SP Trng - Futures

8/3/2019 SP Trng - Futures

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Hedging and Differentials

An Introduction

22 Feb 2003


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PHYSICAL CONTRACTS

PHYSICALS Vs FUTURES

WHAT IS A FUTURES CONTRACT?

WHO ARE THE PLAYERS?

WHY USE FUTURES?

HEDGING

WHATHOW

WHY

STRUCTURE / SPREADS

ARBITRAGE

OPTIONS

WHAT WE WILL COVER ..


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PHYSICAL AND FUTURES CONTRACTS


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PHYSICAL CONTRACT

It is the purchase or sale of coffee where the grade of coffee,quantity, origin, shipment period, terms and price are specifiedand agreed by the buyer and seller. Examples of physical tradeswould be

Buying 200T of Indonesia G4 for Sep 01 shipment at $600 FOB,NSW, Panjang

Selling 100T of Vietnam G1 to Nestle for Nov 01 delivery at $580,CIF Rotterdam

Transfer 100T of IVC G1 for Oct 01 shipment from IVC to Algeria

at $560 C+F Algiers. (Here, the buyer is Olam Algeria and theseller is Olam IVC)


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FUTURES

A coffee futures is an electronic piece of paper that can bebought or sold on the exchange.

It is very similar to shares/stocks, which all of us would have

dabbled in, at some point.Unlike physicals, a futures is a STANDARD contract. The futuresprice is referenced to a standard grade, delivered at exchangenominated warehouses. (more on this during the trainingsession on grading and tendering)

There are no grades or origins specified in a futures contract.The exchange acts as the counter-part in all futures deals, butdoes not take positions !!

FRF=S, Bid [O/H/L/C Bar][MA 40] Daily

06Jan00 -05Oct01

Feb00 Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan01 Feb Mar Apr May Jun Jul Aug Sep Oct

Pr

6.3

6.4

6.5

6.6

6.7

6.8

6.9

7

7.1

7.2

7.3

7.4

7.5

7.6

7.7

7.8

7.9

FRF=S , Bid, O/H/L/C Bar

21Sep017.06857.14557.06557.1045

FRF=S , Close(Bid), MA 40

21Sep017.2535


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Month Price VolumeSep 473 800Nov 489 540

Jan 508 720

Trade entry

Floor Trader

BrokerOLAM

A TYPICAL EXCHANGE FLOOR

Trade entry

Floor Trader

BrokerXYZ


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FUTURES MARKET - PLAYERS

Speculators Funds

Docs/Dentists/Teachers

Locals

Hedgers Origin

Industry

Manufacturers

Trade

Facilitators Clearing House

Brokers

Grading & Warehousing


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SPECULATORS

TAKE A RISK IN ANTICIPATION OF PROFITS

DO NOT, AS A RULE, LIKE TO PLAY WITH THE PHYSICALS

ADD VOLATILITY BY AMPLIFYING THE SENTIMENT

ADD LIQUIDITY TO THE MARKETS

TEND TO FOLLOW TECHNICALS MORE THAN FUNDAMENTALS


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HEDGERS

HEDGE A RISK TO PROTECT PROFITS

LOOK TO THE TERM. FOR REFERENCE PRICES AND LIQUIDITY

THE SUPPLY SIDE WILL LOOK FOR HIGHER PRICES AND WILL

TEND TO SELL AT THE HIGHER LEVELS [THUS MAKING HIGHS]

MOSTLY ON SPOT BASIS FOR THE CURRENT CROP

[MKTG BOARDS - AN EXCEPTION]


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HEDGERS

THE CONSUMERS

WILL LOOK FOR LOWER PRICES AND WILL

TEND TO BUY AT LOWER PRICES [THUS MAKING LOWS]

WILL LIKE TO ENSURE A CONSISTENT SUPPLY AND THUS

BUY FUTURESFAR PHYSICAL TO PICK UP A PRICE COVER

FOR THEIR INVENTORY. THEY WILL MONITOR THE PRICE

OF THIS COVER AND ADJUST THE QUANTITY AS PER THE

MARKET SITUATION


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HEDGERS

THE TRADE

WILL TRY TO REMAIN PRICE LEVEL NEUTRAL AND

ADD VALUE BY

TRADING ON THE BASIS AND BY

ASSUMING THE COUNTERPARTY RISKS INVOLVED

ON BOTH SIDES

BUYING FROM FARMERS AT HIGHS AND SELLING TOCONSUMERS AT LOWS


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FACILITATORS

TRY TO MAINTAIN THE COUNTER-PARTY CREDIBILITY OF

THE EXCHANGE BY

CHECKING ON THE FINANCIAL HEALTH OF THE PLAYERS

THE COMPLIANCE TO THE RULES

THE QUALITY AND AVAILABILITY OF THE STOCK

ENSURE THE SMOOTH FUNCTIONING OF THE EXCHANGE

BY FACILITATING INFORMATION FLOWS


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A PHYSICAL TRADERS PROBLEM

Date Action physicals

14th Sep Buy 100T coffee at $560, expect to sell at $600 and make a profit of $40/T

30th Sep News: Vietnam crop expected 20% higher compared to previous estimates

30th Sep Physical price drops to $550

30th Sep Sell physical coffee at $550

CLOSE Physical profit = ($10)

We ended up losing $10 Vs an expectation of $40 profit

Fortunately, life isnt this bad and we have a way by which we canovercome this risk !! (by the way, this risk is called the price-position risk)


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HOW BIG IS OUR PRICE POSITION RISK?

IN THE PAST 2 YEARS, WE HAVE SEEN:

A 10% MOVE IN PRICES WITHIN A TRADING DAY 7 TIMES

A 15% MOVE WITHIN A WEEK 23 TIMES

AN AVERAGE VOLATILITY OF 2.5% WITHIN A DAY AND 7.5% WITHIN A WEEK.

OUR BUDGETED PAT IS ABOUT 2.5%.

NEED WE SAY MORE?

LETS LOOK AT SOME PRICE CHARTS.


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HEDGING ILLUSTRATEDThe price at which physicals trade and the price at which futurestrade are highly correlated

Because of this, a futures contract is widely used as a hedge(protection) against unfavorable price moves (price-position risk)

Hedging A risk protection mechanism where we sell/buy futurescontracts against a physical purchase/sale respectively.

In hedging, futures lots are sold as soon as physicals are bought

and futures lots are bought as soon as physicals are sold.

Of course, it is much easier if we could sell physicals as soon aswe buy, but, due to reasons of liquidity, lot size, forward purchaseetc., this is not really feasible.


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WHAT IF WE DECIDED TO HEDGE ?Date Action physicals Action futures

14th Sep Buy 100T coffee at $560,expect to sell at $600 and makea profit of $40/T

Futures price = $650

14th

Sep Sell 100T futures at $65030th Sep Vietnam crop expected 20%

higher

30th Sep Physical price drops to $550 Futures falls to $600

30th Sep Sell physical coffee at $550 Buy futures at $600

CLOSE Physical profit = ($10) Futures profit = $50

Net profit = $40. Exactly whatwe started with.


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BASIS

BASIS (differential) is defined as the difference betweenphysical and futures price. It is the relative value of a specificgrade from a specific origin, compared to the futures price. Forexample

We buy 50T Uganda Sc15 at $550 and sell futures (hedge) at$600, we say we have bought at a differential of 50 under

We sold 100T Cameroon G1 at $620 and buy futures (hedge) at$600, we say we have sold at a differential of 20 over

In the first case, we say we are 50T long Uganda Sc15 basis at

50 under and in the second case, we say we are 100T shortCameroon G1 basis at 20 over.


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BASIS

So far, we have assumed physicals and futures to be fullycorrelated. In the hedging example, the physicals droppedexactly by the same amount the futures dropped.

In reality, this is not quite the case. Because of relativedemand/supply situation of a particular origin with respect tothe world coffee output, the basis either moves up or down.

Physicals might fall/rise to a greater/lesser extent compared to

the futures

Though we have worked out a way by which we can hedgeprice-position risk, there is unfortunately no good way to hedgebasis risk.


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BASIS

Basis for an origin goes up, if production (supply) of the origin goesdown and vice versa

Basis for a grade goes down, if outturn (supply) of a grade goes upand vice versa

If demand for a grade goes up, basis goes up and vice versa

If substitute grades are available, basis tends to be sticky in its move

If world output is down, but relative market shares are maintained,futures goes up. Basis stays unchanged

World crop

Uganda

Vietnam

Ivory Coast

Sc18

Sc15

Sc12G2, 5%

G1, 3%

G1

G2


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BASIS

OLAM IS A BASIS TRADER.We always hedge as soon as a fixed price physical deal isconcluded.

While we can hedge price-position risk, a correct view on basisis required to protect/enhance origin margins.

Olam, being the largest robusta shipper in the world, is bestplaced to take basis views.


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WE ARE: DIFFERENTIAL TRADERS

RATIO TRADERS

AS OUR COCOA BUSINESS IS HEDGED WE OPERATE @ PREMIUM

+/OR DISCOUNT TO THE FUTURES MARKETS

- OR IN THE CASE OF RATIOS AT A MULTIPLE

OF THE FUTURES MARKETS.

WE WISH TO BUY HIGH - COUNTERPARTY

SELL LOW - MARKET CREDIBILITY

- MARGIN

WE ARE RISK MANAGERS.

WE ARE FINANCIERS.

WE ARE OPPORTUNISTS.

WE ARE LOGISTIC SPECIALISTS.

WE PROVIDE THE LIQUIDITY TO THE FARMERS/ORIGINS AND TO THE

CHOCOLATE MANUFACTURERS.

WE ENABLE BOTH FARMERS AND MANUFACTURERS TO PRICE THEIR

PRODUCT AT THE PRICE THEY REQUIRE.

DIFFERENTIAL


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BASIS TRADING

MAIN BASKETS: EAST AFRICA, WEST AFRICA, ASIA

CORRELATED GRADES

TOP GRADES BASIS NORMALLY MORE VOLATILE

BASIS SEASON Vs OFF-SEASON

SHORT / LONG BASIS IN A CARRY MARKET


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MORE ON DIFFERENTIALS

When a roaster buys coffee at a fixed price from a small shipper, he isobviously worried about a default if the price were to go up.

To overcome this risk, most roasters buy on what is called adifferential basis. In such a deal, the difference between futuresand physical price is fixed, whereas the actual level of futures is notfixed.

For example, if we sell India Ch AB to a roaster at 70 over, the buyerand seller have just agreed that the final invoice price would be $70more than the futures price on the day they decide to fix.

On the day they decide to fix, if futures trades $700, the invoicing willbe at $770.

95% of sales done today are on differential and it is normally the buyerwho decides when to fix.

DOES THIS INCREASE OUR RISK?


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MORE ON DIFFERENTIALSDate Action Physical Action - Futures Futures

price

14th Sep Buy 100T coffee at $560 (expectation is tosell at $600 and make profit of $40/T)

Hedge (sell futures)at $650

$650

14th Sep Buying differential = 90 under

20th Sep Sell 100T at 50 under $550

30th Sep Buyer fixes price at $520 $520

30th Sep Physical price = 520-50 = 470 Buy futures at $520 $520


Net profit = $40/T, which is nothing but the selling diff buying diff.

It is easy so see, that even if the fixing was done at $800, the Net profit would not change.

However, the break up of physical and futures would change.


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MORE ON DIFFERENTIALSDate Action Physical Action - Futures Futures

price

14th Sep Buy 100T coffee at $560 (expectation is tosell at $600 and make profit of $40/T)

Hedge (sell futures)at $650

$650

14th Sep Buying differential = 90 under

16th Sep Diffs. for the grade crashes to 100 under

20th Sep Sell 100T at 100 under $550

30th Sep Buyer fixes price at $520 $520

30th Sep Physical price = 520-100 = 420 Buy futures at $520 $520


Net profit = ($10/T), which again is nothing but the selling diff buying diff.

So, all that really matters is the selling and buying differential. Fixing does not affect profits.


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ON WHICH MONTH DO WE HEDGE ?

Earlier we saw a saleSold 100T of Vietnam G1 to Nestle for Nov01 shipment at$580, CIF Rotterdam

But, a typical sale would read like this

Sold 100T of Vietnam G1 to Nestle for Nov01 shipment at50 over Jan02, CIF Rotterdam

The sales price has been replaced by a differential and a fixingmonth. Remember that we need to buy back Jan02 futures asand when the buyer decides to fix.


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ON WHICH MONTH DO WE HEDGE ?

Lets say, we buy 100T Vietnam G1 at $460 today against thesale made and hedge on Nov01 at $510

We have bought at 50 under FOB, sold at 50 over CIF

Assuming that the freight and other costs is $65, we wouldexpect a profit of $35/T

We are almost correct, but there is a small problem !!

Our hedges are on two different months and we need to do

what is called a switch (also called spread/roll over/structure)Our short hedges are on Nov01 and the long hedges are onJan02. So, we need to buy Nov01 and sell Jan02 to completelysquare up the position.


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STRUCTURE

The table on the left shows futuresprices on various months

This is called a CARRY structure,where the near months trade at a

discount to farther monthsIn the previous example ofVietnam coffee, where we had toswitch from Nov to Jan, we willmake $20 less actual cost of carryat origin

A situation when spot trades at apremium is called backwardation

Month Price

Nov-01 520

Jan-02 540

Mar-02 560May-02 580

Jul-02 600

Sep-02 620

Nov-02 640


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WHAT IS STRUCTURE?

10 CONTRACT MONTHS

DIFFERENCE IN TRADING PRICES FOR EACH MONTH

[PREMIUM /DISCOUNT]

THE DIFFERENCE / VARIATION IN PRICES CAN BEDUE TO

EXPECTATIONS OF THE SUPPLY/DEMAND SITUATION OVER

TIME [OR AT A PARTICULAR TIME] IN THE FUTURE

SPEC. POSNS BEING TAKEN ON TECHNICAL FACTORS

POSITIONS BEING TAKEN IN A PARTICULAR MONTH

POSITIONS BEING ROLLED ACROSS MONTHS


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WHAT IS STRUCTURE?

BACKWARDATION THE FORWARD MONTHS ARE AT A DISCOUNT TO THE

NEAR MONTHS

REFLECTS A PREMIUM FOR SPOT DELIVERIES OVER

FORWARD DELIVERIESCONTANGO [CARRY]

THE FORWARD MONTHS ARE AT A PREMIUM TO THE NEAR

MONTHS

REFLECTS A PREMIUM FOR SUPPLIES GOING FORWARDAND A DISCOUNT FOR THE NEARBY DELIVERIES DUE TO

INVENTORIES BEING CARRIED BY THE CONSUMERS

THE FUTURES MARKET THUS PAYS TO CARRY STOCK


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STRUCTURE

The month on which we hedge is either when we expect theraw coffee to be processed and shipped OR when we expect tosell, plus a month for voyage.

If we buy coffee in Sep for Oct shipment, which will arrive inNov, AND we expect to sell the coffee for an October shipmentWE HEDGE THE COFFEE ON NOVEMBER

However if the coffee is ready for shipment in October, but weexpect to sell it only later, the decision of which month to hedgeon would depend on our view on the STRUCTURE.


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WHERE TO HEDGE?

Expect

bigger carry

Expect

smaller carry

Liquid grade Hedge verynear

Hedge far

Illiquid grade Hedge far Hedge very

far

Where do you hedge if we expect carry to increase, butthe current carry is higher than origin carry??


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WHAT IS ARB?

A TRADE ACROSS TWO MARKETS IN WHICH THE PRICE

MOVES ARE CORRELATED TO A CERTAIN DEGREE.

THE P/L ARISES OUT OF THE RELATIVE CHANGE IN

PRICES DUE TO A CHANGE IN CORRELATION BETWEENTHE TWO MARKETS

THE CHANGE INCORRELATION CAN BE DUE TO :

SS/DD SCENARIOS

TECHNICAL /SPEC. REASONS


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FUTURES IS AN ELECTRONIC PAPER WHICH IS WIDELY USED TO HEDGE PRICEPOSITION RISK

ONCE COFFEE IS HEDGED, WE LOOK AT IT AS DIFFERENTIAL (BASIS)

BASIS MOVES AFFECT OUR PROFITABILITY WHEREAS OUTRIGHT MOVES DO NOT

BASIS CHANGES BASED ON CROP SIZE, OUTTURN RATIO, SUBSTITUTE GRADES AND

DEMAND SIDE CHANGESBASIS OF COFFEES IN A BASKET TENDS TO MOVE TOGETHER

BASIS DURING OFF SEASON TYPICALLY IS MORE VOLATILE AND FIRMER

BASIS OF TOP GRADES MORE VOLATILE

FIXING PRICE IS IRRELEVANT A TRADER HOUSE THAT HEDGES COFFEE

VIEW ON STRUCTURE IS IMPORTANT TO PROTECT/ENHANCE PROFITABILITY

A QUICK REVIEW

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SP Trng - Futures