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Calculate the Cost of Futures and Options

Feb 06, 2012

How much capital is required by a dairy when using futures and options strategies to manage its milk price?

Carl BablerBy Carl Babler, First Capitol Ag

Informed dairymen are increasingly comfortable with the following realities:

  • ·         There is a cost to any form of commodity risk management.
  • ·         It takes both initial premium and working capital to use futures and options strategies for milk price risk management.
  • ·         Cash and operating accounts are commonly insufficient to fund milk hedging strategies.
  • ·         A separate line of credit is required to properly fund milk hedging activity.
  •  
The amount of capital required for a dairy to meet the financial obligations of holding hedge positions is dependant on three prime variables:
1.       Hedge strategy - There are three general types of hedge strategies commonly used by dairies, and they each have distinct financial obligations associated with them:
·         The straight long (purchased) put strategy is used to establish a minimum price. It requires only the cost of the premium and no margin obligation is incurred.
·         The long (purchased) put combined with the short (sold) call is used to establish a min/max “fence” strategy and requires both a premium and a margin obligation on the sold call in the strategy.
·         Sold futures are used to “fix” a price and require an initial and ongoing margin obligation.
The marginable strategies have unlimited financial exposure as there is risk that the market may move dramatically opposed to the position requiring producers to meet margin calls through the duration of the position. At term the position will be cash settled against the announced USDA price for the given month, resulting in the position’s final P/L with all excess margin return to cash in the dairy’s hedge account.
2.       The duration and volume, where the larger the position and the longer the position is held the greater the exposure to time and price volatility. This increased exposure results in a larger potential margin obligation.
 
3.       The amount of negative price-change “stress” relative to the strategy that is incurred during the duration of the position directly impacts funds required.
Knowing the variables that contribute to the financial obligation of a hedge position, it is therefore possible to conduct a margin stress test for a dairy and thus observe the total possible financial obligation that a dairy may incur. 
For example purposes, let us apply a “Margin Call Stress Test” to a typical 1,000-cow dairy using the different strategies or combination of strategies discussed above to compare and define, “How much capital is required by a dairy when using futures and options strategies to manage milk price?”
 1,000 cows for 100% coverage for 12 months showing the credit line needed per head:
  1. $15.25 Minimum Price Put option hedge: Total $125/hd
·         12-month strip of $15.25 puts for 0.40/cwt. premium: 13 contracts/mo x 12 months x 0.40/cwt. / 1,000hd =  Total $124.80/hd
        2$16/$20 Min/Max “fence” hedge: Total: $985/hd
·         Premium: 13 contracts/mo x 12 months x 0.30/cwt. /1,000 hd = approximately $93.60/hd
·         Initial Margin: approximately $78/hd to $234/hd
·         Stress margin: short $20.00 calls at a $22.00 stress = $625/hd
·         Total: $985/hd
        3. $17 Fixed Price Hedge with sold futures: Total: $1,794/hd
·         Initial margin: 1,500/contract x 12 months x 13 contracts/mo/1,000 hd = $234/hd
·         Stress test if futures would move from $17.00 to 22.00: $1,560/hd
·         Total: $1,794/hd
The range may be from $125 to $1,800/hd but, in practical terms, by combining strategies and managing duration and coverage, one can cut this down to $1,000/hd or less. For instance, consider the example of a 1,000-cow dairy with a $750,000 hedge line of credit ($750/hd). If they wanted to do all futures for 12 months on 100%, they would be well short of protecting against a $5/cwt. move. They could, however, still get a significant amount of coverage by mixing and matching a strategy that fits within their credit capacity -- in this case, going 90% covered and leaning more heavily on option strategies.
Hedging a 1,000 cow dairy with a combination of strategies
·         30% puts, 50% min/max, 10% futures
·         Total = 30% x 124.80 + 30% x 985 + 10% x $1,794/hd = $709/hd
Consider if the dairy’s line was only for $550,000, the positions could be the same strikes and strategies but reduced from 12 months down to nine months:
Hedging a 1,000-cow dairy with hedge duration reduced from 12 months to nine months
·         Total = $709 x 9/12 = $531/hd
The bottom line is that, for every 1,000 cows, a good rule of thumb is that a dairy needs a hedge line of credit of approximately $1 million if it wants to make use of all the available hedging tools. It is also critical to note that stress tests can’t take into account every possible price scenario.
Lenders must be willing to expand the line as necessary if futures prices run beyond initial stress levels to allow the dairy the ability to hold positions to term while waiting out the cash flow mismatch. Significant losses can occur if marginable hedge positions can’t be held to settlement due to a lack of credit. Fortunately, greater numbers of lending institutions nationwide are providing such hedge lines of credit to producers that following strict risk management policies. This is allowing more and more producers to take advantage of the best available tools, whether marginable or not, to capture opportunity and minimizing risk.
Carl B. Babler is a consultant and senior hedge specialist with First Capitol Ag in Galena, Ill. He has been involved in the futures industry as a broker, educator and hedger since 1975. Babler holds master’s degree from the University of Wisconsin-Platteville and completed agribusiness course work at Harvard University. You can reach him at 1-800-884-8290 or cbabler@firstcapitolag.com.

 

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