ACE 222 Midterm 2 Study Guide PDF

ACE 222 Midterm 2 Study Guide PPT 10: Risk Management 1. Risk a. Risk is inherent in the ownership of goods; risks must be borne by someone b. They cannot be eliminated, but they can be transferred c. 2 Type...

ACE 222 Midterm 2 Study Guide PPT 10: Risk Management 1. Risk a. Risk is inherent in the ownership of goods; risks must be borne by someone b. They cannot be eliminated, but they can be transferred c. 2 Types: i. Product Destruction – “Physical Risk” 1. Fire, Wind, Pests, Spoilage Theft, Vandalism ii. Product Deterioration in Value – “Price Risk” 1. Price Risk, Quality Deterioration d. Dealing with Product Destruction Risk i. Insurance ii. Setting aside funds, self-insurance iii. Someone has risk, does not vanish e. Price Risk i. Price risk is the risk of deterioration in value, due to changes in the price of the product ii. Prices change continually and although ag production is seasonal, consumption and marketing continue all year long iii. It is difficult to transfer this risk away f. Risk exists for producers and middlemen g. Limiting risk limits reward h. Grain Farmers’ Risk EX, i. Plant in Spring Without Knowing Fall Harvest Price ii. Sell in Spring Without Knowing Fall Yield iii. Sell in Fall Without Knowing Spring Price iv. Store in Fall Without Knowing Spring price i. Tools for Managing Price Risk i. Cash Sale ii. Forward Pricing 1. Forward contract 2. Hedging 3. Options iii. Others iv. Market Information 2. Cash Sale a. Sale for delivery and payment now b. Could be harvested now or from storage c. Could be stored on farm or elevator 3. Forward Contract a. Agreement with a cash buyer for delivery and payment at a future date b. Not a futures c. Not Standardized, not traded, or transferable d. Can’t be undone easily 4. Things to remember… This study source was downloaded by 100000810229990 from CourseHero.com on 10-21-2024 18:58:03 GMT -05:00 https://www.coursehero.com/file/36236484/ACE-222-Midterm-2-Study-Guidedocx/  a. Risk can be expensive b. If you can’t afford a loss, insurance doesn’t cost, it PAYS i. Insurance is available for both production and price risk 5. Understand Basis a. Basis is the difference between the cash price and the futures price b. At a given place and point in time c. Basis = Cash price minus Futures price d. So, Basis = 3.19 – 3.51 = -.32 e. Usually quoted in nearby futures contract f. “Over” & “Under” is stated cash relative to future price g. Cash prices are sometimes quoted just by giving the basis h. Basis is more predictable than futures prices i. Basis changes much more slowly usually j. Usually basis is seasonal k. Accurate prediction of basis is necessary for hedge to work l. Weakening basis = getting larger m. Strengthening = getting smaller or positive n. Basis is weakest in the fall around harvest 6. Predictable Basis Patterns a. Futures > cash prior to contract maturity b. Futures price and cash price come together as get closer to contract maturity c. Basis widens into harvest d. Basis narrows during the storage season e. Which is the post-harvest period f. Futures prices and cash prices usually move together i. Because they are affected the same way by supply and demand PPT 11: Hedging 1. More about basis a. Note that basis can vary widely, not only from time to time b. Sometimes basis on old crop and new crop can be very different at the same point in time c. Just as price change on a given day can be very different for old crop and new crop 2. Hedging a. Using the futures market to manage price risks b. A temporary substitution of a futures transaction for a planned cash transaction c. Taking equal and opposite positions in the cash and futures markets d. A protective mechanism, and risk management device i. Someone who wants to BUY wants to be protected from RISING PRICES ii. Someone who wants to SELL wants to be protected from FALLING PRICES e. SUCCESS DEPENDS ON ACCURATELY PREDICTING BASIS f. To “unwind” the hedge, reverse the cash position and reverse the position in the futures market This study source was downloaded by 100000810229990 from CourseHero.com on 10-21-2024 18:58:03 GMT -05:00 https://www.coursehero.com/file/36236484/ACE-222-Midterm-2-Study-Guidedocx/  g. Which market you make money in or lose money in depends on whether prices rise or fall h. The hedge transfers price risk from the hedger to speculators i. The speculator who took the other side of the farmer’s futures transaction has price risk j. The farmer has a futures position that exactly offsets her price risk on her cash position, so she has no price risk k. Hedging allows farmer to lock in price, that’s all 3. Types of Hedges a. Short Hedge i. Protects Against falling Prices (most common hedge for grain farmers) ii. SELLER OF GRAIN iii. Short in the market 1. You are long Cash (because you produce a crop) so go short futures in an equal amount 2. Unwind or “exit” or “lift” the hedge: Sell the cash and buy back futures iv. Falling prices are protected by the short hedge v. Rising prices give WORSE outcome with short hedging vi. NARROW = GAIN vii. WIDER = LOSS b. Long Hedge i. Protects against rising prices (common hedge for people who need to acquire a commodity in future – like a cattle feeder who buys corn) ii. BUYER OF GRAIN iii. Long in the market 1. You are short cash, so go long futures in an equal amount 2. To unwind the hedge: do opposite - buy the cash, sell the futures iv. Protects from rising prices v. WIDER = GAIN vi. NARROWER = LOSS c. Pre-Harvest Hedge i. Short Hedge ii. Locks in fall price iii. Successful if accurate prediction of harvest basis 4. Hedge vs. Forward Contract a. You could sell using either one b. With the hedge you still have basis risk c. Forward contract locks in both futures price and basis and so is less risky d. Neither is attractive if you don’t like the price offered e. Forward contract has no margin calls PPT 12: Hedging Cont’d 1. Why don’t more farmers hedge? This study source was downloaded by 100000810229990 from CourseHero.com on 10-21-2024 18:58:03 GMT -05:00 https://www.coursehero.com/file/36236484/ACE-222-Midterm-2-Study-Guidedocx/  a. Lack of understanding ? b. Mistrust of Futures Market c. Prefer Ease of Forward Contracts d. Like risk; Prefer to speculate in Cash Market e. Dislike basis risk PPT 13: Intro to Options 2. Options a. Have been trading since 1984 b. Previously were banned by Congress c. Traded through brokers d. Traded on organized exchanges e. Directly related to futures trading f. Think of an option as a price insurance policy g. Price of options are derived from “underlying” futures contract i. That’s why futures and options are referred to as derivatives h. The Right, but not the obligation, to buy or sell a futures contract at a predetermined price during a specified period of time 3. Strike Price a. The predetermined price at which the futures contract will be bought or sold b. The price at which you someone is allowed to buy or sell at ($3 gas card) 4. Premium a. The cost of the option contract i. What you pay to purchase that right 5. Call Options a. The right, but not the obligation, to BUY a futures contract at a specified price during a specified time period b. A call protects against rising prices (e.g. feed costs) i. because you profit if prices rise FAR ENOUGH, FAST ENOUGH c. Who wants to be “protected” from rising prices? i. Anyone who has to buy the commodity in the future, Like a cattle feeder 6. Put Options a. The right to sell a futures contract at a specified price during a specified time period b. Provides protection against falling prices because you profit if prices fall far enough fast enough c. Sets a minimum price d. Allows you to profit if price fall 7. Put Options a. For the premium price you have the right to sell at a certain price b. You don’t have to, transferable, but an option is less liquid c. You can exercise the option i. Put – short the futures contract at the strike price ii. Call – long the futures contract at the strike price This study source was downloaded by 100000810229990 from CourseHero.com on 10-21-2024 18:58:03 GMT -05:00 https://www.coursehero.com/file/36236484/ACE-222-Midterm-2-Study-Guidedocx/  d. It can expire i. You still pay the premium 1. It can be offset by selling the put or call 8. Option Prices a. An option that would have value if exercised referred to as “In the Money” i. Futures at 5.84 a 56o call is in the money ii. So are all other calls with lower strike price iii. Futures at 5.84 a 600 put is in the money iv. So are all puts above the strike price b. “Out of the Money” is opposite 9. Premiums a. Determined on floor exchanges b. Agreement between buyers and sellers c. The length of the option adds value by potential d. The amount by which the option is in the money is the “Intrinsic Value” i. Amount if you 1. Were given that money option 2. Exercised it 3. Liquidated the resulting futures ii. Options often exceed intrinsic value because of time value 1. Time decay decreases time value 2. This makes options relatively EXPENSIVE 10. Risky a. Risk limited to premium plus commission b. Won’t get a margin call c. Better compared to futures because limited liability d. Lenders like options e. price insurance f. Like some insurance, it may be fine if you never use it g. E.g. if you buy a put in case prices go down and they don’t drop; h. Then you haven’t lost money on your cash grain This study source was downloaded by 100000810229990 from CourseHero.com on 10-21-2024 18:58:03 GMT -05:00 https://www.coursehero.com/file/36236484/ACE-222-Midterm-2-Study-Guidedocx/ Powered by TCPDF (www.tcpdf.org)