cut T0roat Competition'
he govt. Su,sidy on 8ew Cold storage units has resulted in a large no. (f cold storages ,eing coming up in $.P. his has made difficult to ac5uire new
customers #-armers% and to 0eep a loyal ,ase of customers in a,sence of any differentiated service.
2. )ery
0ig0 $epen$ence on Potato prices'
he production of Potato varies significantly each year. 3ncreased production results in full capacity utilisation ,ut hampers the firm when the prices dive south due to increased production. 9ower Production results in storage capacity ,eing lesser utilised. Potato prices during the unloading period may ma0e or ,rea0 the game.
3. ,ig0
)ariability in 8arnings over t0e years'
<ith the production=price of potato/ the earnings of the firm vary highly/ which is not good as it reduces the ,orrowing capacity of the firm. 3t also results in the company paying somewhat higher ta;es due to progressive ta; scales.
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4. ,ig0 $egree of in0erent business ris"'
he very nature of the cold storage ,usiness is ris0y. he ,usiness is very concentrated which increases the ris0 even more.Also wor0ing in a total rural setup pose numerous challenges. .s can be clearly seen( t0e main nee$ is to re$uce t0e level of ris" arising out of e>posure to Potato. 4ut ,ow Do we $o t0at?? ,ow can ris" be better manage$??
Derivatives may be t0e way.
-@T6ODACT-O@ TO D86-).T-)8S
he emergence of the mar0et for derivative products/ most nota,ly forwards/ futures and options/ can ,e traced ,ac0 to the willingness of ris0)averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. 2y their very nature/ the financial mar0ets are mar0ed ,y a very high degree of volatility. hrough the use of derivative products/ it is
possi,le to partially or fully transfer price ris0s ,y loc0ing)in asset prices. As instruments of ris0
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management/ these generally do not influence the fluctuations in the underlying asset prices. *owever/ ,y loc0ing in asset prices/ derivative products minimi4e the impact of fluctuations in asset prices on the profita,ility and cash flow situation of ris0)averse investors.
D86-).T-)8S D8*-@8D
.erivative is a product whose value is derived from the value of one or more ,asic varia,les/ called ,ases #underlying asset/ inde;/ or reference rate%/ in a contractual manner. he underlying asset can ,e e5uity/ fore;/ commodity or any other asset. -or e;ample/ wheat farmers may wish to sell their harvest at a future date to eliminate the ris0 of a change in prices ,y that date. Such a transaction is an e;ample of a derivative. he price of this derivative is driven ,y the spot price of wheat which is the CunderlyingC. 3n the 3ndian conte;t the Securities Contracts #Degulation% Act/ 1916 #SC#D%A% defines CderivativeC to include) 1. A security derived from a de,t instrument/ share/ loan whether secured or unsecured/ ris0 instrument or contract for differences or any other form of security. &. A contract which derives its value from the prices/ or inde; of prices/ of underlying securities. .erivatives are securities under the SC#D%A and hence the trading of derivatives is governed ,y the regulatory framewor0 under the SC#D%A. Producers of agricultural commodities regularly face price and production ris0. -urthermore/ increased glo,al free trade and changes in domestic agricultural policy have increased these Page 15 of 56
ris0s. As the varia,ility of price and production increases/ producers are reali4ing the importance of ris0 management as a component of their management strategies. (ne means of reducing these ris0s is through the use of the commodity futures e;change mar0ets. 9i0e the use of car insurance to hedge the potential costs of a car accident/ agricultural producers can use the commodity futures mar0ets to hedge the potential costs of commodity price volatility. he primary o,"ective of hedging is not to ma0e money ,ut rather to minimi4e price ris0/ and this includes using hedging to minimi4e losses.
D86-).T-)8 P6ODACTS
.erivative contracts have several variants.
he most common variants are forwards/ futures/
options and swaps. <e ta0e a ,rief loo0 at various derivatives contracts that have come to ,e used.
*orwar$s9 A forward contract is a customi4ed contract ,etween two entities/ where settlement ta0es place on a specific date in the future at todayEs pre)agreed price.
*utures9 A futures contract is an agreement ,etween two parties to ,uy or sell an asset at a certain time in the future at a certain price. -utures contracts are special types of forward contracts in the sense that the former are standardi4ed e;change)traded contracts.
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Options9 (ptions are of two types ) calls and puts. Calls give the ,uyer the right ,ut not the o,ligation to ,uy a given 5uantity of the underlying asset/ at a given price on or ,efore a given future date. Puts give the ,uyer the right/ ,ut not the o,ligation to sell a given 5uantity of the underlying asset at a given price on or ,efore a given date.
;arrants9 (ptions generally have lives of upto one year/ the ma"ority of options traded on options e;changes having a ma;imum maturity of nine months. 9onger)dated options are called warrants and are generally traded over)the)counter.
B8.PS9
he acronym 9>APS means 9ong) erm >5uity Anticipation Securities. hese are
options having a maturity of upto three years.
4as"ets9 2as0et options are options on portfolios of underlying assets. he underlying asset is usually a moving average of a ,as0et of assets. >5uity inde; options are a form of ,as0et options.
Swaps9 Swaps are private agreements ,etween two parties to e;change cash flows in the future according to a prearranged formula. hey can ,e regarded as portfolios of forward contracts.
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Swaptions9 Swaptions are options to ,uy or sell a swap that will ,ecome operative at the e;piry of the options. hus a swaption is an option on a forward swap. Dather than have calls and puts/ the swaptions mar0et has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fi;ed and pay floating.
-@T6ODACT-O@ TO *O6;.6DS
3n recent years/ derivatives have ,ecome increasingly important in the field of finance. <hile futures and options are now actively traded on many e;changes/ forward contracts are popular on the ( C mar0et.
*O6;.6D [email protected]
A forward contract is an agreement to ,uy or sell an asset on a specified date for a specified price. (ne of the parties to the contract assumes a long position and agrees to ,uy the underlying asset on a certain specified future date for a certain specified pric e. he other party assumes a short position and agrees to sell the asset on the same date for the same price. (ther contract details li0e delivery date/ price and 5uantity are negotiated ,ilaterally ,y the parties to the contract. he forward contracts are normally traded outside the e;changes.
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T0e salient features of forwar$ contracts are9
F hey are ,ilateral contracts and hence e;posed to counter)party ris0.
F >ach contract is custom designed/ and hence is uni5ue in terms of contract si4e/ e;piration date and the asset type and 5uality.
F he contract price is generally not availa,le in pu,lic domain.
F (n the e;piration date/ the contract has to ,e settled ,y delivery of the asset.
F 3f the party wishes to reverse the contract/ it has to compulsorily go to the same counter)party/ which often results in high prices ,eing charged.
*owever forward contracts in certain mar0ets have ,ecome very standardi4ed/ as in the case of foreign e;change/ there,y reducing transaction costs and increasing transactions volume. his process of standardi4ation reaches its limit in the organi4ed futures mar0et.
-orward contracts are very useful in hedging and speculation. he classic hedging application would ,e that of an e;porter who e;pects to receive payment in dollars three months later. *e is e;posed to the ris0 of e;change rate fluctuations. 2y using the currency forward mar0et to sell
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dollars forward/ he can loc0 on to a rate today and reduce his uncertainty. Similarly an importer who is re5uired to ma0e a payment in dollars two months hence can reduce his e;posure to e;change rate fluctuations ,y ,uying dollars forward.
-@T6ODACT-O@ TO *ATA68S
-utures mar0ets were designed to solve the pro,lems that e;ist in forward mar0ets. A futures contract is an agreement ,etween two parties to ,uy or sell an asset at a certain time in the future at a certain price. 2ut unli0e forward contracts/ the futures contracts are standardi4ed and e;change traded. o facilitate li5uidity in the futures contracts/ the e;change specifies certain standard features of the contract. 3t is a standardi4ed contract with standard underlying instrument/ a standard 5uantity and 5uality of the underlying instrument that can ,e delivered/ #or which can ,e used for reference purposes in settlement% and a standard timing of such settlement. A futures contract may ,e offset prior to maturity ,y entering into an e5ual and opposite transaction. More than 99G of futures transactions are offset this way.
T0e stan$ar$iCe$ items in a futures contract are9
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1. Huantity of the underlying &. Huality of the underlying 6. :. he date and the month of delivery he units of price 5uotation and minimum price change
1. 9ocation of settlement
8>ample'
POT.TO *ATA68S [email protected] SP8C-*-C.T-O@S.
1-2 @[email protected] CO
OD-TD .@D D86-).T-)8 8EC,.@78 1@CD8E2 9
Type of contract 9 -utures Contract Specifications
@ame of commo$ity 9 Potatoes -air Average Huality
Tic"er symbol 9 P( -AH.>9
Tra$ing system 9 8C.>I rading System
4asis 9 >warehouse .elhi gross weight inclusive of all local ta;es and levies.
Anit of tra$ing 9 11 M
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Delivery unit 9 11 M pac0ed in "ute ,ags of 11 0gs gross weight ,asis with tare weight of the ,ags
,eing minimum 61' gms.
Fuotation= 4ase value 9 Ds per 5uintal
Tic" SiCe 9 1' paisa Fuality Specification 9 .ull/ S0in ,lemishes/ Cut / Crac0 #cut and crac0ed not e;ceeding 6G ma;%/ Sprouted #Sprouted content not e;ceeding 1G ma; and Sprout length more than & mm only to ,e considered as Sprouted%/ 2lac0 scars and Jreen Potatoes Soil #0gs per ,ag%. he potatoes should ,e firm and the s0in should ,e mature and thic0.
Fuantity )ariation 9 K=)1'G
Delivery Center 9 .elhi
.$$itional $elivery centres 9 Agra/ *apur and Jalandhar #-or all the centers up to the radius of 1' 0ms from the municipal limits%
,ours of Tra$ing 9
on$ays t0roug0 *ri$ay ) 1'7'' AM to 17'' PM Satur$ays ) 1'.'' AM to &.'' PM
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Delivery specification 9 $pon e;piry of the contract/ all outstanding open positions would result in compulsory delivery. A penalty of minimum 1G #of final settlement price% would ,e imposed on longs and=or shorts on failure of delivery o,ligation.
Delivery Bogic 9 Compulsory .elivery.
Opening of contracts 9 rading in a new month contract will open on the 1'th day of the month in which the near month contract is due to e;pire. 3f the 1'th day happens to ,e a non)trading day/ contracts would open on the ne;t trading day.
Due $ate=8>piry $ate 9 &'th day of the delivery month. 3f &'th happens to ,e a holiday+ a Saturday or a Sunday then the due date shall ,e the immediately preceding trading day of the >;change/ which is not a Saturday .
--2
ulti Commo$ity 8>c0ange of -n$ia Bimite$ 1 CE2 9
Decogni4ed ,y the central government started the online trading of potatoes from Septem,er 16/ &''6. he potatoes are sold under the ,rand name Tarakeswar Alu though the crop would ,e procured from *ooghly #where ara0eshwar is located% as well as 2urdwan/ *owrah and other districts of the <est 2engal. he ara0eshwar ,rand potato is popular for !ufri Jyoti variety grown in <est 2engal. (nline trading ,rings parity in prices across the country and ,enefit ,oth for the farmers and the traders. According to a study ,y MCI/ there is scope for a ,ig turnover in potato trade annually. he !ufri Jyoti variety is produced in a,undance and hence/ it chosen for
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online sale. MCI is a "oint venture of the -inancial echnologies #3% 9td./ State 2an0 of 3ndia and its associates/ 8ational 2an0 for Agriculture and Dural .evelopment #8A2AD.%/ 8ational Stoc0 >;change of 3ndia 9td. #8S>%/ -id -und #Mauritius% 9td. >tc.
*ATA68S T86 -@OBO7D
Spot price: he price at which an asset trades in the spot mar0et.
Futures price: he price at which the futures contract trades in the futures mar0et.
Contract cycle: he period over which a contract trades. he inde; futures contracts on the 8S> have one) month/ two)months and three months e;piry cycles which e;pire on the last hursday of the month. hus a January e;piration contract e;pires on the last hursday of January and a -e,ruary e;piration contract ceases trading on the last following the last trading. hursday of -e,ruary. (n the -riday
hursday/ a new contract having a three) month e;piry is introduced for
Expiry date: 3t is the date specified in the futures contract. contract will ,e traded/ at the end of which it will cease to e;ist.
his is the last day on which the
Contract size: he amount of asset that has to ,e delivered under one contract. .lso calle$ as lot siCe.
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Basis: 3n the conte;t of financial futures/ ,asis can ,e defined as the futures price minus the spot price. here will ,e a different ,asis for each delivery month for each contract. 3n a normal
mar0et/ ,asis will ,e positive. his reflects that futures prices normally e;ceed spot prices.
Cost of carry:
he relationship ,etween futures prices and spot prices can ,e summari4ed in
terms of what is 0nown as the cost of carry. his measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
Initial margin: he amount that must ,e deposited in the margin account at the time a futures contract is first entered into is 0nown as initial margin.
arking!to!market: 3n the futures mar0et/ at the end of each trading day/ the margin account is ad"usted to reflect the investorEs gain or loss depending upon the futures closing price. his is called mar0ing)to)mar0et.
aintenance margin: his is somewhat lower than the initial margin. his is set to ensure that the ,alance in the margin account never ,ecomes negative. 3f the ,alance in the margin account falls ,elow the maintenance margin/ the investor receives a margin call and is e;pected to top up the margin account to the initial margin level ,efore trading commences on the ne;t day.
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*ATA68S P.DO**S
-utures contracts have linear payoffs. 3n simple words/ it means that the losses as well as profits for the ,uyer and the seller of a futures contract are unlimited. hese linear payoffs are
fascinating as they can ,e com,ined with options and the underlying to generate various comple; payoffs.
Payoff for buyer of futures9 Bong futures
he payoff for a person who ,uys a futures contract is similar to the payoff for a person who holds an asset. *e has a potentially unlimited upside as well as a potentially unlimited downside. a0e the case of a speculator who ,uys a two month 8ifty inde; futures contract when the 8ifty stands at &&&'. he underlying asset in this case is the 8ifty portfolio. <hen the inde; moves up/ the long futures position starts ma0ing profits/ and when the inde; moves down it starts ma0ing losses.
Payoff for a buyer of @ifty futures
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he figure shows the profits=losses for a long futures position. he investor ,ought futures when the inde; was at &&&'. 3f the inde; goes up/ his futures position starts ma0ing profit. 3f the inde; falls/ his futures position starts showing losses.
Payoff for seller of futures9 S0ort futures
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he payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. *e has a potentially unlimited upside as well as a potentially unlimited downside. a0e the case of a speculator who sells a two)month 8ifty inde; futures contract when the 8ifty stands at &&&'. he underlying asset in this case is the 8ifty portfolio. <hen the inde; moves down/ the short futures position starts ma0ing profits/ and when the inde; moves up/ it starts ma0ing losses. -igure :.& shows the payoff diagram for the seller of a futures contract.
Payoff for a seller of @ifty futures
he figure shows the profits=losses for a short futures position. he investor sold futures when the inde; was at &&&'. 3f the inde; goes down/ his futures position starts ma0ing profit. 3f the inde; rises/ his futures position starts showing losses.
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P6-C-@7 *ATA68S
Pricing of futures contract is very simple. $sing the cost)of)carry logic/ we calculate the fair value of a futures contract. >verytime the o,served price deviates from the fair value/ ar,itragers would enter into trades to capture the ar,itrage profit. his in turn would push the futures price ,ac0 to its fair value. he cost of carry model used for pricing futures is given ,elow7
where7
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rL Cost of financing #using continuously compounded interest rate%
L ime till e;piration in years
eL &.M1A&A
Distinction between futures an$ forwar$s
*utures
rade on an organi4ed e;change Standardi4ed contract terms More li5uid De5uires margin payments -ollows daily settlement
*orwar$s
( C in nature Customised contract terms 9ess li5uid 8o margin payment Settlement happens at end of period
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*edging7
3n finance/ a hedge is a position esta,lished in one mar0et in an attempt to offset e;posure to the price ris0 of an e5ual ,ut opposite o,ligation or position in another mar0et N usually/ ,ut not always/ in the conte;t of oneEs commercial activity. *edging is a strategy designed to minimi4e e;posure to such ,usiness ris0s as a sharp contraction in demand for oneEs inventory/ while still allowing the ,usiness to profit from producing and maintaining that inventory. A typical hedger might ,e a farmer with &''' acres of unharvested wheat in the ground/ who would rather tend his crop without the distraction of uncertain prices. *eEs a farmer/ not a speculator/ yet his unharvested CinventoryC may have lost 61G of its value #O&A1/'''% in the three months heEs ,een planning his planting. *e might have decided he could live with a price of only eight or nine dollars a ,ushel/ and to offset his planted position with an appro;imately e5ual ,ut opposite position in the mar0et for wheat on the Minneapolis Jrain >;change ,y selling ten wheat futures contracts for .ecem,er delivery. his farmer is there,y a hedger indifferent to the movements of the mar0et as a whole/ and has reduced his price ris0 to the difference ,etween the price he will receive from a local ,uyer at harvest time/ and the price at which he will simultaneously li5uidate his o,ligation to the >;change. *ol,roo0 <or0ing/ a pioneer in hedging theory/ called this strategy Cspeculation in the ,asis/CP1Q where the ,asis is the difference ,etween todayEs mar0et value of #in this e;ample% wheat and todayEs value of the hedge. 3f that difference widens/ he earns a little more at harvest time. 3f that difference narrows/ he earns a little less. *e has mitigated/ ,ut not eliminated/ the ris0 of losing the value of his wheat as of the day he esta,lished his hedge.
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Some form of ris0 ta0ing is inherent to any ,usiness activity. Some ris0s are considered to ,e CnaturalC to specific ,usinesses/ such as the ris0 of oil prices increasing or decreasing is natural to oil drilling and refining firms. (ther forms of ris0 are not wanted/ ,ut cannot ,e avoided without hedging. Someone who has a shop/ for e;ample/ e;pects to face natural ris0s such as the ris0 of competition/ of poor or unpopular products/ and so on. he ris0 of the shop0eeperEs
inventory ,eing destroyed ,y fire is unwanted/ however/ and can ,e hedged via a fire insurance contract. 8ot all hedges are financial instruments7 a producer that e;ports to another country/ for e;ample/ may hedge its currency ris0 when selling ,y lin0ing its e;penses to the desired currency. 2an0s and other financial institutions use hedging to control their asset)lia,ility mismatches/ such as the maturity matches ,etween long/ fi;ed)rate loans and short)term #implicitly varia,le)rate% deposits. A hedger #such as a manufacturing company% is thus distinguished from an ar,itrageur or speculator #such as a ,an0 or ,ro0erage firm% in derivative purchase ,ehavior.
T0e Corporate ,e$ging Process
T,8 ,8D7-@7 D8C-S-O@
he issue of whether or not to hedge ris0 continues to ,affle many corporations. At the heart of the confusion are misconceptions a,out ris0/ concerns a,out the cost of hedging/ and fears a,out reporting a loss on derivative transactions. A lac0 of familiarity with hedging tools and strategies Page 32 of 56
compounds this confusion. Corporate ris0 managers also face the difficult challenge of getting hedging tools #i.e./ derivatives% approved ,y the companyEs ,oard of directors. he purpose of this article is to clarify ,oth some of the ,asic misconceptions surrounding the issue of ris0 as well as the tools and strategies used to manage it. T,8 C,.BB8@78 An effective hedging program does not attempt to eliminate all ris0. Dather/ it attempts to transform unaccepta,le ris0s into an accepta,le form. he 0ey challenge for the corporate ris0 manager is to determine the ris0s the company is willing to ,ear and the ones it wishes to transform ,y hedging. he goal of any hedging program should ,e to help the corporation achieve the optimal ris0 profile that ,alances the ,enefits of protection against the costs of hedging.
ST8P 19 -D8@T-*D T,8 6-SGS 2efore management can ,egin to ma0e any decisions a,out hedging/ it must first identify all of the ris0s to which the corporation is e;posed. hese ris0s will generally fall into two categories7 operating ris0 and financial ris0. -or most non)financial organi4ations/ operating ris0 is the ris0 associated with manufacturing and mar0eting activities. A computer manufacturer/ for e;ample/ is e;posed to the operating ris0 that a competitor will introduce a technologically superior product which ta0es mar0et share away from its leading model. 3n general/ operating ris0s cannot ,e hedged ,ecause they are not traded.
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he second type of ris0/ financial ris0/ is the ris0 a corporation faces due to its e;posure to mar0et factors such as interest rates/ foreign e;change rates and commodity and stoc0 prices. -inancial ris0s/ for the most part/ can ,e hedged due to the e;istence of large/ efficient mar0ets through which these ris0s can ,e transferred. 3n determining which ris0s to hedge/ the ris0 manager needs to distinguish ,etween the ris0s the company is paid to ta0e and the ones it is not. Most companies will find they are rewarded for ta0ing ris0s associated with their primary ,usiness activities such as product development/ manufacturing and mar0eting. -or e;ample/ a computer manufacturer will ,e rewarded #i.e./ its stoc0 price will appreciate% if it develops a technologically superior product or for implementing a successful mar0eting strategy. Most corporations/ however/ will find they are not rewarded for ta0ing ris0s which are not central to their ,asic ,usiness #i.e./ interest rate/ e;change rate/ and commodity price ris0%. he computer manufacturer in the previous e;ample is unli0ely to see its stoc0 price appreciate "ust ,ecause it made a successful ,et on the dollar=yen e;change rate. Another critical factor to consider when determining which ris0s to hedge is the materiality of the potential loss that might occur if the e;posure is not hedged. As noted previously/ a corporationEs optimal ris0 profile ,alances the ,enefits of protection against the costs of hedging. $nless the potential loss is material #i.e./ large enough to severely impact the corporationEs earnings% the ,enefits of hedging may not outweigh the costs/ and the corporation may ,e ,etter off not hedging.
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ST8P 29 D-ST-@7A-S, 48T;88@ ,8D7-@7 .@D SP8CAB.T-@7 (ne reason corporate ris0 managers are sometimes reluctant to hedge is ,ecause they associate the use of hedging tools with speculation. hey ,elieve hedging with derivatives introduces additional ris0. 3n reality/ the opposite is true. A properly constructed hedge always lowers ris0. 3t is ,y choosing not to hedge that managers regularly e;pose their companies to additional ris0s. -inancial ris0s ) regardless of whether or not they are managed ) e;ist in every ,usiness. he manager who opts not to hedge is ,etting that the mar0ets will either remain static or move in his favor. -or e;ample/ a $.S. computer manufacturer with -rench franc receiva,les that decides to not hedge its e;posure to the -rench franc is speculating that the value of the -rench franc relative to the $.S. dollar will either remain sta,le or appreciate. 3n the process/ the manufacturer is leaving itself e;posed to the ris0 that the -rench franc will depreciate relative to the $.S. dollar and hurt the companyEs revenues. A reason some managers choose not to hedge/ there,y e;posing their companies to additional ris0/ is that not hedging often goes unnoticed ,y the companyEs ,oard of directors. Conversely/ hedging strategies designed to reduce ris0 often receive a great deal of scrutiny. Corporate ris0 managers who wish to use hedging techni5ues to improve their companyEs ris0 profile must educate their ,oard of directors a,out the ris0s the company is naturally e;posed to when it does not hedge.
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ST8P 39 8).BA.T8 T,8 COSTS O* ,8D7-@7 -@ B-7,T O* T,8 COSTS O* @OT ,8D7-@7 he cost of hedging can sometimes ma0e ris0 managers reluctant to hedge. Admittedly/ some hedging strategies do cost money. 2ut consider the alternative. o accurately evaluate the cost of hedging/ the ris0 manager must consider it in light of the implicit cost of not hedging. 3n most cases/ this implicit cost is the potential loss the company stands to suffer if mar0et factors/ such as interest rates or e;change rates/ move in an adverse direction. 3n such cases the cost of hedging must ,e evaluated in the same manner as the cost of an insurance policy/ that is/ relative to the potential loss. 3n other cases/ derivative transactions are su,stitutes for implementing a financing strategy using a traditional method. -or e;ample/ a corporation may com,ine a floating)rate ,an0 ,orrowing with a floating)to)fi;ed)rate swap as an alternative to issuing fi;ed)rate de,t. Similarly/ a manufacturer may com,ine the spot purchase of a commodity with a floating)to)fi;ed swap instead of ,uying the commodity and storing it. 3n most cases where derivative strategies are used as su,stitutes for traditional transactions/ it is ,ecause they are cheaper. .erivatives tend to ,e cheaper ,ecause of the lower transaction costs that e;ist in highly li5uid forward and options mar0ets.
ST8P 49 AS8 T,8 6-7,T P86*O6 .@C8
8.SA6-@7 ST-CG TO 8).BA.T8 ,8D78
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Another reason for not hedging often cited ,y corporate ris0 managers is the fear of reporting a loss on a derivative transaction. his fear reflects widespread confusion over the proper ,enchmar0 to use in evaluating the performance of a hedge. he 0ey to properly evaluating the performance of all derivative transactions/ including hedges/ lies in esta,lishing appropriate goals at the onset. As noted previously/ many derivative transactions are su,stitutes for traditional transactions. A fi;ed)rate swap/ for e;ample/ is a su,stitute for the issuance of a fi;ed)rate ,ond. Degardless of mar0et conditions/ the swapEs cash flows will mirror the ,ondEs. hus/ any money lost on the swap would have ,een lost if the corporation had issued a ,ond instead. (nly if the swapEs performance is evaluated in light of managementEs original o,"ective #i.e./ to duplicate the cash flows of the ,ond% will it ,ecome clear whether or not the swap was successful.
ST8P &9 DO@HT 4.S8 DOA6 ,8D78 P6O76.
O@ DOA6
.6G8T )-8;
Many corporate ris0 managers attempt to construct hedges on the ,asis of their outloo0 for interest rates/ e;change rates or some other mar0et factor. *owever/ the ,est hedging decisions are made when ris0 managers ac0nowledge that mar0et movements are unpredicta,le. A hedge
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should always see0 to minimi4e ris0. 3t should not represent a gam,le on the direction of mar0et prices.
ST8P +9 A@D86ST.@D DOA6 ,8D7-@7 TOOBS A final factor that deters many corporate ris0 managers from hedging is a lac0 of familiarity with derivative products. Some managers view derivatives as instruments that are too comple; to understand. he fact is that most derivative solutions are constructed from two ,asic instruments7 forwards and options/ which comprise the following ,asic ,uilding ,loc0s7 -orwards ) Swaps ) -utures ) -DAs ) 9oc0s (ptions ) Caps ) -loors ) Puts ) Calls ) Swaptions he manager who understands these will ,e a,le to understand more comple; structures which are simply com,inations of the two ,asic instruments.
ST8P /9 8ST.4B-S, . SDST8
O* CO@T6OBS
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As is true of all other financial activities/ a hedging program re5uires a system of internal policies/ procedures and controls to ensure that it is used properly. he system/ often documented in a hedging policy/ esta,lishes/ among other things/ the names of the managers who are authori4ed to enter into hedges+ the managers who must approve trades+ and the managers who must receive trade confirmations. he hedging policy may also define the purposes for which hedges can and cannot ,e used. -or e;ample/ it might state that the corporation uses hedges to reduce ris0/ ,ut it does not enter into hedges for trading purposes. 3t may also set limits on the notional value of hedges that may ,e outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the companyEs ,oard of directors are aware of the hedging activities used ,y the corporationEs ris0 managers and that all ris0s are properly accounted for and managed.
8>ample 0e$ge
A stoc0 trader ,elieves that the stoc0 price of Company A will rise over the ne;t month/ due to the companyEs new and efficient method of producing widgets. *e wants to ,uy Company A shares to profit from their e;pected price increase. 2ut Company A is part of the highly volatile widget industry. 3f the trader simply ,ought the shares ,ased on his ,elief that the Company A shares were underpriced/ the trade would ,e a speculation. Since the trader is interested in the company/ rather than the industry/ he wants to hedge out the industry ris0 ,y short selling an e5ual value #num,er of shares R price% of the shares of Company AEs direct competitor/ Company 2. 3f the trader was a,le to short sell an asset whose price had a
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mathematically defined relation with Company AEs stoc0 price #for e;ample a call option on Company A shares% the trade might ,e essentially ris0less. 2ut in this case/ the ris0 is lessened ,ut not removed. he first day the traderEs portfolio is7
• •
9ong 1''' shares of Company A at O1 each Short 1'' shares of Company 2 at O& each
#8otice that the trader has sold short the same value of shares.% (n the second day/ a favora,le news story a,out the widgets industry is pu,lished and the value of all widgets stoc0 goes up. Company A/ however/ ,ecause it is a stronger company/ goes up ,y 1'G/ while Company 2 goes up ,y "ust 1G7
• •
9ong 1''' shares of Company A at O1.1' each7 O1'' gain Short 1'' shares of Company 2 at O&.1' each7 O1' loss
#3n a short position/ the investor loses money when the price goes up.% he trader might regret the hedge on day two/ since it reduced the profits on the Company A position. 2ut on the third day/ an unfavora,le news story is pu,lished a,out the health effects of widgets/ and all widgets stoc0s crash7 1'G is wiped off the value of the widgets industry in the course of a few hours. 8evertheless/ since Company A is the ,etter company/ it suffers less than Company 27 Balue of long position #Company A%7
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• •
.ay 17 O1''' .ay &7 O11'' .ay 67 O11' LS #O1''' T O11'% L O:1' loss
•
Balue of short position #Company 2%7
• •
.ay 17 )O1''' .ay &7 )O1'1' .ay 67 )O1&1 LS #O1''' T O1&1% L O:M1 profit
•
<ithout the hedge/ the trader would have to lost O:1' #or O9'' if the trader too0 the O1''' he has used in short selling Company 2Es shares to ,uy Company AEs shares as well%. 2ut the hedge ) the short sale of Company 2 ) gives a profit of O:M1/ for a net profit of O&1 during a dramatic mar0et collapse.
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.gri'Commo$ity ,e$ging
Price ris0 for agricultural commodities can occur for a num,er of reasons/ including drought/ near record production/ an increase in demand or decreased international production. he
commodity futures mar0ets provide a means to transfer ris0 ,etween persons holding the
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physical commodity #hedgers% and other hedgers or persons speculating in the mar0et. -utures e;changes e;ist and are successful ,ased on the principle that hedgers may forgo some profit potential in e;change for less ris0 and that speculators will have access to increased profit potential from assuming this ris0. *or e>ample( suppose a person wor"s on commission an$ receives I2(%%%( I#(%%%( I&(%%%( an$ I13(%%% in salary for four consecutive mont0s for an average salary of I/(%%% per mont0 over t0is perio$. @ow suppose t0e person coul$ accept a salarie$ position for a stea$y I+(%%% a mont0. -f t0e person prefers less income variability( 0e or s0e woul$ pay for t0e $ecrease$ variability an$ accept t0e pay cut( on average( of I1(%%% per mont0. .lternatively( t0e employer woul$ reJuire t0e I1(%%% per mont0 to offset t0e ris" 0e or s0e now assumes from t0e person not being motivate$ to sell more. his concept applies to hedging in that hedgers might ,e willing to give up some revenue for a 0nown price/ and speculators would re5uire the opportunity for more revenue ,y assuming the price ris0.
,8D78 8>ample
In
8ovem,er a farmer plants 1%% acres of w0eat. At this time/ he notices that he can sell a
portion of his wheat production through the futures mar"et at 6s 11(34% a ton #let us say/ the March e;piry contract%. ,is cost of pro$uction is 6s #(%%% a ton. he farmer decides to sell his
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e;pected production at the currently availa,le futures price and ris0 only half his production to the price uncertainties of the future.
his is an e;ample of hedging ,y the producer and involves selling the commodity at the commodity e;change mar0et ,ecause pro$ucers want to loc" in a price. T0e farmer sells a futures contract for 0is w0eat and the li0ely ,uyers are either speculators or ,uying hedgers #processors/ large physical traders/ etc./ who are loo0ing to loc0 in a price for the grain they are forward contracting% are simultaneously ,uying the contracts.
T0ree t0ings can 0appen after t0is sale.
T0e futures price goes 0ig0er...
he futures and cash price of wheat in March goes up to Ds 1&/''' a ton when the farmer is ready to harvest the crop. he farmer s5uares up his transactions in the futures mar0et ,y ,uying ,ac0 and sells the entire production in the cash mar0et at 1&/''' a ton. 3n the futures mar0et he loses 66' a ton #futures s5uare off% and in the physical mar0et for his total production he gains :/''' a ton. (n ,alance he ma0es 6/6:' per ton
T0e futures price goes lower...
he futures and cash price of wheat in March goes down to Ds 9/''' a ton when the farmer is ready to harvest the crop. he farmer s5uares up his transactions in the futures mar0et ,y ,uying
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,ac0 and sells the entire production in the cash mar0et at 9/''' a ton. . 3n the futures mar0et he ma0es &/6:' a ton #futures s5uare off% and in the physical mar0et for his total production he gains 1/''' a ton. (n ,alance he ma0es 6/6:' per ton
T0e futures price $oesnHt c0ange...
he futures and cash price of wheat in March remain at Ds 11/6:' a ton when the farmer is ready to harvest the crop. he farmer s5uares up his transactions in the futures mar0et ,y ,uying ,ac0 and sells the entire production in the cash mar0et at 11/6:' a ton. . 3n the futures mar0et he ma0es ' #futures s5uare off% and in the physical mar0et for his total production he gains 6/6:' a ton. (n ,alance he ma0es 6/6:' per ton
3n all of these scenarios the farmer ma0es e;actly the same amount. hus irrespective of what happens in the future/ his profits are loc0ed in. hus the price ris0 is fully addressed.
he costs of hedging are Commissions paid to a ,ro0er for administrative costs/ futures e;change operation/ and futures e;change regulation. his can ,e termed as the cost of loc0ing in your future price.
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,ow ,e$ging can 0elp S 5 .gro Pro$ucts 1;are0ousing in$ustry2'
1. 6e$ucing t0e in0erent business ris"'
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Since the ,usiness is dependent to a very large e;tent on the prices of potato/ *edging reduces the downside ris0 on the potato stored/ acting as sort of an insurance.
2. Besser )ariability in 8arnings'
A proper hedging policy carried out over a couple of years is e;pected to result in more sta,ilised earnings with lesser variance/ which in turn lead to increased ,orrowing capacity.
3. 4etter price realisation for customers 1*armers2'
Jood hedging strategy formulation and implementation shall definetly result in ,etter price realisation for the customers #farmers%/ ,uilding a good reputation and goodwill for the ,usiness.
4. -ncrease$ profit on own pro$uce'
2etter price realisation and minimised ris0s on own produce.
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&. 8$ge in t0e competitive mar"et'
he firm can have a competitive edge ,y offering enhanced ris0 aversion to the farmers through hedging and gain customer loyalty.
Tentative ,e$ging strategy'
*ormulating ,e$ging Strategy base$ upon Cropping an$ Price pattern over t0e years'
3n 3ndia/ more than A'G of the potato crop is raised in the winter season #Da,i% under assured irrigation during short winter days from (cto,er to March. A,out AG area lies in the hills during long summer days from April to (cto,er. Dainy season #!harif% potato production is ta0en in !arnata0a/ Maharashtra/ *P/ JU! and $ttranchal.
Summer crop) March) April)))))))))))))))))))))August)Septem,er
Autumn crop) August)Septem,er))))))))))))))).ecem,er) January
Spring crop) January ) -e,ruary)))))))))))))) May)June
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Price tren$s9
Over t0e years price 0as remaine$ at t0e top $uring October '@ovember. his is ,ecause of lean season with limited availa,ility of supplies from cold storages during these months. he only source is produce from !arnata0a which is not a,le to meet the high demand. Most of the harvest starts 8ovem,er onwards. As more and more produce start arriving in the mar0et prices
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start coming down. his is evident from .ecem,er to April when price has remained lower. 2y April harvesting stops and Potato from cold storage is utili4ed and ,y (cto,er cold storage is almost empty. his trend is almost similar in all the ma"or potato mar0ets in 3ndia.
Strategy'
1. Short potato futures for (cto,er)8ovem,er e;piry/ loc0ing in a ,etter price. Balue of *edge should ,e as close to actual physical holding as possi,le.
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&. S5uare off (pen position during (cto,er)8ovem,er during lean period when the farmers start unloading Potato from the storage.#2uy in -utures Mar0et when prepared to sell in Physical Mar0et%
Conclusion'
3t is important to limit the ris0 that a ,usiness is e;posed to/ for a sustaina,le growth. A ,usiness enterprise must manage itVs ris0s prudently for long term success. *edging may ,e used for limiting the commodity ris0 that a ,usiness is e;posed to with proper analysis and research ,ac0ing each decision of the company. Proper formulation and implementation of a hedging policy can wor0 wonders for a ,usiness closely related with commodities. he company must follow itVs hedging policy 5uite strictly for a long term ,enefit.
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4ibliograp0y'
1. .ahiya/ P. S./ &''1. Potato Scenario)&''1.Agriculture oday/ 3ssue)June&''1 2. www.ncde;.com
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3. www.mc;.com 4. www.Cpri.ernet.in &. www.ficciagroindia.com +. www.agricooop.nic.in /. www.cipotato.org #. >conomics of Potato Storage7 Case Studies( !eith (. -uglie/ Paper presented at the Symposium on Potato Storage/ Processing and Mar0eting Jlo,al Conference on Potato 8ew .elhi/ .ecem,er M)9/ 1999. 3. www.!arvycomtrade.com
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doc_903143944.doc
A PROJECT REPORT ON
Hedging Agricultural Commodities with Futures
SUBMITTED Page 1 of 56
BY Av !a" D#$e% ROLL NO&2' (M&M&S& II)
Table of Contents S.no. Particulars. 1. 2. 3. 4. &. +. Company Overview Dynamics of Potato storage a!or mar"ets Problems face$ by commercial col$ storages Derievatives' Definition()ariants(*orwar$s(*utures. ,e$ging' -ntro$uction(Corporate ,e$ging Process( .gri. commo$ity ,e$ging. /. #. ,ow ,e$ging can 0elp Col$ Storages1ware0ousing in$ustry2 Tentative ,e$ging strategy for Col$ Storages1ware0ousing in$ustry2
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Pg no. 3 4 # 1% 11 2%
23 3%
3. 1%.
Conclusion 4ibliograp0y
32 33
Company Overview'
S 5 .gro Pro$ucts'
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SMJ Agro Products was formed in 1996 with the purpose of providing Cold Storage facility for the potato farmers of the region. he company is also engaged in Potato farming on its own and contract farming of potatoes. he company has a cold storage at !anau"i #$ttar Pradesh% with a storage capacity of &'''' metric tonnes.Modus (perandi) Post *arvest+ the farmers ,ring their potato produce to the cold storage for storing intending to sell it at higher rates in the offseason. -armers are given loans against the potato they store in the cold storage. .uring off season/ as the prices go north/ the farmers pay the loan with interest and also the storage costs per pac0et #1' 0g% and get their produce unloaded for selling it off in the near,y Mar0ets #minds%. he company is also engaged in trading Potato where,y the farmers sell off their produce to the cold storage and the company sells the potatoes in whole sale mar0ets of $P and 2ihar #through commission agents%. he earnings of the company are dependent on the prices of potato in the mar0et and there is a su,stantial ris0 involved which results in high varia,ility in the earnings.
Dynamics of Potato Storage'
STO6.789
3t has ,een noticed that over the years/ production of potato has increased manifold which led to glut situation in the mar0et. he practice of storage helps to sta,ili4e the prices in the mar0et. Storing potatoes for longer period in normal temperature is not possi,le as it is a living material and through respiration/ the changes occurs due to heat/ resulting in loss of dry matter and
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ultimate deterioration of 5uality of tu,ers. At optimum condition/ the 5uality of potatoes remains good in storage for 6)1 wee0s. potatoes are as follows7 he ,est temperature and humidity condition for storage of
Sprouting in stored potato is always a serious pro,lem. o avoid sprout inhi,ition/ suppressant li0e 3sopropyl 8)Chloroprene Car,onate #CP3C%/ 8C2/ and M* are used. he irradiation
process has also ,een found effective for sprout inhi,ition. he condition and health of the tu,er while in storage is important coupled with good management during storage also plays an important role.
4enefits9
i% Minimum losses occurred due to tu,er rotting disease. ii% Preserve appearance ,y inhi,iting development of surface ,lemishes. iii% Minimi4e moisture loss and softening. iv% Minimi4e losses during sprouting. v% Prevent damages. vi% Colour 9oss.
Storage Structures9
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-2 Tra$itional Storage9
a2 -n situ storage9 3n this system/ farmers do not harvest the tu,ers and allow it to remain in soil. his method is used for short term storage of &)6 months only in upland and lowland areas of 8orth eastern states b2 ,eap storage9 3n this method/ potatoes are heaped under the shade of trees/ where 6)6' tonnes of potatoes can ,e stored. he heaps are covered with a layer of availa,le straw material #a,out 6'cm thic0%. his is a popular storage method practiced in $.P/ Maharashtra and !arnata0a. c2 Pit storage9 his is a traditional method of storage. 3n this storage system/ two types of pits are prepared i.e. 0etches and puc0 pits. !etches pit is rectangular in shape measures :.1 met. #9ength% ; 6.6 met. #<idth% ; 1: met.#depth%: whereas puce pit is normally circular in shape with a diameter of a,out :.& met. All the pits are covered with '.6 met. thic0 availa,le straw material #wheat/ paddy%. 3t is a popular storage method in Madhya Pradesh. $2 ;oo$en storage structure9 3n this system/ small wooden rooms li0e stores a,out 1' ft. heights are ,uilt in the field or near residential area. he walls of the store are ,uilt ,y hori4ontally fi;ed overlapping wooden plan0s which help in preventing seepage in store and running off the rain water. he roof of the store is covered with tin sheet and a gap is left ,etween roof and wall for aeration purpose. e2 Storage in rooms9
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3n this method/ farmers used to store potatoes in small rooms ,uilt of ,ric0 = stones = cement at the ground floor of their residence. he potatoes are stored in this storage either in heaps/ gunny ,ags or in ,am,oo ,as0ets. f2 Storage in bas"ets9 3n 8orth >astern states/ potatoes are stored in ,am,oo ,as0ets 0nown as ?polo@ which provides ,etter aeration to the tu,ers. he ,as0ets are made of different si4es. he smallest si4e holds 1' )1& 0egs and the largest si4e one 5uintal potatoes. Smaller ,as0ets are suita,le for use as they are convenient to carry to the fields. g2 Storage in layers9 he method is not very common ,ut popular where platforms of ,am,oo or wooden plan0s are constructed ,y the support of the store wall on one side and ,am,oo on the other side. 3t provides ,etter space utili4ation and helps to minimi4e rotting of potato.
ii2 -mprove$ Storage9
a2 Storage at low temperature9 he low temperature #at &)
C and A)1'oC% is the most common method for potato storage. he following recommendations are adopted in this type of storage9 Store seed potatoes at &)C as no sprouting ta0es place at this temperature and meta,olic process goes down. 2esides/ low temperature/ sweetening is of little importance in case of seed potatoes. Store potatoes for e;port and processing purposes at A)1'oC/ will not only save a lot of energy ,ut also ma0e the potatoes more suita,le for consumption/ processing and e;port. b2 Storage at 1%'12oC9Page 7 of 56
his storage method is suita,le for potatoes for processing and e;port.
Storage *acilities9
a2 *armer<s storage9
-armers generally use indigenous in)situ storage system of without harvesting the tu,ers and to allow them remaining in the soil and also the e
situ system where the farmers used to store potatoes in pits/ ,as0ets/ wooden structures or in heaps or layers in room.b2 Private = Co'operative = Public Storage9
3n Private = Co)operative = Pu,lic Storage sectors/ potatoes are stored in cold storages at low temperature situated throughout the country. he state)wise distri,utions of Potato cold storage in a,ove sectors are furnished on the ne;t page)
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a!or
ar"ets'
.ssembling9
Assem,ling is the first step in mar0eting of farm produce. 3t involves collection of small surpluses from num,er of small farms scattered over large areas and ,ul0ing the same for su,se5uent distri,ution in volume.
he agencies engaged in the assem,ling of potato are as ,elow 9
a% Producers ,% Billage Merchants c% 3tinerant Merchants d% <holesale Merchants e% Commission Agent f% Producers Co)operative Societies
a!or' .ssembling
ar"ets 9
he ma"or assem,ling mar0ets are located in $ttar Pradesh/ Pun"a,/ <est 2engal in which the assem,ling of potato is done along with other commodities. Some ma"or assem,ling mar0ets in ma"or producing states in the country are listed ,elow7
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Problems face$ by commercial storage owners 1S 5 .gro Pro$ucts2'
1. Cut T0roat Competition'
he govt. Su,sidy on 8ew Cold storage units has resulted in a large no. (f cold storages ,eing coming up in $.P. his has made difficult to ac5uire new
customers #-armers% and to 0eep a loyal ,ase of customers in a,sence of any differentiated service.
2. )ery
0ig0 $epen$ence on Potato prices'
he production of Potato varies significantly each year. 3ncreased production results in full capacity utilisation ,ut hampers the firm when the prices dive south due to increased production. 9ower Production results in storage capacity ,eing lesser utilised. Potato prices during the unloading period may ma0e or ,rea0 the game.
3. ,ig0
)ariability in 8arnings over t0e years'
<ith the production=price of potato/ the earnings of the firm vary highly/ which is not good as it reduces the ,orrowing capacity of the firm. 3t also results in the company paying somewhat higher ta;es due to progressive ta; scales.
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4. ,ig0 $egree of in0erent business ris"'
he very nature of the cold storage ,usiness is ris0y. he ,usiness is very concentrated which increases the ris0 even more.Also wor0ing in a total rural setup pose numerous challenges. .s can be clearly seen( t0e main nee$ is to re$uce t0e level of ris" arising out of e>posure to Potato. 4ut ,ow Do we $o t0at?? ,ow can ris" be better manage$??
Derivatives may be t0e way.
-@T6ODACT-O@ TO D86-).T-)8S
he emergence of the mar0et for derivative products/ most nota,ly forwards/ futures and options/ can ,e traced ,ac0 to the willingness of ris0)averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. 2y their very nature/ the financial mar0ets are mar0ed ,y a very high degree of volatility. hrough the use of derivative products/ it is
possi,le to partially or fully transfer price ris0s ,y loc0ing)in asset prices. As instruments of ris0
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management/ these generally do not influence the fluctuations in the underlying asset prices. *owever/ ,y loc0ing in asset prices/ derivative products minimi4e the impact of fluctuations in asset prices on the profita,ility and cash flow situation of ris0)averse investors.
D86-).T-)8S D8*-@8D
.erivative is a product whose value is derived from the value of one or more ,asic varia,les/ called ,ases #underlying asset/ inde;/ or reference rate%/ in a contractual manner. he underlying asset can ,e e5uity/ fore;/ commodity or any other asset. -or e;ample/ wheat farmers may wish to sell their harvest at a future date to eliminate the ris0 of a change in prices ,y that date. Such a transaction is an e;ample of a derivative. he price of this derivative is driven ,y the spot price of wheat which is the CunderlyingC. 3n the 3ndian conte;t the Securities Contracts #Degulation% Act/ 1916 #SC#D%A% defines CderivativeC to include) 1. A security derived from a de,t instrument/ share/ loan whether secured or unsecured/ ris0 instrument or contract for differences or any other form of security. &. A contract which derives its value from the prices/ or inde; of prices/ of underlying securities. .erivatives are securities under the SC#D%A and hence the trading of derivatives is governed ,y the regulatory framewor0 under the SC#D%A. Producers of agricultural commodities regularly face price and production ris0. -urthermore/ increased glo,al free trade and changes in domestic agricultural policy have increased these Page 15 of 56
ris0s. As the varia,ility of price and production increases/ producers are reali4ing the importance of ris0 management as a component of their management strategies. (ne means of reducing these ris0s is through the use of the commodity futures e;change mar0ets. 9i0e the use of car insurance to hedge the potential costs of a car accident/ agricultural producers can use the commodity futures mar0ets to hedge the potential costs of commodity price volatility. he primary o,"ective of hedging is not to ma0e money ,ut rather to minimi4e price ris0/ and this includes using hedging to minimi4e losses.
D86-).T-)8 P6ODACTS
.erivative contracts have several variants.
he most common variants are forwards/ futures/
options and swaps. <e ta0e a ,rief loo0 at various derivatives contracts that have come to ,e used.
*orwar$s9 A forward contract is a customi4ed contract ,etween two entities/ where settlement ta0es place on a specific date in the future at todayEs pre)agreed price.
*utures9 A futures contract is an agreement ,etween two parties to ,uy or sell an asset at a certain time in the future at a certain price. -utures contracts are special types of forward contracts in the sense that the former are standardi4ed e;change)traded contracts.
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Options9 (ptions are of two types ) calls and puts. Calls give the ,uyer the right ,ut not the o,ligation to ,uy a given 5uantity of the underlying asset/ at a given price on or ,efore a given future date. Puts give the ,uyer the right/ ,ut not the o,ligation to sell a given 5uantity of the underlying asset at a given price on or ,efore a given date.
;arrants9 (ptions generally have lives of upto one year/ the ma"ority of options traded on options e;changes having a ma;imum maturity of nine months. 9onger)dated options are called warrants and are generally traded over)the)counter.
B8.PS9
he acronym 9>APS means 9ong) erm >5uity Anticipation Securities. hese are
options having a maturity of upto three years.
4as"ets9 2as0et options are options on portfolios of underlying assets. he underlying asset is usually a moving average of a ,as0et of assets. >5uity inde; options are a form of ,as0et options.
Swaps9 Swaps are private agreements ,etween two parties to e;change cash flows in the future according to a prearranged formula. hey can ,e regarded as portfolios of forward contracts.
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Swaptions9 Swaptions are options to ,uy or sell a swap that will ,ecome operative at the e;piry of the options. hus a swaption is an option on a forward swap. Dather than have calls and puts/ the swaptions mar0et has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fi;ed and pay floating.
-@T6ODACT-O@ TO *O6;.6DS
3n recent years/ derivatives have ,ecome increasingly important in the field of finance. <hile futures and options are now actively traded on many e;changes/ forward contracts are popular on the ( C mar0et.
*O6;.6D [email protected]
A forward contract is an agreement to ,uy or sell an asset on a specified date for a specified price. (ne of the parties to the contract assumes a long position and agrees to ,uy the underlying asset on a certain specified future date for a certain specified pric e. he other party assumes a short position and agrees to sell the asset on the same date for the same price. (ther contract details li0e delivery date/ price and 5uantity are negotiated ,ilaterally ,y the parties to the contract. he forward contracts are normally traded outside the e;changes.
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T0e salient features of forwar$ contracts are9
F hey are ,ilateral contracts and hence e;posed to counter)party ris0.
F >ach contract is custom designed/ and hence is uni5ue in terms of contract si4e/ e;piration date and the asset type and 5uality.
F he contract price is generally not availa,le in pu,lic domain.
F (n the e;piration date/ the contract has to ,e settled ,y delivery of the asset.
F 3f the party wishes to reverse the contract/ it has to compulsorily go to the same counter)party/ which often results in high prices ,eing charged.
*owever forward contracts in certain mar0ets have ,ecome very standardi4ed/ as in the case of foreign e;change/ there,y reducing transaction costs and increasing transactions volume. his process of standardi4ation reaches its limit in the organi4ed futures mar0et.
-orward contracts are very useful in hedging and speculation. he classic hedging application would ,e that of an e;porter who e;pects to receive payment in dollars three months later. *e is e;posed to the ris0 of e;change rate fluctuations. 2y using the currency forward mar0et to sell
Page 19 of 56
dollars forward/ he can loc0 on to a rate today and reduce his uncertainty. Similarly an importer who is re5uired to ma0e a payment in dollars two months hence can reduce his e;posure to e;change rate fluctuations ,y ,uying dollars forward.
-@T6ODACT-O@ TO *ATA68S
-utures mar0ets were designed to solve the pro,lems that e;ist in forward mar0ets. A futures contract is an agreement ,etween two parties to ,uy or sell an asset at a certain time in the future at a certain price. 2ut unli0e forward contracts/ the futures contracts are standardi4ed and e;change traded. o facilitate li5uidity in the futures contracts/ the e;change specifies certain standard features of the contract. 3t is a standardi4ed contract with standard underlying instrument/ a standard 5uantity and 5uality of the underlying instrument that can ,e delivered/ #or which can ,e used for reference purposes in settlement% and a standard timing of such settlement. A futures contract may ,e offset prior to maturity ,y entering into an e5ual and opposite transaction. More than 99G of futures transactions are offset this way.
T0e stan$ar$iCe$ items in a futures contract are9
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1. Huantity of the underlying &. Huality of the underlying 6. :. he date and the month of delivery he units of price 5uotation and minimum price change
1. 9ocation of settlement
8>ample'
POT.TO *ATA68S [email protected] SP8C-*-C.T-O@S.
1-2 @[email protected] CO
OD-TD .@D D86-).T-)8 8EC,.@78 1@CD8E2 9
Type of contract 9 -utures Contract Specifications
@ame of commo$ity 9 Potatoes -air Average Huality
Tic"er symbol 9 P( -AH.>9
Tra$ing system 9 8C.>I rading System
4asis 9 >
warehouse .elhi gross weight inclusive of all local ta;es and levies.Anit of tra$ing 9 11 M
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Delivery unit 9 11 M pac0ed in "ute ,ags of 11 0gs gross weight ,asis with tare weight of the ,ags
,eing minimum 61' gms.
Fuotation= 4ase value 9 Ds per 5uintal
Tic" SiCe 9 1' paisa Fuality Specification 9 .ull/ S0in ,lemishes/ Cut / Crac0 #cut and crac0ed not e;ceeding 6G ma;%/ Sprouted #Sprouted content not e;ceeding 1G ma; and Sprout length more than & mm only to ,e considered as Sprouted%/ 2lac0 scars and Jreen Potatoes Soil #0gs per ,ag%. he potatoes should ,e firm and the s0in should ,e mature and thic0.
Fuantity )ariation 9 K=)1'G
Delivery Center 9 .elhi
.$$itional $elivery centres 9 Agra/ *apur and Jalandhar #-or all the centers up to the radius of 1' 0ms from the municipal limits%
,ours of Tra$ing 9
on$ays t0roug0 *ri$ay ) 1'7'' AM to 17'' PM Satur$ays ) 1'.'' AM to &.'' PM
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Delivery specification 9 $pon e;piry of the contract/ all outstanding open positions would result in compulsory delivery. A penalty of minimum 1G #of final settlement price% would ,e imposed on longs and=or shorts on failure of delivery o,ligation.
Delivery Bogic 9 Compulsory .elivery.
Opening of contracts 9 rading in a new month contract will open on the 1'th day of the month in which the near month contract is due to e;pire. 3f the 1'th day happens to ,e a non)trading day/ contracts would open on the ne;t trading day.
Due $ate=8>piry $ate 9 &'th day of the delivery month. 3f &'th happens to ,e a holiday+ a Saturday or a Sunday then the due date shall ,e the immediately preceding trading day of the >;change/ which is not a Saturday .
--2
ulti Commo$ity 8>c0ange of -n$ia Bimite$ 1 CE2 9
Decogni4ed ,y the central government started the online trading of potatoes from Septem,er 16/ &''6. he potatoes are sold under the ,rand name Tarakeswar Alu though the crop would ,e procured from *ooghly #where ara0eshwar is located% as well as 2urdwan/ *owrah and other districts of the <est 2engal. he ara0eshwar ,rand potato is popular for !ufri Jyoti variety grown in <est 2engal. (nline trading ,rings parity in prices across the country and ,enefit ,oth for the farmers and the traders. According to a study ,y MCI/ there is scope for a ,ig turnover in potato trade annually. he !ufri Jyoti variety is produced in a,undance and hence/ it chosen for
Page 23 of 56
online sale. MCI is a "oint venture of the -inancial echnologies #3% 9td./ State 2an0 of 3ndia and its associates/ 8ational 2an0 for Agriculture and Dural .evelopment #8A2AD.%/ 8ational Stoc0 >;change of 3ndia 9td. #8S>%/ -id -und #Mauritius% 9td. >tc.
*ATA68S T86 -@OBO7D
Spot price: he price at which an asset trades in the spot mar0et.
Futures price: he price at which the futures contract trades in the futures mar0et.
Contract cycle: he period over which a contract trades. he inde; futures contracts on the 8S> have one) month/ two)months and three months e;piry cycles which e;pire on the last hursday of the month. hus a January e;piration contract e;pires on the last hursday of January and a -e,ruary e;piration contract ceases trading on the last following the last trading. hursday of -e,ruary. (n the -riday
hursday/ a new contract having a three) month e;piry is introduced for
Expiry date: 3t is the date specified in the futures contract. contract will ,e traded/ at the end of which it will cease to e;ist.
his is the last day on which the
Contract size: he amount of asset that has to ,e delivered under one contract. .lso calle$ as lot siCe.
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Basis: 3n the conte;t of financial futures/ ,asis can ,e defined as the futures price minus the spot price. here will ,e a different ,asis for each delivery month for each contract. 3n a normal
mar0et/ ,asis will ,e positive. his reflects that futures prices normally e;ceed spot prices.
Cost of carry:
he relationship ,etween futures prices and spot prices can ,e summari4ed in
terms of what is 0nown as the cost of carry. his measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
Initial margin: he amount that must ,e deposited in the margin account at the time a futures contract is first entered into is 0nown as initial margin.
arking!to!market: 3n the futures mar0et/ at the end of each trading day/ the margin account is ad"usted to reflect the investorEs gain or loss depending upon the futures closing price. his is called mar0ing)to)mar0et.
aintenance margin: his is somewhat lower than the initial margin. his is set to ensure that the ,alance in the margin account never ,ecomes negative. 3f the ,alance in the margin account falls ,elow the maintenance margin/ the investor receives a margin call and is e;pected to top up the margin account to the initial margin level ,efore trading commences on the ne;t day.
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*ATA68S P.DO**S
-utures contracts have linear payoffs. 3n simple words/ it means that the losses as well as profits for the ,uyer and the seller of a futures contract are unlimited. hese linear payoffs are
fascinating as they can ,e com,ined with options and the underlying to generate various comple; payoffs.
Payoff for buyer of futures9 Bong futures
he payoff for a person who ,uys a futures contract is similar to the payoff for a person who holds an asset. *e has a potentially unlimited upside as well as a potentially unlimited downside. a0e the case of a speculator who ,uys a two month 8ifty inde; futures contract when the 8ifty stands at &&&'. he underlying asset in this case is the 8ifty portfolio. <hen the inde; moves up/ the long futures position starts ma0ing profits/ and when the inde; moves down it starts ma0ing losses.
Payoff for a buyer of @ifty futures
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he figure shows the profits=losses for a long futures position. he investor ,ought futures when the inde; was at &&&'. 3f the inde; goes up/ his futures position starts ma0ing profit. 3f the inde; falls/ his futures position starts showing losses.
Payoff for seller of futures9 S0ort futures
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he payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. *e has a potentially unlimited upside as well as a potentially unlimited downside. a0e the case of a speculator who sells a two)month 8ifty inde; futures contract when the 8ifty stands at &&&'. he underlying asset in this case is the 8ifty portfolio. <hen the inde; moves down/ the short futures position starts ma0ing profits/ and when the inde; moves up/ it starts ma0ing losses. -igure :.& shows the payoff diagram for the seller of a futures contract.
Payoff for a seller of @ifty futures
he figure shows the profits=losses for a short futures position. he investor sold futures when the inde; was at &&&'. 3f the inde; goes down/ his futures position starts ma0ing profit. 3f the inde; rises/ his futures position starts showing losses.
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P6-C-@7 *ATA68S
Pricing of futures contract is very simple. $sing the cost)of)carry logic/ we calculate the fair value of a futures contract. >verytime the o,served price deviates from the fair value/ ar,itragers would enter into trades to capture the ar,itrage profit. his in turn would push the futures price ,ac0 to its fair value. he cost of carry model used for pricing futures is given ,elow7
where7
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rL Cost of financing #using continuously compounded interest rate%
L ime till e;piration in years
eL &.M1A&A
Distinction between futures an$ forwar$s
*utures
rade on an organi4ed e;change Standardi4ed contract terms More li5uid De5uires margin payments -ollows daily settlement
*orwar$s
( C in nature Customised contract terms 9ess li5uid 8o margin payment Settlement happens at end of period
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*edging7
3n finance/ a hedge is a position esta,lished in one mar0et in an attempt to offset e;posure to the price ris0 of an e5ual ,ut opposite o,ligation or position in another mar0et N usually/ ,ut not always/ in the conte;t of oneEs commercial activity. *edging is a strategy designed to minimi4e e;posure to such ,usiness ris0s as a sharp contraction in demand for oneEs inventory/ while still allowing the ,usiness to profit from producing and maintaining that inventory. A typical hedger might ,e a farmer with &''' acres of unharvested wheat in the ground/ who would rather tend his crop without the distraction of uncertain prices. *eEs a farmer/ not a speculator/ yet his unharvested CinventoryC may have lost 61G of its value #O&A1/'''% in the three months heEs ,een planning his planting. *e might have decided he could live with a price of only eight or nine dollars a ,ushel/ and to offset his planted position with an appro;imately e5ual ,ut opposite position in the mar0et for wheat on the Minneapolis Jrain >;change ,y selling ten wheat futures contracts for .ecem,er delivery. his farmer is there,y a hedger indifferent to the movements of the mar0et as a whole/ and has reduced his price ris0 to the difference ,etween the price he will receive from a local ,uyer at harvest time/ and the price at which he will simultaneously li5uidate his o,ligation to the >;change. *ol,roo0 <or0ing/ a pioneer in hedging theory/ called this strategy Cspeculation in the ,asis/CP1Q where the ,asis is the difference ,etween todayEs mar0et value of #in this e;ample% wheat and todayEs value of the hedge. 3f that difference widens/ he earns a little more at harvest time. 3f that difference narrows/ he earns a little less. *e has mitigated/ ,ut not eliminated/ the ris0 of losing the value of his wheat as of the day he esta,lished his hedge.
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Some form of ris0 ta0ing is inherent to any ,usiness activity. Some ris0s are considered to ,e CnaturalC to specific ,usinesses/ such as the ris0 of oil prices increasing or decreasing is natural to oil drilling and refining firms. (ther forms of ris0 are not wanted/ ,ut cannot ,e avoided without hedging. Someone who has a shop/ for e;ample/ e;pects to face natural ris0s such as the ris0 of competition/ of poor or unpopular products/ and so on. he ris0 of the shop0eeperEs
inventory ,eing destroyed ,y fire is unwanted/ however/ and can ,e hedged via a fire insurance contract. 8ot all hedges are financial instruments7 a producer that e;ports to another country/ for e;ample/ may hedge its currency ris0 when selling ,y lin0ing its e;penses to the desired currency. 2an0s and other financial institutions use hedging to control their asset)lia,ility mismatches/ such as the maturity matches ,etween long/ fi;ed)rate loans and short)term #implicitly varia,le)rate% deposits. A hedger #such as a manufacturing company% is thus distinguished from an ar,itrageur or speculator #such as a ,an0 or ,ro0erage firm% in derivative purchase ,ehavior.
T0e Corporate ,e$ging Process
T,8 ,8D7-@7 D8C-S-O@
he issue of whether or not to hedge ris0 continues to ,affle many corporations. At the heart of the confusion are misconceptions a,out ris0/ concerns a,out the cost of hedging/ and fears a,out reporting a loss on derivative transactions. A lac0 of familiarity with hedging tools and strategies Page 32 of 56
compounds this confusion. Corporate ris0 managers also face the difficult challenge of getting hedging tools #i.e./ derivatives% approved ,y the companyEs ,oard of directors. he purpose of this article is to clarify ,oth some of the ,asic misconceptions surrounding the issue of ris0 as well as the tools and strategies used to manage it. T,8 C,.BB8@78 An effective hedging program does not attempt to eliminate all ris0. Dather/ it attempts to transform unaccepta,le ris0s into an accepta,le form. he 0ey challenge for the corporate ris0 manager is to determine the ris0s the company is willing to ,ear and the ones it wishes to transform ,y hedging. he goal of any hedging program should ,e to help the corporation achieve the optimal ris0 profile that ,alances the ,enefits of protection against the costs of hedging.
ST8P 19 -D8@T-*D T,8 6-SGS 2efore management can ,egin to ma0e any decisions a,out hedging/ it must first identify all of the ris0s to which the corporation is e;posed. hese ris0s will generally fall into two categories7 operating ris0 and financial ris0. -or most non)financial organi4ations/ operating ris0 is the ris0 associated with manufacturing and mar0eting activities. A computer manufacturer/ for e;ample/ is e;posed to the operating ris0 that a competitor will introduce a technologically superior product which ta0es mar0et share away from its leading model. 3n general/ operating ris0s cannot ,e hedged ,ecause they are not traded.
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he second type of ris0/ financial ris0/ is the ris0 a corporation faces due to its e;posure to mar0et factors such as interest rates/ foreign e;change rates and commodity and stoc0 prices. -inancial ris0s/ for the most part/ can ,e hedged due to the e;istence of large/ efficient mar0ets through which these ris0s can ,e transferred. 3n determining which ris0s to hedge/ the ris0 manager needs to distinguish ,etween the ris0s the company is paid to ta0e and the ones it is not. Most companies will find they are rewarded for ta0ing ris0s associated with their primary ,usiness activities such as product development/ manufacturing and mar0eting. -or e;ample/ a computer manufacturer will ,e rewarded #i.e./ its stoc0 price will appreciate% if it develops a technologically superior product or for implementing a successful mar0eting strategy. Most corporations/ however/ will find they are not rewarded for ta0ing ris0s which are not central to their ,asic ,usiness #i.e./ interest rate/ e;change rate/ and commodity price ris0%. he computer manufacturer in the previous e;ample is unli0ely to see its stoc0 price appreciate "ust ,ecause it made a successful ,et on the dollar=yen e;change rate. Another critical factor to consider when determining which ris0s to hedge is the materiality of the potential loss that might occur if the e;posure is not hedged. As noted previously/ a corporationEs optimal ris0 profile ,alances the ,enefits of protection against the costs of hedging. $nless the potential loss is material #i.e./ large enough to severely impact the corporationEs earnings% the ,enefits of hedging may not outweigh the costs/ and the corporation may ,e ,etter off not hedging.
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ST8P 29 D-ST-@7A-S, 48T;88@ ,8D7-@7 .@D SP8CAB.T-@7 (ne reason corporate ris0 managers are sometimes reluctant to hedge is ,ecause they associate the use of hedging tools with speculation. hey ,elieve hedging with derivatives introduces additional ris0. 3n reality/ the opposite is true. A properly constructed hedge always lowers ris0. 3t is ,y choosing not to hedge that managers regularly e;pose their companies to additional ris0s. -inancial ris0s ) regardless of whether or not they are managed ) e;ist in every ,usiness. he manager who opts not to hedge is ,etting that the mar0ets will either remain static or move in his favor. -or e;ample/ a $.S. computer manufacturer with -rench franc receiva,les that decides to not hedge its e;posure to the -rench franc is speculating that the value of the -rench franc relative to the $.S. dollar will either remain sta,le or appreciate. 3n the process/ the manufacturer is leaving itself e;posed to the ris0 that the -rench franc will depreciate relative to the $.S. dollar and hurt the companyEs revenues. A reason some managers choose not to hedge/ there,y e;posing their companies to additional ris0/ is that not hedging often goes unnoticed ,y the companyEs ,oard of directors. Conversely/ hedging strategies designed to reduce ris0 often receive a great deal of scrutiny. Corporate ris0 managers who wish to use hedging techni5ues to improve their companyEs ris0 profile must educate their ,oard of directors a,out the ris0s the company is naturally e;posed to when it does not hedge.
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ST8P 39 8).BA.T8 T,8 COSTS O* ,8D7-@7 -@ B-7,T O* T,8 COSTS O* @OT ,8D7-@7 he cost of hedging can sometimes ma0e ris0 managers reluctant to hedge. Admittedly/ some hedging strategies do cost money. 2ut consider the alternative. o accurately evaluate the cost of hedging/ the ris0 manager must consider it in light of the implicit cost of not hedging. 3n most cases/ this implicit cost is the potential loss the company stands to suffer if mar0et factors/ such as interest rates or e;change rates/ move in an adverse direction. 3n such cases the cost of hedging must ,e evaluated in the same manner as the cost of an insurance policy/ that is/ relative to the potential loss. 3n other cases/ derivative transactions are su,stitutes for implementing a financing strategy using a traditional method. -or e;ample/ a corporation may com,ine a floating)rate ,an0 ,orrowing with a floating)to)fi;ed)rate swap as an alternative to issuing fi;ed)rate de,t. Similarly/ a manufacturer may com,ine the spot purchase of a commodity with a floating)to)fi;ed swap instead of ,uying the commodity and storing it. 3n most cases where derivative strategies are used as su,stitutes for traditional transactions/ it is ,ecause they are cheaper. .erivatives tend to ,e cheaper ,ecause of the lower transaction costs that e;ist in highly li5uid forward and options mar0ets.
ST8P 49 AS8 T,8 6-7,T P86*O6 .@C8
8.SA6-@7 ST-CG TO 8).BA.T8 ,8D78
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Another reason for not hedging often cited ,y corporate ris0 managers is the fear of reporting a loss on a derivative transaction. his fear reflects widespread confusion over the proper ,enchmar0 to use in evaluating the performance of a hedge. he 0ey to properly evaluating the performance of all derivative transactions/ including hedges/ lies in esta,lishing appropriate goals at the onset. As noted previously/ many derivative transactions are su,stitutes for traditional transactions. A fi;ed)rate swap/ for e;ample/ is a su,stitute for the issuance of a fi;ed)rate ,ond. Degardless of mar0et conditions/ the swapEs cash flows will mirror the ,ondEs. hus/ any money lost on the swap would have ,een lost if the corporation had issued a ,ond instead. (nly if the swapEs performance is evaluated in light of managementEs original o,"ective #i.e./ to duplicate the cash flows of the ,ond% will it ,ecome clear whether or not the swap was successful.
ST8P &9 DO@HT 4.S8 DOA6 ,8D78 P6O76.
O@ DOA6
.6G8T )-8;
Many corporate ris0 managers attempt to construct hedges on the ,asis of their outloo0 for interest rates/ e;change rates or some other mar0et factor. *owever/ the ,est hedging decisions are made when ris0 managers ac0nowledge that mar0et movements are unpredicta,le. A hedge
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should always see0 to minimi4e ris0. 3t should not represent a gam,le on the direction of mar0et prices.
ST8P +9 A@D86ST.@D DOA6 ,8D7-@7 TOOBS A final factor that deters many corporate ris0 managers from hedging is a lac0 of familiarity with derivative products. Some managers view derivatives as instruments that are too comple; to understand. he fact is that most derivative solutions are constructed from two ,asic instruments7 forwards and options/ which comprise the following ,asic ,uilding ,loc0s7 -orwards ) Swaps ) -utures ) -DAs ) 9oc0s (ptions ) Caps ) -loors ) Puts ) Calls ) Swaptions he manager who understands these will ,e a,le to understand more comple; structures which are simply com,inations of the two ,asic instruments.
ST8P /9 8ST.4B-S, . SDST8
O* CO@T6OBS
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As is true of all other financial activities/ a hedging program re5uires a system of internal policies/ procedures and controls to ensure that it is used properly. he system/ often documented in a hedging policy/ esta,lishes/ among other things/ the names of the managers who are authori4ed to enter into hedges+ the managers who must approve trades+ and the managers who must receive trade confirmations. he hedging policy may also define the purposes for which hedges can and cannot ,e used. -or e;ample/ it might state that the corporation uses hedges to reduce ris0/ ,ut it does not enter into hedges for trading purposes. 3t may also set limits on the notional value of hedges that may ,e outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the companyEs ,oard of directors are aware of the hedging activities used ,y the corporationEs ris0 managers and that all ris0s are properly accounted for and managed.
8>ample 0e$ge
A stoc0 trader ,elieves that the stoc0 price of Company A will rise over the ne;t month/ due to the companyEs new and efficient method of producing widgets. *e wants to ,uy Company A shares to profit from their e;pected price increase. 2ut Company A is part of the highly volatile widget industry. 3f the trader simply ,ought the shares ,ased on his ,elief that the Company A shares were underpriced/ the trade would ,e a speculation. Since the trader is interested in the company/ rather than the industry/ he wants to hedge out the industry ris0 ,y short selling an e5ual value #num,er of shares R price% of the shares of Company AEs direct competitor/ Company 2. 3f the trader was a,le to short sell an asset whose price had a
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mathematically defined relation with Company AEs stoc0 price #for e;ample a call option on Company A shares% the trade might ,e essentially ris0less. 2ut in this case/ the ris0 is lessened ,ut not removed. he first day the traderEs portfolio is7
• •
9ong 1''' shares of Company A at O1 each Short 1'' shares of Company 2 at O& each
#8otice that the trader has sold short the same value of shares.% (n the second day/ a favora,le news story a,out the widgets industry is pu,lished and the value of all widgets stoc0 goes up. Company A/ however/ ,ecause it is a stronger company/ goes up ,y 1'G/ while Company 2 goes up ,y "ust 1G7
• •
9ong 1''' shares of Company A at O1.1' each7 O1'' gain Short 1'' shares of Company 2 at O&.1' each7 O1' loss
#3n a short position/ the investor loses money when the price goes up.% he trader might regret the hedge on day two/ since it reduced the profits on the Company A position. 2ut on the third day/ an unfavora,le news story is pu,lished a,out the health effects of widgets/ and all widgets stoc0s crash7 1'G is wiped off the value of the widgets industry in the course of a few hours. 8evertheless/ since Company A is the ,etter company/ it suffers less than Company 27 Balue of long position #Company A%7
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• •
.ay 17 O1''' .ay &7 O11'' .ay 67 O11' LS #O1''' T O11'% L O:1' loss
•
Balue of short position #Company 2%7
• •
.ay 17 )O1''' .ay &7 )O1'1' .ay 67 )O1&1 LS #O1''' T O1&1% L O:M1 profit
•
<ithout the hedge/ the trader would have to lost O:1' #or O9'' if the trader too0 the O1''' he has used in short selling Company 2Es shares to ,uy Company AEs shares as well%. 2ut the hedge ) the short sale of Company 2 ) gives a profit of O:M1/ for a net profit of O&1 during a dramatic mar0et collapse.
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.gri'Commo$ity ,e$ging
Price ris0 for agricultural commodities can occur for a num,er of reasons/ including drought/ near record production/ an increase in demand or decreased international production. he
commodity futures mar0ets provide a means to transfer ris0 ,etween persons holding the
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physical commodity #hedgers% and other hedgers or persons speculating in the mar0et. -utures e;changes e;ist and are successful ,ased on the principle that hedgers may forgo some profit potential in e;change for less ris0 and that speculators will have access to increased profit potential from assuming this ris0. *or e>ample( suppose a person wor"s on commission an$ receives I2(%%%( I#(%%%( I&(%%%( an$ I13(%%% in salary for four consecutive mont0s for an average salary of I/(%%% per mont0 over t0is perio$. @ow suppose t0e person coul$ accept a salarie$ position for a stea$y I+(%%% a mont0. -f t0e person prefers less income variability( 0e or s0e woul$ pay for t0e $ecrease$ variability an$ accept t0e pay cut( on average( of I1(%%% per mont0. .lternatively( t0e employer woul$ reJuire t0e I1(%%% per mont0 to offset t0e ris" 0e or s0e now assumes from t0e person not being motivate$ to sell more. his concept applies to hedging in that hedgers might ,e willing to give up some revenue for a 0nown price/ and speculators would re5uire the opportunity for more revenue ,y assuming the price ris0.
,8D78 8>ample
In
8ovem,er a farmer plants 1%% acres of w0eat. At this time/ he notices that he can sell a
portion of his wheat production through the futures mar"et at 6s 11(34% a ton #let us say/ the March e;piry contract%. ,is cost of pro$uction is 6s #(%%% a ton. he farmer decides to sell his
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e;pected production at the currently availa,le futures price and ris0 only half his production to the price uncertainties of the future.
his is an e;ample of hedging ,y the producer and involves selling the commodity at the commodity e;change mar0et ,ecause pro$ucers want to loc" in a price. T0e farmer sells a futures contract for 0is w0eat and the li0ely ,uyers are either speculators or ,uying hedgers #processors/ large physical traders/ etc./ who are loo0ing to loc0 in a price for the grain they are forward contracting% are simultaneously ,uying the contracts.
T0ree t0ings can 0appen after t0is sale.
T0e futures price goes 0ig0er...
he futures and cash price of wheat in March goes up to Ds 1&/''' a ton when the farmer is ready to harvest the crop. he farmer s5uares up his transactions in the futures mar0et ,y ,uying ,ac0 and sells the entire production in the cash mar0et at 1&/''' a ton. 3n the futures mar0et he loses 66' a ton #futures s5uare off% and in the physical mar0et for his total production he gains :/''' a ton. (n ,alance he ma0es 6/6:' per ton
T0e futures price goes lower...
he futures and cash price of wheat in March goes down to Ds 9/''' a ton when the farmer is ready to harvest the crop. he farmer s5uares up his transactions in the futures mar0et ,y ,uying
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,ac0 and sells the entire production in the cash mar0et at 9/''' a ton. . 3n the futures mar0et he ma0es &/6:' a ton #futures s5uare off% and in the physical mar0et for his total production he gains 1/''' a ton. (n ,alance he ma0es 6/6:' per ton
T0e futures price $oesnHt c0ange...
he futures and cash price of wheat in March remain at Ds 11/6:' a ton when the farmer is ready to harvest the crop. he farmer s5uares up his transactions in the futures mar0et ,y ,uying ,ac0 and sells the entire production in the cash mar0et at 11/6:' a ton. . 3n the futures mar0et he ma0es ' #futures s5uare off% and in the physical mar0et for his total production he gains 6/6:' a ton. (n ,alance he ma0es 6/6:' per ton
3n all of these scenarios the farmer ma0es e;actly the same amount. hus irrespective of what happens in the future/ his profits are loc0ed in. hus the price ris0 is fully addressed.
he costs of hedging are Commissions paid to a ,ro0er for administrative costs/ futures e;change operation/ and futures e;change regulation. his can ,e termed as the cost of loc0ing in your future price.
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,ow ,e$ging can 0elp S 5 .gro Pro$ucts 1;are0ousing in$ustry2'
1. 6e$ucing t0e in0erent business ris"'
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Since the ,usiness is dependent to a very large e;tent on the prices of potato/ *edging reduces the downside ris0 on the potato stored/ acting as sort of an insurance.
2. Besser )ariability in 8arnings'
A proper hedging policy carried out over a couple of years is e;pected to result in more sta,ilised earnings with lesser variance/ which in turn lead to increased ,orrowing capacity.
3. 4etter price realisation for customers 1*armers2'
Jood hedging strategy formulation and implementation shall definetly result in ,etter price realisation for the customers #farmers%/ ,uilding a good reputation and goodwill for the ,usiness.
4. -ncrease$ profit on own pro$uce'
2etter price realisation and minimised ris0s on own produce.
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&. 8$ge in t0e competitive mar"et'
he firm can have a competitive edge ,y offering enhanced ris0 aversion to the farmers through hedging and gain customer loyalty.
Tentative ,e$ging strategy'
*ormulating ,e$ging Strategy base$ upon Cropping an$ Price pattern over t0e years'
3n 3ndia/ more than A'G of the potato crop is raised in the winter season #Da,i% under assured irrigation during short winter days from (cto,er to March. A,out AG area lies in the hills during long summer days from April to (cto,er. Dainy season #!harif% potato production is ta0en in !arnata0a/ Maharashtra/ *P/ JU! and $ttranchal.
Summer crop) March) April)))))))))))))))))))))August)Septem,er
Autumn crop) August)Septem,er))))))))))))))).ecem,er) January
Spring crop) January ) -e,ruary)))))))))))))) May)June
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Price tren$s9
Over t0e years price 0as remaine$ at t0e top $uring October '@ovember. his is ,ecause of lean season with limited availa,ility of supplies from cold storages during these months. he only source is produce from !arnata0a which is not a,le to meet the high demand. Most of the harvest starts 8ovem,er onwards. As more and more produce start arriving in the mar0et prices
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start coming down. his is evident from .ecem,er to April when price has remained lower. 2y April harvesting stops and Potato from cold storage is utili4ed and ,y (cto,er cold storage is almost empty. his trend is almost similar in all the ma"or potato mar0ets in 3ndia.
Strategy'
1. Short potato futures for (cto,er)8ovem,er e;piry/ loc0ing in a ,etter price. Balue of *edge should ,e as close to actual physical holding as possi,le.
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&. S5uare off (pen position during (cto,er)8ovem,er during lean period when the farmers start unloading Potato from the storage.#2uy in -utures Mar0et when prepared to sell in Physical Mar0et%
Conclusion'
3t is important to limit the ris0 that a ,usiness is e;posed to/ for a sustaina,le growth. A ,usiness enterprise must manage itVs ris0s prudently for long term success. *edging may ,e used for limiting the commodity ris0 that a ,usiness is e;posed to with proper analysis and research ,ac0ing each decision of the company. Proper formulation and implementation of a hedging policy can wor0 wonders for a ,usiness closely related with commodities. he company must follow itVs hedging policy 5uite strictly for a long term ,enefit.
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4ibliograp0y'
1. .ahiya/ P. S./ &''1. Potato Scenario)&''1.Agriculture oday/ 3ssue)June&''1 2. www.ncde;.com
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3. www.mc;.com 4. www.Cpri.ernet.in &. www.ficciagroindia.com +. www.agricooop.nic.in /. www.cipotato.org #. >conomics of Potato Storage7 Case Studies( !eith (. -uglie/ Paper presented at the Symposium on Potato Storage/ Processing and Mar0eting Jlo,al Conference on Potato 8ew .elhi/ .ecem,er M)9/ 1999. 3. www.!arvycomtrade.com
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