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USING FUTURES TO MANAGE RISK RICHARD BRIGGS RBC Dominion Securities USING FUTURES TO MANAGE RISK RICHARD BRIGGS RBC Dominion Securities

What is a Basis? § Basis Spot price of hedged asset - Futures price What is a Basis? § Basis Spot price of hedged asset - Futures price of contract § A negative number means futures above spot price. A positive number means spot price above futures. § Basis varies less then spot or futures prices

Basis § Spot prices reflect current conditions where as futures reflect anticipatory conditions § Basis § Spot prices reflect current conditions where as futures reflect anticipatory conditions § Seasonality may affect the basis • Narrow basis occur during Aug-Sept period • Increasing supply conditions • Widening basis occur during Dec-Jan period • Decreasing supply conditions § At futures maturity both prices will be about the same

Spot and Future Price -Daily Spot Price -Daily Future Price Spot and Future Price -Daily Spot Price -Daily Future Price

Using Futures to Hedge Price Risk § Futures and Spot prices will move up Using Futures to Hedge Price Risk § Futures and Spot prices will move up or down together § Hedging involves taking the opposite side of the spot position § Remaining risk is Basis which has a lower risk profile then remaining un-hedged § CME Lean Hog contract is for 40000 lbs § Currency of contract is USD § Margin requirement per contract $1250

Hedging - Upward moving market Date Spot Market Futures Market Basis January 5 2012 Hedging - Upward moving market Date Spot Market Futures Market Basis January 5 2012 81. 40 87. 55 cwt 81. 40 - 87. 55 Sell 1 CME LH J 2 -6. 15 89. 40 cwt 83. 25 – 89. 40 Buy 1 CME LH J 2 -6. 15 Hedge is placed April 16 2012 Hedge is lifted 83. 25 Operation in futures market results in loss of (87. 55 -89. 40)x 40000= -$740 usd per contract FINAL PRICE RECEIVED Spot Price + G/L on Futures Operation 83. 25 – 1. 85= 81. 40 cwt

Hedging - Downward moving market Date Spot Market Futures Market Basis January 5 2012 Hedging - Downward moving market Date Spot Market Futures Market Basis January 5 2012 83. 25 87. 55 cwt 83. 25 - 87. 55 Sell 1 CME LH J 2 -4. 30 85. 70 cwt 81. 40 – 85. 70 Buy 1 CME LH J 2 -4. 30 Hedge is placed April 16 2012 Hedge is lifted 81. 40 Operation in futures market results in gain of (87. 55 -85. 70)x 40000= +$740 usd per contract FINAL PRICE RECEIVED Spot Price + G/L on Futures Operation 81. 40 + 1. 85= 83. 25 cwt

How many contracts does one need to hedge? 1. Verify the impact of $1 How many contracts does one need to hedge? 1. Verify the impact of $1 cwt change in futures 2. Divide 400 by this (LH contract is 40 k lbs, about 150 market ready pigs each penny change represents $400. 00 3. This number represents the amount of contracts to place on your hedge Number of Pigs per 1 LH Contracts = 400 1 X % of futures used for pig price Example: finisher buys 100 feeder pigs for 85% of July LH futures price Number of Pigs per 1 LH Contracts = 470 400 1 X. 85

Using Options to Hedge § Using options is another way to hedge your production Using Options to Hedge § Using options is another way to hedge your production § Can sell calls or buy puts when prices falling § Can buy calls and sell puts when prices are rising § Can create neutral, bullish and bearish option strategies through options

Using Options to Hedge (cont’d) § Options can be combined with futures to enhance Using Options to Hedge (cont’d) § Options can be combined with futures to enhance risk profile § Buying options to hedge = producer knows maximum cash outlay § Options provide flexibility in your hedge

Reasons to Hedge with Futures § Most Marketing contracts don’t have a fixed price Reasons to Hedge with Futures § Most Marketing contracts don’t have a fixed price § Many contractors use LH futures to determine a sales price § Usually restricted on how far out you can hedge your price § Can protect against un-priced physical § Producers can use futures to manage price risk § Flexible, offset at any time

Reasons to Hedge with Futures (cont’d) § Futures can be used to manage input Reasons to Hedge with Futures (cont’d) § Futures can be used to manage input price risk and currency risk § Basis may change but the reduction in risk through hedging outweighs being un-hedged. § Will enhance your credit profile with lenders § Flexible, offset at any time

Hedging no Panacea § Hedging does not always guarantee best selling price § Basis Hedging no Panacea § Hedging does not always guarantee best selling price § Basis does change • Quality of hogs • Delivery location • Time Contracts may not match exactly with production

Using Futures to Manage Risk Thank You Richard Briggs Tel# 1 -855 -602 -4113 Using Futures to Manage Risk Thank You Richard Briggs Tel# 1 -855 -602 -4113 Email : richard. [email protected] com RBC Dominion Securities Inc. * and Royal Bank of Canada are separate corporate entities which are affiliated. *Member. Canadian Investor Protection Fund. ®Registered trademark of Royal Bank of Canada. Used under licence. RBC Dominion S®Registered trademark of Royal Bank of Canada. Used under licence. RBC Wealth Management is a registered trademark of Royal Bank of Canada. Used under licence. ©Copyright 2011. All rights reserved.