Hedging Against Falling Rice Prices using Rice Futures

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Rough Rice May ’20 (ZRK20)

grains Futures News

Michael Seery – Seery Futures Sun Apr 5, 10:42AM CDT

Jerry Welch – Sat Apr 4, 11:41AM CDT

Things were wild this week but back in.

Brady Sidwell – Sidwell Strategies Fri Apr 3, 8:30PM CDT

It was a wild start to Q2 with cattle markets making new lows, grains selling off and a record surge in unemployment. Payroll protection applications started.

Ben Dicostanzo – Walsh Trading, Inc. Fri Apr 3, 5:07PM CDT

More down side for cattle and hogs

Sean Lusk – Walsh Trading Fri Apr 3, 3:27PM CDT

Supply Side Rally Play

Murray Rosenberg – Fri Apr 3, 2:20PM CDT

I follow many trading products using the same mathematical formulas for intraday, daily and weekly trends.

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    Basis Risk

    What is Basis Risk?

    Basis risk is defined as the inherent risk a trader The Winning Mindset of a Trader Being a master trader is not just about formulating better strategies and analysis but is also about developing a winning mindset. Traders have important psychological skills that give them a distinct trading edge. takes when hedging a position by taking a contrary position in a derivative of the asset, such as a futures contract. Basis risk is accepted in an attempt to hedge away price risk.

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    As an example, if the current spot price of gold is $1190 and the price of gold in the June gold futures contract is $1195, then the basis, the differential, is $5.00. Basis risk is the risk that the futures price might not move in normal, steady correlation with the price of the underlying asset Types of Assets Common types of assets include: current, non-current, physical, intangible, operating and non-operating. Correctly identifying and classifying assets is critical to the survival of a company, specifically its solvency and risk. An asset is a resource, controlled by a company, with future economic benefits. , and that this fluctuation in the basis may negate the effectiveness of a hedging strategy employed to minimize a trader’s exposure to potential loss. The price spread (difference) between the cash price and the futures price may either widen or narrow.

    Hedging Strategies

    A hedging Hedging Arrangement Hedging arrangement refers to an investment whose aim is to reduce the level of future risks in the event of an adverse price movement of an asset. Hedging provides a sort of insurance cover to protect against losses from an investment. strategy is one where a trader adopts a second market position for the purpose of minimizing the risk exposure in the initial market position. The strategy may involve taking a futures position contrary to one’s market position in the underlying asset. For example, a trader might sell futures short to offset a long, buy position in the underlying asset. The idea behind the strategy is that at least part of any potential loss in the underlying asset position will be offset by profits in the hedge futures position.

    When large investments are involved, basis risk can have a significant effect on eventual profits or losses realized. Even a modest change in the basis can make the difference between bagging a profit and suffering a loss. The inherently imperfect correlation between cash and futures prices means there is potential for both excess gains and excess losses. This risk that is specifically associated with a futures hedging strategy is the basis risk.

    Components of Basis Risk

    Risk can never be altogether eliminated in investments. However, risk can be at least somewhat mitigated. Thus, when a trader enters into a futures contract to hedge against possible price fluctuations, they are at least partly changing the inherent “price risk” into another form of risk, known as “basis risk”. Basis risk is considered a systematic, or market, risk. Systematic risk is the risk arising from the inherent uncertainty of the markets. Unsystematic, or non-systematic, risk, which is the risk associated with a specific investment. The risk of a general economic turndown, or depression, is an example of systematic risk Systematic Risk Systematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. Systematic risk is caused by factors that are external to the organization. All investments or securities are subject to systematic risk and therefore, it is a non-diversifiable risk. . The risk that Apple may lose market share to a competitor is unsystematic risk.

    Between the time a futures position is initiated and closed out, the spread between the futures price and the spot price may widen or narrow. As the visual representation below shows, the normal tendency is for the basis spread to narrow. As the futures contract nears expiration, the futures price usually converges toward the spot price. This logically happens as the futures contract becomes less and less “future” in nature. However, this common narrowing of the basis spread is not guaranteed to occur.

    Hedging with Futures Contracts

    Suppose a rice farmer wants to hedge against possible price fluctuations in the market. For example, in December, he decides to enter into a short-sell position in a futures contract in order to limit his exposure to a possible decline in the cash price prior to the time when he will sell his crop in the cash market. Assume that the spot price of rice is $50 and the futures price for a March futures contract is $55. The basis, then, is $5.00 (the futures price minus the spot price). In this situation the market is in contango, Contango vs Backwardation Contango vs backwardation are terms used to describe the shape of the futures curve for commodity markets. The futures curve has two dimensions, plotting time across the horizontal axis and delivery price of the commodity across the vertical axis. i.e., the spot price is less than the futures price.

    Suppose the farmer decides to lift the hedge in February, due to falling prices. At the time he decides to close out his market positions, the spot price is $47 and the March futures price is $49. He sells his rice crop at $47 per unit and lifts his hedge by buying futures to close out his short sell position at $49. In this case, his $3 per unit loss in the cash market is more than offset by his $6 gain from short selling futures ($55 – $49). Therefore, his net sales revenue Sales Revenue Sales revenue is the income received by a company from its sales of goods or the provision of services. In accounting, the terms “sales” and “revenue” can be, and often are, used interchangeably, to mean the same thing. Revenue does not necessarily mean cash received. becomes $53 ($47 cash price + $6 futures profit). The farmer has enjoyed extra profits as a result of the basis narrowing from $5 to $2.

    If the basis remained constant, then the farmer would not gain any extra profit, nor incur any additional loss. His $3.00 profit in futures would have exactly offset the $3.00 loss in the cash market. It’s important to note, however, that while his short sell hedge in futures didn’t generate any additional profit, it did successfully protect him from the price decline in the cash market. If he had not taken the futures position, then he would have suffered a $3.00 per unit loss.

    The other possible scenario would be where the cash market price declined while the futures price increased. Suppose when the farmer closed out his short sell futures hedge, the cash price was $47 but the futures price was $57. Then he would have lost $3.00 per unit in the cash market and lost an additional $2.00 in his short futures trade ($57 – $55). His net sales revenue would be only $45 per unit. Why the extra loss? Because in this instance the basis widened, as opposed to narrowing or remaining constant. It was the opposite of the basis pattern the farmer was looking for to successfully hedge his cash crop. In this case, the farmer took the basis risk and lost.

    It’s also worth noting that a buyer of rice, looking to hedge against a possible cash market increase in the price of rice, would have bought futures as a hedge. That hedger would realize maximum profit from the third scenario, where the basis widened from $5.00 to $10.00.

    Different Types of Basis Risk

    Different types include:

    1. Price basis risk: The risk that occurs when the prices of the asset and its futures contract do not move in tandem with each other.
    2. Location basis risk: The risk that arises when the underlying asset is in a different location from the where the futures contract is traded. For example, the basis between actual crude oil sold in Mumbai and crude oil futures traded on a Dubai futures exchange may differ from the basis between Mumbai crude oil and Mumbai-traded crude oil futures.
    3. Calendar basis risk: The selling date of the spot market position may be different from the expiry date of a futures market contract.
    4. Product quality basis risk: When the properties or qualities of the asset are different from that of the asset as represented by the futures contract.

    Main Takeaways

    Basis risk is the risk that is inherent whenever a trader attempts to hedge a market position in an asset by adopting a contrary position in a derivative of the asset, such as a futures contract. Basis risk is accepted in an attempt to hedge away price risk. If the basis remains constant until the trader closes out both of his positions, then he will have successfully hedged his market position. If the basis has changed significantly, then he will likely experience extra profits or increased losses. Producers looking to hedge their market position will profit from a narrowing basis spread, while buyers will profit from a widening basis.

    More Resources

    Thank you for reading this CFI guide to basis risk. CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ certification FMVA® Certification Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari . To prepare for the FMVA curriculum, these additional resources will be helpful:

    • Contango vs. Backwardation Contango vs Backwardation Contango vs backwardation are terms used to describe the shape of the futures curve for commodity markets. The futures curve has two dimensions, plotting time across the horizontal axis and delivery price of the commodity across the vertical axis.
    • How to read stock charts How to Read Stock Charts If you’re going to actively trade stocks as a stock market investor, then you need to know how to read stock charts. Even traders who primarily use fundamental analysis to select stocks to invest in still often use technical analysis of stock price movement to determine specific buy and sell, stock charting
    • Hedge fund strategies Hedge Fund Strategies A hedge fund is an investment fund created by accredited individuals and institutional investors for the purpose of maximizing returns and reducing or eliminating risk, regardless of market climb or decline. Hedge fund strategies are employed through private investment partnerships between a fund manager and investors
    • Risk Averse Risk Averse Definition Someone who is risk averse has the characteristic or trait of preferring avoiding loss over making a gain. This characteristic is usually attached to investors or market participants who prefer investments with lower returns and relatively known risks over investments with potentially higher returns but also with higher uncertainty and more risk.

    Hedging Strategies Using Futures – Basics of Hedging

    Hedging Strategies Using futures

    Financial Risk Manager (FRM®)

    Part I of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.

    Hedging Strategies Using Futures

    Welcome to the 3rd session of Financial Markets and Products. In the earlier session, we have learned the basics of futures markets, including the settlement and delivery procedures. In this session, we will learn the basic concepts of hedging. The term hedging means protection from uncertainty. For example, a trader insuring his shipment is hedging himself against loss due to unforeseen events such as theft etc. We will learn how futures can be used to hedge a position and reduce risk. Let us begin our discussion.

    The main agenda of our discussion will be learning the various concepts used in hedging with futures contracts. In this session, we will begin by learning the basic concepts and types of hedging. We will then introduce the concept of basis risk, which arises due to a mismatch between an underlying price and its futures contracts. We will learn how to quantify the number of contracts for an effective hedge. We will use this concept of hedging for adjusting the systematic risk of a portfolio. Finally, we will end the session by briefly discussing about rolling a hedge.

    In financial markets, any trader can be in a long or a short position. In a long position, the trader has a requirement to sell any asset on the future date, while in a short position, the trader needs to purchase the asset on a future date. For example, a farmer who has yet to harvest his crops is in a long position, as he will need to sell the crops on a future date when the harvesting is complete. There is always uncertainty associated with future dates, and traders usually hedge their uncertain positions through purchasing or selling futures contracts. In a short position, traders enter into a long hedge by buying futures contracts. This is done to protect them against chances of rising prices. For example, an oil company buys crude oil futures to hedge against rising prices. In a long position, traders enter into a short hedge by shorting futures contracts. This is done to protect them against the chances of a decline in prices. For example, a farmer sells rice futures to hedge against declining prices. There are advantages of hedging, such as the reduction of risks due to uncertain price movements, as in the examples we just quoted. Another advantage is that it enables companies to accurately forecast earnings into the future, and thus enable them to maintain a more stable financial position. A major disadvantage with hedging is that the hedger forgoes the advantage due to favorable price movement. For example, a hedged farmer has no advantage if the prices increase in the future, as any advantage is offset due to the loss in the futures contracts.

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