Commodity Marketing

Introduction The term commodity is commonly used in reference to basic agricultural products that are either in their original form or have undergone only primary processing. Examples include cereals, coffee beans, sugar, palm oil, eggs, milk, fruits, vegetables, beef, cotton and rubber. A related characteristic is that the production methods, postharvest treatments and/or primary processing to which they have been subjected, have not imparted any distinguishing characteristics or attributes. Thus, within a particular grade, and with respect to a given variety, commodities coming from different suppliers, and even different countries or continents, are ready substitutes for one another. For example whilst two varieties of coffee bean, such as robusta and arabica, do have differing characteristics but two robustas, albeit from different continents, will, within the same grade band, have identical characteristics in all important respects. Agricultural commodities are generic, undifferentiated products that, since they have no other distinguishing and marketable characteristics, compete with one another on the basis of price. Commodities contrast sharply with those products which have been given a trademark or branded in order to communicate their marketable differences. Agricultural commodity marketing system A commodity marketing system encompasses all the participants in the production, processing and marketing of an undifferentiated or unbranded farm product (such as cereals), including farm input suppliers, farmers, storage operators, processors, wholesalers and retailers involved in the flow of the commodity from initial inputs to the final consumer. The commodity marketing system also includes all the institutions and arrangements that effect and coordinate the successive stages of a commodity flow such as the government and its parastatals, trade associations, cooperatives, financial partners, transport groups and educational organisations related to the commodity. The commodity system framework includes the major linkages that hold the system together such as transportation, contractual coordination, vertical integration, joint ventures, tripartite marketing arrangements, and financial arrangements. The systems approach emphasises the interdependence and inter relatedness of all aspects of agribusiness, namely: from farm input supply to the growing, assembling, storage, processing, distribution and ultimate consumption of the product.

Stages in agricultural commodity marketing The marketing systems differ widely according to the commodity, the systems of production, the culture and traditions of the producers and the level of development of both the particular country and the particular sector within that country. This being the case, the overview of the structure of the selected major commodities marketed, which follows, is both broad and general. The major commodities whose marketing systems will be discussed in this chapter are: large grains, livestock and meat, poultry and eggs, cotton, fruit and vegetables and milk. Table 6.1 identifies the main stages of agricultural marketing and this provides a loose framework around which to structure the discussion of the marketing of these commodities. This is a general model and therefore not all of the stages it describes are equally applicable to the commodities selected for discussion. This being so, certain stages are given more or less emphasis; and for some commodities specific stages are omitted altogether from the discussion. Table 4.1 Stages of agricultural commodity marketing Stages Stage 1 Activity Assembly Example Commodity buyers specialising in specific agricultural products, such commodities as grain, cattle, beef, oil palm, poultry and eggs, milk. Stage 2 Transportation Independent trucking truckers, companies,

railroads, airlines etc. Stage 3 Storage Grain elevators, public

refrigerated

warehouse,

controlled-atmosphere warehouses, warehouses, warehouses Stage 4 Grading and classification Commodity merchants or heated freezer

government grading officials Stage 5 Processing Food and fibre processing plants such as flour mills, oil mills, rice mills, cotton mills, wool mills, and fruit and vegetable canning or freezing plants Stage 6 Packaging Makers of tin cans, cardboard boxes, film bags, and bottles for food packaging or fibre products for Stage 7 Distribution and retailing Independent marketing wholesalers products for

various processing plants to retailers (chain retail stores sometimes have their own separate warehouse

distribution centres)

Characteristics of agricultural commodities Agricultural commodities differ in nature and contents from industrial goods in the following respects. Agricultural commodities tend to be bulky and their weight and volume are great for their value in comparison with many industrial goods. The demand on storage and transport facilities is heavier, and more specialized in case of agricultural commodities than in the case of manufactured commodities. Agricultural commodities are comparatively more perishable than industrial goods. Although some crops such as rice and paddy retain their quality for long time, most of the farm products are perishable and cannot remain long on the way to the final consumer without suffering loss and deterioration in quality.

Most agricultural products are produced seasonally; this condition of seasonal production and availability is not found in the case of industrial goods. Finally, both demand and supply of agricultural products are inelastic. A bumper crop, without any minimum guaranteed support price from the government may spell disaster for the farmer.

Commodity (futures) exchanges Since the early development of agricultural markets, producers have attempted to protect themselves against falling commodity prices at harvest time. Many producers ignored marketing techniques and sold their commodities at harvest regardless of the price. Today, producers have realised that a marketing strategy is equal in importance to production, capital, and labour strategies. Forward contracts The development of forward contracts was a major step in allowing producers to reduce marketing risks. Forward contract is a cash market transaction in which a seller agrees to deliver a specific cash commodity to a buyer at some point in the future. The price is specified in a cash forward contract for a specific commodity. The forward price makes the forward contract have no value when the contract is written. However, if the value of the underlying commodity changes, the value of the forward contract becomes positive or negative, depending on the position held. Example Before a wheat farmer plants his crop, he executes a contract with a cereal company for the delivery and purchase of 75,000 bushels of wheat at a price of $1 per bushel. The actual exchange of the wheat for money will, of course, not take place until after the crop is harvested in the fall. By entering into a forward contract, both the farmer and the cereal company reduce their respective risks. By pre-selling his crop at $1 per bushel, the farmer has protected himself against the risk that in the fall the then-current price (or spot price) will be lower than $1 per bushel. The cereal company, on the other hand, by pre-purchasing has protected itself against the risk that in the fall the spot price of wheat will be greater than $1

per bushel. Both parties to the transaction sacrifice the possibility of getting a better price for themselves in exchange for eliminating the risk of getting a worse price. When harvest time arrives, the spot price will either be higher or lower than $1 per bushel depending on the normal circumstances that affect supply and demand. If the price at harvest has risen to, say $1.35 a bushel, the farmer will undoubtedly wish that he had not entered into the forward contract. The cereal company, however, will be quite pleased to pay a belowmarket price of $1 per bushel. On the other hand, if the spot price in the fall drops to $0.75 per bushel, the farmer will be delighted to be getting the above-market price of $1. The cereal company, of course, will not be so thrilled to have to pay $1 per bushel when the market rate is $0.75. In this contract, as with all forward contracts, the buyer is pleased if the agreed-upon contract price is lower than the spot price and the seller is happy if the contract price is higher than the spot price. Changes from forward contracts to futures contracts Forward contracts had a lot of drawbacks. They were not standardized in terms of quality or delivery time, and merchants and traders did not always fulfil their forward commitments. Due to these drawbacks, steps were taken to formalize commodity trading by developing standardized agreements called futures contracts. Futures contracts This is a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity at a pre-determined price in the future. Futures contracts in contrast to forward contracts were standardized as to quality, quantity, and time and location of delivery of delivery for the commodity being traded. The only variable is price, which is set through an auction like process on the trading floor of an organized exchange. Example A producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price

that both parties believe will be a fair price in June. It is this contract - and not the grain per se that can then be bought and sold in the futures market.

So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). A futures contract has the same general features as a forward contract but is transacted through a futures exchange. Unlike futures contracts (which occur on a trading floor), forward contracts are privately negotiated and are not standardized. Further, the two parties must bear each other's credit risk, which is not the case with a futures contract. Also, since the contracts are not exchange traded, there is no marking to market requirement, which allows a buyer to avoid almost all capital outflow initially (though some counterparties might set collateral requirements). Given the lack of standardization in these contracts, there is very little scope for a secondary market in forwards. Forwards are priced in a manner similar to futures. Like in the case of a futures contract, the first step in pricing a forward is to add the spot price to the cost of carry (interest forgone, convenience yield, storage costs and interest/dividend received on the underlying). Unlike a futures contract though, the price may also include a premium for counterparty credit risk, and the fact that there is not daily marking to market process to minimize default risk. If there is no allowance for these credit risks, then the forward price will equal the futures price. Purpose of commodity (futures) markets Futures exchanges, no matter how they are organized and run, exist because they provide two vital economic functions for the marketplace: risk transfer and price discovery. Futures markets makes it possible for those who want to manage risks-hedgers- to transfer some or all of that risk to those who are willing to accept it speculators. Buying futures contracts Futures contracts are not formalized contract written by an attorney, they are legally binding agreements, made on the trading floor of a futures exchange, to buy or sell something in the future. That something could be corn, soybeans, wheat, tobacco, live beef or some other

commodities. In other words, a futures contract establishes a price today for a commodity that will be delivered later. Buyers and sellers in the futures markets look at current economic information (supply and demand) and anticipate how it may affect the price of a commodity. Though not written each future contract specifies the time of delivery or payment, where the commodity should be delivered, and the quality and quantity of the item. This specificity is what makes the futures contracts attractive to those who want to plan ahead and protect themselves from dangerous price swings and to investors wanting to profit from market fluctuations.

The standard features are called contract specifications. The futures exchange where the commodity is traded usually provides contract specifications for commodity. Business journals are one of the best sources for commodity market information. A common example of how commodity prices may appear is given below: Friday April 16 Corn (CBOT) 5,000 bushels, cents per bushels Open May July Sept Dec 231 236 241 246 High 231 237 241 246 Low 227 232 237 242 Settle 227 233 237 243 Change -4 -4 -3 -3

Name of commodity: corn Where it is traded: Chicago board of Trade Contract size: 5,000 bushels

Price quote: price per bushel Open is the first price anyone paid for corn. High is the highest price anyone paid for corn. Settle or settlement is the last price anyone paid for corn. Change or net change is the difference between the settlement price today, and the previous trading day. Practice: July corn opened at.......................... and settles at............... on April 16. The lowest price anyone paid for July corn, on April 16, was........................., and the highest price anyone paid for July corn on that day was.................. the contract size is ..............., prices are quoted in........................, and it is traded at the ................ Determining the value of a futures contract Suppose the settlement price for December corn futures is 200 cents a bushel: that is , $2.00 a bushel. To calculate the dollar value of one corn contract, multiply the $2.00 settlement price by the contract size. In the case of CBOT corn futures, each contract equals 5,000bushels of corn, so if 1 bushel of corn is worth $2.00, then a 5,000 bushel contract is worth $10,000; $ 2.00 per bushel times 5,000 bushels equals $ 10,000. Futures contracts do not always trade in even numbers: sometimes they move in fractions. These fractions are the smallest price unit at which a futures contract trades and are called minimum price fluctuations. in futures lingo it is referred to as ticks. The tick size of a futures contract varies according to the commodity. The minimum price fluctuation for a CBOT corn futures contract, for instance, is cent per bushel, or $12.50 per contract (5,000 X $.0025). Keeping in mind that the minimum price fluctuation for CBOT corn futures is 14 cents per bushel, the next few higher prices above corn trading at 200 cents per bushel ($2.00/bu) would be 200 cents, 200 cents, 200 , and 201 cents. To calculate the value of a futures contract when fractions are involved, just use the same equation of settlement price times contract size. For example, if December corn futures are trading at 200 cents /bu. Then the contract value is $2.0025/bushel X 5,000 bushels = $ 10,012.50.

Determining profit or loss on a futures contract Suppose you read in the paper that soil moisture in the midlands was below normal for the month of June and the forecast does not look promising for rain. Limited rainfall during the growing season could cause the production of corn to decrease, thus increasing the price. Anticipating higher corn prices, you buy one December corn futures contract at 250 cents/bushels. On July 1, if you were right and corn prices rise, you will make a profit. Throughout the month of July, there is no rain in the Corn Belt. The end result is higher prices, so you decide to offset your position on July 30 by selling one December futures contract at $2.55/bushel. Did you make a profit or loss? : Calculation: Jul 1 BUY 1 Dec. Corn futures at $2.50/bushel

Jul 30 SELL 1 Dec. Corn futures at $ 2.55/bushel Profit The total profit is $250 ($.05 X 5000 bushel). ** remember that brokerage fees are always subtracted from your profit. Who participates? There are two main categories of futures traders that utilize futures contracts. These are the hedgers and speculators. Hedgers either now own, or will at some time own, the commodity they are trading. Hedger may be producers, elevator owners, or any others in the agribusiness input and outputs sectors. Hedgers Hedging is a tool used by producers and agribusinesses to shift some of the risk resulting from price uncertainty to speculators who trade in the futures market. Hedgers use the futures primarily to reduce their price risks in dealing with the cash commodity. They may speculate to some extent on the relationship between futures prices and cash prices, but their goal is to $ .05/ bushel

avoid the substantial decline or rises in prices often encountered in the commodity market. Hedging involves taking a position in the futures market equal but opposite to what one has in the cash market. If prices fall, a producer who placed a hedge will be protected. This is why hedgers willingly give up the opportunity to benefit from favourable price changes to achieve protection from unfavourable changes. Long (buying) and short (selling) hedgers Two terms used to describe buying and selling are long and short. If you first buy a futures contract, this is called going long, or going long hedge. If you first sell a futures contract, this is called going short, or going short hedge. Hedging in the futures market is a two step process. Depending on your cash market situation, you will either buy or sell futures as your first position. For instance, if you are going to buy a commodity in the cash market at a later time, your fist step is to buy a futures contract. In contrast, if you are going to sell a cash commodity at a later time, your first step in the hedging process is to sell futures contracts. The second stage in the process occurs when the cash market transaction takes place. At this time, the futures position is no longer needed for price protection, so it should therefore be offset (closed out). If your hedge was initially long, you would offset your position by selling the contract back. If your hedge was initially short, you would buy back the futures contract. Both the opening and closing positions must be for the same commodity, number of contracts, and delivery month. Example of a long hedge A food processor is planning to buy 240,000 pounds of soybean oil over the next few months to cover production needs. Currently, soybean oil is quoted at 26 cents a pound, but the company management is concerned that prices will rise by the time it is ready to purchase and take delivery of the oil. To take advantage of current prices, the company decides to buy four CBOT September soybean oil futures contracts at 26 cents a pound. The standard contract size for CBOT soy bean oil is 60, 000 pounds. The managements greatest fear comes true. The price of soybean oil jumps to 31 cents a pound by the time the food processor is ready to purchase it. The company offsets its futures position by selling four CBOT September soybean oil contracts for 31 cents a pound. The companys hedging activities result in the following:

Cash market June

Futures market June

Plans to buy 240,000 ibs. Soybean oil in the Buys 4 CBOT Sept. soybean oil futures cash market at $.26 / ib. August contracts at $.26/ib. August

Purchases 240,000 ibs. Soybean oil in the Sells 4 CBOT Sept. soybean oil futures cash market at $.31/ib. Purchase price of cash soybean oil Less futures gain ($.31 - $.26) Net purchase price contracts at $ .31/ib. $.31/ib $.05/ib $.26/ib

By using CBOT soybean oil futures, the food processor lowered its purchase price from 31 cents to 26 cents a pound. That was exactly what the company expected to pay. Example of a short hedge Rather than selling for whatever price the local elevator is willing to pay come harvest time, a producer decides to explore a variety of marketing alternatives including futures. Her ultimate goal is to improve her bottom line. Suppose she figures that it cost her $ 2.00 to produce one bushel of corn. When corn enters a price range of where the producer can make a profit, she may decide to hedge a portion of her crop by selling one CBOT December corn futures contract. (The standard contract size for one CBOT corn futures contract is 5,000 bushels) By early may, CBOT December corn futures hit $ 2.60 a bushel. To lock in a selling price of 42.60, the grain producer sells one CBOT December corn futures contract. As it turns out, there was a near perfect growing condition that year and corn yields are above normal, causing prices to drop. By harvest time, corn has fallen to $1.90 a bushel. The producer therefore offsets her futures position by purchasing one CBOT December corn futures contract. The corn producers hedging activities result in the following:

Cash market May

Futures market May

Plans to sell 5,000 bu. Corn in the cash Sells one CBOT Dec. Corn futures contract market at $2.60/bu. October at $ 2.60/bu. October

Sells 5,000bu. Corn in the market at $ Buys one CBOT Dec. Corn futures contract 1.90/bu. Sales price of cash corn Plus futures gain ($2.60-$1.90) Net sales price $ 1.90/bu. $ 0.70/bu. $ 2.60/bu. at $ 1.90/bu.

By using CBOT corn futures, the producer increased her final sale price from $1.90 to $ 2.60 a bushel. That was exactly what she wanted to receive. Better yet, the final sale price was 60 cents per bushel higher than her production expenses. ** keep in mind that these examples are simplified to give an overview of hedging. Speculators Speculators, in contrast, will likely never own or even see the physical commodity. They are in the game to profit from a move up or down in the market. Agricultural producers, commodity processors, exporters, food manufacturers, and others use the futures market to shift market risk (the risk of adverse price movements) to someone else. The party who assumes the risk is the speculator. They just buy and sell futures contracts and hope to make a profit on their expectations and predictions of future price movements. The profit potential of a speculator is proportional to the amount of risk that is assumed and the speculators skill in forecasting price movement. Speculators always offset their positions by buying (selling) futures contacts they originally sold (bought). Speculators take a price risk on a given product with the hope of making a profit. The risk a speculator takes is not the same as that a gambler takes in buying a lottery ticket. In contrast to gambling, a commodity speculator assumes a naturally occurring risk rather than one that is deliberately created. In agribusiness, risk is

inherent when one holds inventories of commodities. If speculators were not willing to assume some of the risk, a producers costs would increase due to losses from adverse prices. Instead, agribusiness firms are able to produce items at lower costs because they have shifted some of their natural risk to commodity speculators. With this type of market, society benefits. Speculators can be classified by their trading methods: A position trader: this is a public or professional trader who initiates a futures or options position and holds it over a period of days, weeks, or months. A day trader: holds market positions only during the course of a single trading session, and rarely carries a position overnight. Most day traders are exchange members who execute their transactions in the trading pits. Scalpers: trades only for themselves in the pits. Scalpers trade in minimum fluctuations, taking small profits and losses on a heavy volume of trades. Like a day trader, a scalper rarely holds positions overnight. Spreaders: trade on the shifting price relationships between two or more different futures contracts. Examples include: different delivery months for the same commodity, the prices of the same commodity on different exchanges, products and their by-products, and different but related commodities. Economic functions of futures markets Due to the presence of speculations and hedging in futures contracts, futures markets provide a number of very useful economic functions. They can be enumerated in terms of their role in: Enabling hedgers to transfer price risk to speculators: without futures the process of commodity marketing will be more risky and inefficient. The importance of futures can be observed if for whatever reason, futures are not operating. This might be due to severe weather at the location of the exchange, limit moves in the contract price, etc. At those times in the grain trade, the comment is often heard that, elevator are taking protection. This means that being unable to hedge; they widen their margins as they face increased price risks.

Facilitate price discovery: futures markets provide central facilities for buyers and sellers to interact and bring all the forces impinging on price formation together. In many cases, this is a face to face confrontation of buyers and sellers in octagonal pits or similar sites. Typically, the trading is by open outcry in a very transparent process. The floor brokers involved are mainly representing the real buyers and sellers, who may be from all parts of the world.

Enhancing information collection and dissemination: information needed for effective use of futures markets is so valuable that many resources are devoted to collection and dissemination. This involves both public and private organizations. The ministry of agriculture, national farmers union, agricultural marketing association and various cooperating counterparts, play a major role in providing comprehensive, unbiased crop and livestock estimates, and market information. Private consulting firms and specialised market news services are also prominent. Futures market themselves collect and make available an extensive amount of data on prices, volume, and open interest. Open position data on hedgers, small traders and large trades are also generated and distributed.

Assisting in the coordination of economic activity: another economic function of futures market is to help coordinate economic activity. Futures price information is so prevalent that commercial houses simply refer to cash prices in terms of their relationships to futures. This facilitates day to day operations in moving products through the system. With prices on products and in/or inputs locked in, a firm can devote more energy into the production line operation and increasing efficiency.

Stabilizing markets and providing liquidity: active future markets are liquid (many buyers and sellers are ever present either on the trading floor or linked to brokerage offices). At times, cash markets can be a bit clumsy allowing gluts in supplies to unduly depress prices. At other times, shortages can move markets above levels warranted by supply-demand conditions. Some do question whether futures help stabilise prices and cite examples of high volatility in futures at times. Research on commodities futures trading supports the contention that futures stabilize markets. However, in the very short time context, futures may be less stable because market information can quickly be reflected in price moves as compared to more dispersed and less coordinated cash markets.

Providing flexibility in forward pricing: Also related to the transfer of risk, futures markets provide commercial operators considerable flexibility in forward pricing both products and inputs. They can choose to use futures or not and can decide what proportion of their products and inputs to hedge, determining how much risk they are willing to assume.

What commodities are traded, where and why? Futures markets are worldwide. In addition to 13 exchanges in the US, 12 other nations have futures markets. They include Australia, Brazil, Canada (four), France (three), Hong Kong, Japan (four), Malaysia, the Netherlands, New Zealand, Singapore, Sweden, and the United Kingdom (nine). A wide variety of commodities are actively traded in futures markets. Among agricultural products are grains, oilseeds, livestock and meat, milk, dairy products, tropical products such as sugar, coffee and cocoa, frozen orange juice and cotton. A list of some of the commodities and where they are trade is given below: List of traded commodities Agricultural (grains, and food and fibre) Commodity Main Exchange Contract Size Trading Symbol Corn CBOT 5000 bu C Corn EURONEXT 50 tons EMA Oats CBOT 5000 bu O Rough Rice CBOT 2000 cwt RR Soybeans CBOT 5000 bu S Rapeseed EURONEXT 50 tons ECO Soybean Meal CBOT 100 short tons SM Soybean Oil CBOT 60,000 lb BO Wheat CBOT 5000 bu W Cocoa NYBOT 10 tons CC Coffee C NYBOT 37,500 lb KC Cotton No.2 NYBOT 50,000 lb CT Sugar No.11 NYBOT 112,000 lb SB Sugar No.14 NYBOT 112,000 lb SE

Livestock and meat Commodity Lean Hogs Frozen Pork Bellies Live Cattle Feeder Cattle Contract Size Currency 40,000 lb (20 tons) 40,000 lb (20 tons) 40,000 lb (20 tons) 50,000 lb (25 tons) USD ($) Main Exchange Trading Symbol LH PB LC FC

Chicago Mercantile Exchange Chicago Mercantile USD ($) Exchange Chicago Mercantile USD ($) Exchange Chicago Mercantile USD ($) Exchange

The following agricultural products are not, at present (2008), traded on any exchange, and, therefore, no spot or futures market where producers, consumers and traders can fix an official or settlement price exists for these minerals. Generally the only price information that is available is based on information from producers, consumers and traders. Fresh Flowers, Cut Flowers, Melons, Lemons, Tung Oil, Gum Arabic, Pine Oil, Xanthan, Milk, Tomatoes, Grapes, Eggs, Potatoes, and Figs. Others Commodity Ethanol Rubber Palm Oil Wool Polypropylene Linear Low Polyethylene (LL) And so many more In reviewing the list of commodities traded in futures markets, certain common characteristics are apparent: 1. Prices are volatile: volatility attracts both speculative and hedger interest. Speculators can profit (or lose) in a volatile market, but has little opportunity for profit in a stable Unit Currency 29,000 US gallon USD ($) (110 m) 1 kg 1000 kg 1 kg 1000 kg Density 1000 kg US cents () Bourse CBOT *Singapore Commodity Exchange

Malaysian Ringgit Bursa Malaysia (RM) AUD (p) ASX USD ($) London Metal Exchange USD ($) London Metal Exchange

market. Hedgers need protection in a volatile market, but have no need for such protection in a stable market. 2. Products are standardized. Grading is established: because trading in futures markets focuses on a base grade, with the possibility of delivery, the product must have grades and standards acceptable to the industry. This is particularly important with agricultural commodities that are not easily produced to a particular standard. 3. Products are actively produced and marketed: products broadly produced and marketed have a better chance of success as actively traded commodities than those with concentrated production areas with few marketing channels. For example, live cattle futures succeeded, but beef carcass did not, ostensibly because live cattle had a broad production base while beef carcass production was much more concentrated. 4. Many products are storable: at one time, storability was felt to be a prime consideration. Reasons for this related to the delivery process. However, the continuance of live cattle, feeder cattle, and hog futures is testimony that storability is not a necessary condition. However, very perishable products such as fresh fruits and vegetables are not viable candidates.

Options on futures In contrast to futures, options on futures allow investors and risk managers to define risk and limit it to the cost of a premium paid for the right to buy and sell a futures contract. Options provide the opportunity but not the obligation to sell or buy a commodity at a certain price. When talking about options, the underlying commodity is a futures contract and not the physical commodity. With an option, producers have the right, but not the obligation to buy or sell a specific commodity within a specific period of time at a specific price. Producers can use options contracts to establish a minimum selling price for their produce while still retaining the right to any price increase. Futures options are much more attractive to many hedgers and speculators than straight futures contracts. (House example). Example of a simplified options contract: consider a call option that conveys the right to buy a used combine from your neighbour. You are debating whether to buy a used combine or to

put up capital for a new combine. You convince your neighbour to sell you an option to purchase the combine at any time before April 1. In turn, the neighbour gives you the right to buy the used combine for $ 10,000. For this right, you pay $2,000. In option terms, the combine is the underlying commodity, and $10,000 is the strike price. April 1 is the expiration date, and the $2,000 you paid for the option is the premium. At any time before the expiration date, your option contract gives you the right to exercise your option and purchase the combine. However, you are not obligated to buy the combine. You may choose to not exercise your option-you can simply let your option expire. You may offset your current position by selling your option to someone else. Whatever measure you take, the writer (seller) of the option keeps the $2,000 premium. With options, once you make a transaction, you can predict your maximum losses. A call is an option that gives the option buyer the right (without obligation) to purchase a futures contract at a certain price on or before the expiration date of the option, for a price called the premium which is determined in open-outcry trading in pits on the trading floor. A put is an option that gives the option buyer the right (without obligation) to sell a futures contract at a certain price on or before the expiration date of the option. The premium is the cost of futures options. It is the only variable in the options contract traded on the trading floor. The premium depends on market conditions such as volatility, time until the option expires, and other economic variables. The premium is the only element of an option contract that is negotiated in the trading pit; all the other parts of an option contract- such as the strike price and expiration date- are predetermined or standardized by the trading board. Factors affecting premiums Intrinsic value: the intrinsic value of an option is the positive difference between the strike price and the underlying futures price. For a put, the intrinsic value is the amount that the strike price exceeds the futures price. For example, when the July corn futures price is $2.50, a July corn put with a strike price of $2.70 has an intrinsic value of 20 cents a bushel. If the futures price

increases to $2.60, the options intrinsic value declines to 10 cents a bushel. If the strike for a put is below the futures, the intrinsic value is zero, not negative. For a call, the intrinsic value is the amount that the strike price is below the futures price. For example, when the December corn futures price is $2.50, a December corn call with a strike price of $2.20 has an intrinsic value of 30 cents a bushel. If the futures price increases to $2.60, the options intrinsic value increases to 40 cents a bushel. If the futures price declines to $2.40, the intrinsic value declines to 20 cents a bushel

Time value: time value originates from the fact that the longer the time until expiration, the more the opportunity for buyers and sellers to profit. Time valuesometimes called extrinsic value- reflects the amount of money that buyers are willing to pay hoping that an option will be worth exercising at or before expiration. For example, if July corn futures are at $2.16 and a July corn call with a strike price of $2 is selling for 18 cents, then the intrinsic value equals 16 cents (the difference between the strike price and futures price) and the time value equals 2 cents (difference between the total premium and the intrinsic value). The time value of an option declines as the expiration date of the option approach. The option will have no time value at expiration, and any remaining premium will consist entirely of intrinsic value. Major factors affecting time value include the following: Time remaining until expiration: the greater the number of days remaining until expiration, the greater the time value of an option will be. This occurs because option sellers will demand a higher price because it is more likely that the option will eventually be worth exercising Market volatility: time value also increases as market volatility increases. Again, option sellers will demand a higher premium because the more volatile or variable a market is, the more likely it is that the option will be worth exercising. Interest rate: although the effect is minimal, interest rates affect the time value of an option: as interest rates increases, time value decreases.

Determining option classification Call option In the money At the money Out of the - money Futures price > strike price Futures price = strike price Futures price < strike price Put option Futures price > strike price Futures price = strike price Futures price > strike price

Ways to exit a futures option position Once an option has been traded, there are three ways you can get out of a position: exercise the option, offset the option, or let the option expire. Exercise: only the option buyer can decide whether to exercise the option. When an option position is exercised, both the buyers and the seller of the option are assigned a futures position. The option buyer first notifies his/her broker, who then submits an exercise notice to the board of trade clearing corporation. The exercise is carried out that night. The clearing corporation creates a new futures position at the strike price to a randomly selected customer who sold the same option. The entire procedure is carried out before trading opens on the following business day. Offsetting: offsetting is the most common method of closing out an option position. You do this by purchasing a put or call identical to the put or call you originally sold: or by selling a put or call identical to the one you originally bought. Offsetting an option before expiration is the only way you can recover any remaining time value. Offsetting also precludes the risk of being assigned a futures position if you originally sold an option and want to avoid the possibility of being exercised against. Your net profit or loss, after a commission is deducted, is the difference between the premium you paid to buy the option and the premium you receive when you offset the option. Market participants always face the risk that there may not be an active market for their particular options at the time they choose to offset, especially if the option is out of the money or the expiration date is near. Expiration: the other choice you have is to let the option expire by simply doing nothing. In fact, the right to hold the option up until the final day for exercise is one of the features that make options attractive to investors. Therefore, if the change in price initially moves in the opposite direction, you have the assurance that the most you can lose is the premium you paid for the option.

Group Assignment 1. Some say speculating is the same as gambling. Others say that speculating is a calculated business decision. Which view do you favour? Write an essay defending your position. 2. If you decided to trade futures commodities as either a hedger or a speculator, would you trade futures contracts or futures options? Defend your choice. This group assignment will be presented to the class along with other students, in the form of a debate.