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Purpose: Provide a general overview of the business decisions involved in using Futures and Options on Futures to protect prices
This is NOT a "how to" - We aim to provide a general framework to use when addressing your business' risk management and if Futures
and Options will help you run your business more effectively.
When considering these concepts and ideas, take in to account that market prices are a function of humans and their emotions.
What may be the logical outcome is not always the real world outcome. |
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There are U.S. and foreign exchange traded Futures and Options contracts in the following catagories:
- Energy Products
- Equity Indexes
- Food products
- Foreign currency
- Industrial products
- Interest Rates
- Precious metals
Many physical and financial products have cash and forward markets that set prices in relation to the Futures markets:
Cash Market: Your deliverable product's quality and quantity are known, but the date is uncertain or you have an impending delivery but don't like the prevailing price.
Forward Contract: An agreement entered into by two parties for the future delivery of a specified commodity under specified terms.
Forward contracts' potential problems:
Futures Prices: Many forward contracts are set relative to the price of an exchange-traded futures contract. It is important to note that this does not protect from fluctuations in that futures contract. The Futures price is often the largest portion of a forward contract's delivery
price and, therefore, holds the most price risk.
A large price change in the futures market on or before the delivery date may drastically affect your bottom line (Positive or negative).
If you don't protect yourself, you are speculating by default.
Counterparty risk: One party's inability or unwillingness to meet the contract terms. Have you (or are you aware of someone who has) been a victim of counter-party default? There are times when parties are locked into a contract with terms they feel are unfavorable because it is the best available at the time.
Illiquidity: Changes in your business that necessitate terminating the agreement |
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Sustainability - Allows you to continue your business in the face of adverse price moves
Flexibility - Improve your ability to adapt to changing marketplace conditions. Price protection strategies may allow you to buy time for your business in a hostile pricing environment
Opportunity - With a smoothed and more predictable revenue stream,
you can plan for:
- Capital improvements in your equipment.
- Acquisitions and expansion of your business.
- Equipment upgrades and enhanced maintenance.
- Labor and compensation issues for both your workers and yourself.
- The cost of financing expansion of your business may be lowered if your lender sees that your business has price risk management procedures in place.
- Peace of Mind- Allow for more predictable accounting and focus on your business plan while minimizing the ever present threat and distraction of volatile prices.
Do you hedge? Do volatile price moves hurt your business?
Too often, we hear from businesses who want to have the "hedging conversation" when it's
too late. You should be addressing this issue as a normal cost of doing business in the normal course of doing business. Otherwise you may actually put your business's survival at risk. |
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When addressing the following issues, ask yourself questions in the following areas:
Clarify your risks:
- What prices am I exposed to?
- When am I going to be exposed to price changes?
- For how long will I be exposed?
- Am I a buyer or seller of the price risks?
- What do I pay attention to that affects these prices?
Assess your need for protection:
- Have my revenues or expenses been negatively affected in the past by an adverse price change?
- Is my business disproportionately exposed to prices in some specific market?
- Do the normal price fluctuations make my business vulnerable?
- Have I endured "lean" seasons because of drastically lower revenues or higher expenses?
Quantify your price risks:
- How much exposure am I at risk for?
- What level of price change will drastically affect my bottom line?
Evaluate how much risk you want to protect against.
- How much cash can you reasonably afford to use to fund risk management?
- What is the price of insurance?
- Don't spend $1,000 to protect $1,000.
Balance uncertainty with opportunity cost:
- Do you want to set a price or insure against a catastrophic move?
- Do you like the current price?
- Do you think prices may improve?
These initial steps will help you decide whether to protect yourself. Your thoughts and input will help us show you which products, or combination of products, offer you the best protection. Each case is different. Fortunately, futures and options contracts provide the flexibility for you to develop a price protection strategy that may effectively complement your overall business plan. |
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If you choose not to protect prices in any way, you are speculating by default.
Are you prepared for the consequences involved with speculation?
We feel it is important to address this issue up front in running your business.
When considering whether to enter into a hedge position, you might ask yourself questions such as:
- Do you like the current price?
- Do you think it will stay at these levels?
- Futures allow you to "fix" a price for a specific period of time. |
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Protection against Counter Party Risk: The marketplace is protected against counter-party risk by the exchanges and clearing firms. The exchanges and the exchange's clearing members, known as Futures Commission Merchants (FCM), guard against default through the exchange's clearing house.
Regulated marketplaces: In the United States, Futures marketplaces are regulated by the U.S. Government through the Commodity Futures Trading Commission and the industry's Self Regulatory Organization, the National Futures Association. They regulate and monitor marketplace integrity and member professional conduct.
Standardized contract terms: Each December 2006 Gold Futures contract is identical to every other December 2006 Gold Futures contract in:
- Size
- Grade or quality
- Expiration or delivery date
- Designated delivery points and methods.
- This supports the ease of exit and entry for positions.
Access to price discovery: Getting into and out of positions is as simple as calling your broker and asking to put your position on or take it off.
* Futures contracts are offered in specific delivery contracts months.
* Options are offered in all serial months.
Support evaluation and duplication of strategies: Standardized futures contracts allow you to implement and evaluate a strategy that can be flexible and can be duplicated in your business model.
* There are marketplace conditions that may preclude market participants from exiting or entering positions in a timely manner. |
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ADVANTAGES
Understandable:
A hedge is the initiation of an agreement or contract as a temporary substitute for the purchase or sale of a cash commodity at a later date. Ask yourself: am I buying something or selling something in the future?
Reduced Uncertainty:
Fixes your price. Since futures prices tend to move with cash prices, losses in your "cash" transaction should be somewhat offset by a gain in your futures transaction and vice versa.
Delivery:
Enables you to go into the delivery process if there is a problem with your physical transaction.
Low Transaction Costs:
Sometimes just tenths of a cent per unit (lb, gal, bushel, etc)
DISADVANTAGES
Margin Calls:
A favorable move in cash prices is an unfavorable move in futures prices. Resulting margin calls may be a drain on your cash flow.
No Windfall Profits:
Cannot profit if "cash" prices move in your favor. Additionally, in a favorable price move in your cash product, not only will you not be able to participate in windfall profits, you will have to fund margin calls. Will it tempt you to remove your hedge?
Potential Speculative Exposure:
An uncertain delivery size may result in unwanted speculative exposure. This is especially true for producers. |
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If you do fix your price and it changes favorably, you have foregone potentially higher profits. These windfall profits may be a part of your expected revenue stream.
Options serve to protect prices while still allowing you to participate in potential windfall profits. Protecting with options is much like an insurance policy. You pay a premium for protection. More protection costs more money. |
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ADVANTAGES
Profits:
You may profit from favorable price moves in your commodity while still protecting yourself.
Known costs:
The price of the option is paid for upfront at an agreed upon price.
Margin calls:
No margin calls (drain on your cash flow) if prices move favorably in your commodity. You have already paid for the protection up front.
Flexibility:
- Price. If a "runaway market" reverses, you are not locked into inferior prices.
- Time. Trades in all calendar months. However, there can be limitations on which options trade further out in time.
- Size. Allows for a more precise hedge size related to your desired protection.
- Protection. Different strike prices can enable you to protect prices at different levels.
DISADVANTAGES
Higher Cost:
Premium paid is an upfront cost and requires an initial cash outlay.
Wasting Asset:
Much like an insurance policy, option contracts expire at a specific date in the future.
Under most circumstances, their price (premium) tends to decline over time.
Efficiency:
Lower trading volume in some contracts may compromise efficiency.
Volatility:
More volatile product prices typically raise premium. We, as brokers, can help you determine the appropriate instrument to use.
It is important to remember that both futures and options involve a cash outlay or investment: Futures needs a cash balance in your margin account to "finance" the hedge and may require further cash outlays to meet margin calls.
Options are a direct purchase out of your cash balance and are paid for once and upfront. |
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At Providio, it is our job to help guide you through the process of using futures and options contracts to protect prices. It is quite possible you are already addressing some of these steps.
We feel strongly this is the process any broker should work through
with you in using futures & options to manage price risk:
- Duration of hedge
- Size of exposure needed
- Timing of implementation
- Other Implementation criteria
- Hedge account cash management
- Hedge position removal criteria
- Evaluation of results
If desired or needed, your strategy may combine futures and options to protect prices in different ways. You may want to reduce uncertainty of your transaction: futures. You may want to devote the necessary capital to purchasing insurance that will allow you to enjoy windfall profits: options. You may want to combine both.
We will work with you to determine your business's price protection needs. |
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The purpose of this Hedging Overview is to discuss an initial set of issues to address when considering using futures and options to protect prices for your business. Some concepts include why you should protect prices, the decision process itself and some basic differences
in the characteristics of futures and options contracts.
However, we feel strongly that the most important item to take away from this Overview is that the goal of any price protection program is ensuring your business survives and prospers.
Whether you decide to use futures and options (with us or some other broker), you need to address this issue. Today's business environment has become too competitive not to. |
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