Commodity Futures and Options as a Price Risk Management Tool

Author(s):

Michael Stanly, C.P.M.
Michael Stanly, C.P.M., Vice President, International Multifoods Corporation's Pueringer Division, Rice, MM 56367-0187, 612 / 393-2060.

79th Annual International Conference Proceedings - 1994 - Atlanta, GA

EXECUTIVE SUMMARY
Demands for profit margin enhancement have dictated that today's purchasing professional utilize all available resources to better manage price volatility associated with the raw materials that they or even their suppliers purchase. This paper is introductory, yet comprehensive, and addresses the very practical aspects of initially developing a futures and options hedging program. The first portion of the paper examines the historical development of futures hedging; governmental regulation on the industry; commodity exchange functions and operations; trading floor procedures; basis analysis; the benefits and limitations of hedging; and futures-based pricing strategies. As a result, the reader should gain an understanding of the mechanics and benefits of futures and options hedging and an understanding of the initial steps to take in having their companies begin using this price risk management tool. It has been found that an understanding of exchange development, procedures, and government regulation, aid in minimizing the misconceptions which do exist concerning futures use in business and their role in the economy. With this as a reference, the NAPM seminar will rely heavily on case studies to develop practical knowledge of this price risk management tool.

DEVELOPMENT OF COMMODITY EXCHANGES
Interestingly, similarities exist between commodity exchanges of today and those of 17th century Japan. Our modern exchanges developed as the U.S. economy grew in the 1800's, while stock exchanges began to answer the needs for capital, and a national banking system answered needs for new credit. At this time, Chicago was the agricultural center of the country and "to-arrive" or "forward contracts" were a way for producers to "sell ahead" grains. Non-grain speculators began participating in these agreements and such contracts tended to change hands several times before delivery dates. Prior to the railroad network development in the 1830's and 1840's grain would arrive at Chicago at harvest-time and "glut" the marketplace. Such supplies forced prices lower and absorbed all available storage space. Crop inventories often rotted and thousands of tons of grain would be dumped into Lake Michigan.

During the spring or summer, opposite events occurred; prices rose sharply as millers scrambled to cover their grain needs. The "to-arrive, contracts of the mid-1800's aided in better employment of elevator space, borrowed funds, and transportation. However, these contracts did not address:

• standards of quality
• terms of payment
• publication or sharing of prices
• the conditions for resale of the contracts

The first exchange in the USA was the Chicago Board of Trade, established in 1848. The primary impetus for its establishment was that trades were occurring everywhere--saloons, street corners, merchant's offices, and the like. The Board of Trade set standards for wheat with a system for weighing and inspecting, and made possible warehouse receipts so as to change title easily and use as collateral for borrowing.

In October 1865 the Chicago Board of Trade formalized and truly began functioning as an exchange. Now it is the world's largest with the most variety of contracts. It was followed by the Chicago Mercantile Exchange in the late 1800's, which was first known as the Chicago Butter & Egg board. This exchange added meat in 1961 and financial derivatives in 1972. other major exchanges include the London Cocoa and Sugar Exchange, New York Cotton Exchange, New York Mercantile Exchange, and exchange in Paris, Winnipeg, and Kansas City.

EXCHANGE CHARACTERISTICS
Futures trading is not new; it has been a risk management tool for centuries. The key elements are simple, those being the arrangement of pricing, payment, title exchange, and delivery. Further, the basic characteristics are the same at exchanges globally, as listed in Table 1.

TABLE 1
EXCHANGE CHARACTERISTICS

• Organized with members and management committees
• Specific rules of trading apply
  • Trades occur in 'pit' or 'ring' by open outcry during prescribed hours
  • Anti-competitive practices are forbidden
• Contracts are standardized as to:
  • quantity, delivery location, month of delivery, delivery procedure [therefore, all that is left to be determined is the price]
• All trades are with the clearing house
  • Trades are not with an individual or company, so credit worthiness issues are minimized
• Contracts are legally canceled by an opposite or offset trade
• Clearing house members post margin
  • This is a type of performance bond--not a down payment
  • Prior to delivery, title is not passed and credit is not extended

COMMODITY LAW
A variety of laws have developed over the years to protect the free enterprise nature of futures trading. In the USA the Cotton Futures Act of 1916 was followed by the 1922 Grain Futures Act. In the 1930's this law evolved into the Commodity Exchange Act, and in 1974 became the act which established the Commodity Futures Trading Commission [CFTC]. Obviously, futures trading is federally regulated.

The CFTC's objectives are to [1] protect participants from fraud, deceit, and abusive practices, and, (2] ensure competition in the marketplace. Administration of the commission is by a Chairperson and Commissioners appointed by the President (of the USA), and it is headquartered in Washington DC. Brokers, traders, and advisors are required to pass examinations and register with the CFTC, and all standardized exchange contracts are first approved by the CFTC. The CFTC's role, then, includes market surveillance, rules review, registration and audit, research, education, enforcement, and reparations.

EXCHANGE OPERATIONS
Exchanges are a marketplace for buyers and sellers and their role is to provide facilities, establish trading rules, supervise floor conduct, and collect and disseminate information (primarily that of price.

The exchange does not trade, and it does not influence or establish price; participants and economics determine price. Typically the member ship owns the exchange in the form of shares or 'seats', and is managed by a Board of Governors composed of members, and non-member advisors such as producers, bankers, and users.

Staffing will typically include departments for audit and investigations, statistics, quotations, research, and public relations. Committees will include those for arbitration, membership, rules, business conduct, the clearing house, floor practices, public relations, contract specifications, and a floor brokerage qualifications committee.

Though new paperless, computerized trading has been developed in recent years, trading floor typically operates in a 'pit' or 'ring' by open outcry [and hand signals) while observers record price and quantity, then report it worldwide instantaneously. Nearby, in most exchanges will be banks of phones, a library, telexes, news wires, charts, and an information room.

The order execution process is represented in Figure 1 below.

1. Individual places order with futures broker (order includes instructions to buy or sell a particular commodity, the number of contracts, a specified price, period of time in which the order is valid)
2. Order is time stamped
3. Wired to floor
4. Order is written by phone clerk on order form
5. 'Runner' takes written order to their trader or broker in 'pit'
6. Trader fills order (or places in 'deck' for later execution)
7. Order confirmation [back to customer] reverses at this point

Remarkably, the time elapsed from order placement to execution can be as little as 45 seconds. It is important to remember that for every buyer there is a seller, and vice versa. The clearinghouse offsets all trades and is the guarantor of all trades, and, in the case of actual deliveries against a contract(which represents a very small percentage of all trades) matches buyers with sellers.

HEDGING
Hedging may be considered a form of 'price insurance'. Just as a prudent businessperson would not operate a business without insurance on motor vehicles, or for fire, product liability, personal injury, theft, or flooding, companies often do operate without 'price insurance', on raw material prices, international currency values, or fuel costs.

A comprehensive definition of hedging may be stated as "a transaction or position in any futures or options contract which [a] represents a temporary substitute for a transaction or position to be made or taken at a later time in a physical marketing channel, [b] are economically appropriate to the reduction of risk in the conduct and management of a commercial enterprise, and [c] arise from potential change in the price of assets, liabilities, and services (existing or anticipated) associated with the operation of a business enterprise".

In practice, let's say that a buyer is planning to make a component in six months that requires a sizable amount of copper, and based upon her reading and study feels that those prices will be rising. She wants to reduce that risk, and consequently chooses to buy a copper futures contract [25,000 pounds). Later, when time approached that the company actually needs the commodity, she buys the physical commodity from her typical sources and she cancels the futures obligation by selling a futures contract. The futures contract, therefore, has acted as the temporary substitute for the later 'real' transaction and is canceled by an opposite or 'off-set' transaction.

In another example, a buyer holds an inventory of pork bellies but determines that prices are likely to fall. She may choose to sell the inventory now, thereby protecting the inventories from price risk. Later, when the inventory is used in the manufacturing process, she cancels her outstanding obligation by buying [and off-setting] the futures contract. Again, futures functioned as a substitute transaction.

Literally thousands of firms hedge. Some of the befits realized from hedging are summarized in Table 2 below.

Benefits of Hedging

• Protect profit margins and stabilize income
• Control timing of a purchase
• Buy goods without physical space requirements [thereby reducing capital needs]
• Reduce storage costs of inventoried goods [such costs are typically reflected in price]
• Knowing or locking-in' prices can be a sound business planning tool
• Price risk management should increase borrowing capacity and credit-worthiness

BASIS
There is, most always, a variance between futures prices and the prices of materials used in industry. Key factors causing the variance include specification and transportation differences. Recall that all futures contracts specify a delivery point and specification; and these two items rarely coincide with the buyers actual needs.

There are basically two methods of determining basis

1. Historic Relationships: Basis patterns tend to repeat themselves year after year.
2. Actual Cost Calculation: Transportation, shrink & loss, interest, insurance, temporary storage, et. al.

Causes for change in the basis may result from local supply and demand factors, local production costs, crop or production projections, or changes in government programs.

OPTIONS
By definition, options are a "standardized legal document traded on recognized exchanges that for a fee gives the holder [the buyer] the right but not the obligation to buy or sell one futures contract at a predetermined price [the strike price]". options trading can therefore be a very attractive hedging alternative for the buyer. In practice, however, the premium demanded in the marketplace for the contract,, the lack of liquidity and volume in options, or even the lack of an options contract being offered altogether may limit their use.

'Call', options grant the right to buy the underlying futures contract, while 'puts' grant the option to sell. The only cost of such a position is the premium paid upon buying such an option.

BASIC STRATEGIES
Numerous strategies may be employed utilizing futures and options in order to protect pricing. Three such strategies are presented which are in common use.

TRAILING StopS
A 'stop order', is an order placed with a futures broker that buys or sells a futures contract only after it reaches a particular point. It's used to enter and exit that market when a price trend reversal has occurred. A buy stop, for example, would be placed in the market by a buyer at a higher level than that at which the market is currently trading, so that the buyer is positioned to buy the commodity once it has 'bottomed out', and the trend will be moving higher. Placing stop orders at increasingly lower levels as market prices erode can serve to lower the buyer's cost of goods.

SCALE IN
A scale in is a way in which to average or weighted average a market position in the lower end of a trading range. For example, assume that you will need to pay for an equipment component in 3 months in German marks [DM]. You determine that the Mark is likely to trade in a range of 57.00 to 71.50 in the coming months. YOU determine that if you can at least achieve Mark values in the lower end of this trading range that the savings will be significant, so you elect to begin your buying in the lower half of this projected range, accelerating your coverage as prices move lower. Even if a price decline is short-lived and the bottom of the range is never realized, you have still lowered your costs and therefore your component cost.

POINTS OVER
Points Over Futures can often be used as a pricing mechanism with a supplier when there is no intent to enter into any futures or option position. Rather, it is simply a definable, convenient pricing medium to fix the price of a commodity, particularly when poor cross-hedge relationships exist. This was often used in the USA sugar markets to fix USA (domestic] prices using world prices as a general barometer of global sugar values. It could be used to fix the price of a petroleum product beyond those which are regularly traded and hedgeable (those include unleaded gas, heating oil, and crude oil]. A contract can be entered into that specifies a quantity, period of time, and a fixed premium or discount that the cash product will be sold by the supplier to the buyer during a specified period of time. The buyer may, at his or her declaration, fix a purchase price based upon their agreed upon 'points over' when that futures contract has traded at a level that they buyer feels is a reasonable, profit enhancing level.

INITIAL STEPS IN HEDGING PROGRAM DEVELOPMENT AND SUGGESTED FURTHER STUDY
Commodity markets are driven by forces of supply and demand, and a thorough understanding of these factors is necessary for successful hedging. Such data will include production data, consumption trends, technological changes, shifts in consumer preferences, weather, stocks, and governmental policy changes. Further, at least a basic understanding of technical market analysis is well-advised, as such analysis not only assists in the timing of placing and 'lifting' hedges, but it puts the buyer in tune with the factors that many speculators and program or 'computer' traders are watching.

Policy development for a company is important, and is an important initial real step in futures and option use. There must be great clarity on who within the organization is designated to make futures and options trades, how much monetary risk the company is willing to accept, and over what period of time the risk will exist. For many businesses, having more than one competent purchasing professional person designated to trade the account is prudent, should the key decision make be unavailable for any period of time. A written trading strategy, approved by senior management can be vital too, to overcome the emotions of trading as well as seeking-out a second opinion. Selection of a competent commodity broker, of which there are many, will be necessary.

A successful hedge is not necessarily getting the lowest price, but one which allows you to achieve your target price through correct basis calculation and prudent hedging. Why hedge at all? As a buyer, it is your intent to lower your cost of goods, and this will dictate whether taking a 'cash' or futures position will be most advisable. In many instances, however, your regular suppliers may be unwilling to extend a deferred price commitment because of their expectations of rising prices (and their desire to maximize profits] or suppliers may be unwilling to accept a risk position for future quarters. It is at these times, in particular, that futures and options become a powerful tool to manage your price risk.

REFERENCES

1. Bobin, Christopher A. Agricultural Options. New York: John Wiley & Sons, 1990.
   
   
2. Buchanan, Susan and Seymour Gaylinn, editors. 1992 CRB Commodity Year Book. New York: Commodity Research Bureau, 1992.
   
   
3. Carter, Joseph R., Shawnee K. Vickery, and Michael P. D'Itri. "Currency Risk Management Strategies for Contracting with Japanese Suppliers." International Journal of Purchasing and Materials Management Volume 29, Number 3 (Summer 1993]: 19-25.
   
   
4. Oster, Merrill J., Darrell Jobman, Sherman L. Levin, Mike Walsten, and Paul Wilcox. How to Multiply Your Money. Cedar Falls, Iowa: Investor Publications, 1979.
   
   
5. Power, Mark J. Getting Started in Commodity Futures Trading. Cedar Falls Iowa: Investor Publications, 1983.
   
   
6. Sklarew, Arthur. Techniques of a Professional Commodity Chart Analyst. New York: Commodity Research Bureau, 1980.

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