4-Managing Basis Risk

Managing Basis Risk

Commodity & Ingredient Hedging, LLC www.cihedging.com 312-596-7755 An introduction to Managing Basis starts with an introduction to Merchandising

The art of using basis and spreads to maximize your return to storage.

3 Merchandising

Keys to success: – Accurate & detailed historical basis records – Accurate Internal Position Records – Capital for physical purchases and hedges – Competitive grain origination tools & plans – The skill & discipline to capture basis appreciation

4 5 YR Seasonal Corn Basis: Central Il.

Sell

Originate

5 6 Basis and Futures Prices have a tendency to move in opposite directions.

7 Which Futures Month?

Sep. July 4.36 May 4.34 Mar. 4.29 4.24 On January 1, Buy Physical corn at ….. 4.10 4.10 4.10 4.10 Basis is: -.14H -.19K -.24N -.26U int. cost +.04 +.08 +.12 +.16 -.10H -.11K -.12N -.10U

8 Futures Spreads

11 2 Kinds of Market Spread Profiles

• Carry market – Nearby futures trades less than deferred contracts. “Normal” for storable commodities. (also sometimes referred to as “contango”) • Inverted market – Nearby futures contract trades at a premium to the deferred contracts. (also sometimes referred to as “backwardation”

12 Carrying-charge Market

• Nearby futures contract month trades at a discount to the deferred contracts and the price difference reflects the cost of carry. • Full Carry is equal to 100% of: storage costs (exchange approved Sep location), interest costs, & 6.45 insurance. Rarely do markets July 6.38 trade at full carry. May 6.29 March 6.20

13 Inverted Market

• Nearby futures contract trades at a premium to the deferred contracts. This usually reflects a shortage in the cash market for a storable commodity.

March 6.35 May 6.28 July 6.23 Sep 6.17

14 Managing Basis Risk: Using Futures Calendar Spreads

• Tend to move in the same direction – If basis strengthens then spreads tend to strengthen. In other words, if the cash market price gains on the futures market price, then the nearby futures contract gains on the deferred futures contracts. – And the reverse is true; if basis weakens, then spreads tend to weaken also.

16 Bear Spreads

• Definition: Buying the deferred futures contract and selling the nearby futures contract is commonly called a “Bear Spread” • Example: Selling (short) December Corn and Buying (long) July Corn (of the following year) Bear Spreads: Key Points

• Implemented to assist in managing the risk of a weakening basis. – Before a selling basis is established – To protect against the opportunity cost of a weakening basis after a buying basis has been established • Removed when: – The selling basis is established (physical is flat priced) – The risk no longer exists Price Example

Gulf Export Price - Nearby Corn Futures Basis

Minimum Maximum Average

140

120

100

40 BasisBasis (Cents(Cents perper Bushel)Bushel)

0 1-Jul 1-Jan 8-Apr 3-Jun 7-Oct 4-Nov 2-Dec 15-Jul 29-Jul 9-Sep 6-M ay 15-Jan 29-Jan 22-Apr 17-Jun 21-Oct 18-Nov 12-Feb 26-Feb 11-M ar 25-M ar 16-Dec 30-Dec 12-Aug 26-Aug 23-Sep 20-M ay Week of the Year Seasonal Basis Chart

Bull Spreads

• Definition: Buying the nearby futures contract and selling the deferred futures contract is commonly called a “ Bull Spread” • Example: Buy (long) December Wheat and Sell (short) July Wheat (of the following year) Bull Spreads: Key Points

• Implemented to assist in managing the risk of strengthening a basis. – Prior to a basis purchase. – To protect the opportunity cost after a selling basis has been established. • Removed when: – The purchase basis has been fixed – The perceived risk or opportunity cost no longer exists Seasonal Basis Chart

Basis & Spreads: Key Points

• General Observations: – Basis and spreads are not as highly correlated as physical and futures. Offsetting the spread and buying the basis may not happen at the same time. – As hedgers; spreads are not implemented to profit on the spread trade, rather spreads are used to assist in basis management. Basis & Spreads: Key Points (cont.)

• For Bear Spreads: – If basis weakens, the objective is to profit on the spread to offset the depreciation of commodity value associated with a weaker basis in the cash market. – If basis strengthens there may be a loss on the spread that will be reduce the commodity value and offset the appreciation associated with a stronger basis. Basis & Spreads: Key Points (cont.)

• For Bull Spreads: – If basis strengthens, the objective is to profit on the spread to capture basis appreciation and offset the loss associated with a higher purchase price in the cash market. – If basis weakens there may be a loss on the spread, although there likewise should be a similar savings associated with being able to purchase a cheaper basis. Basis & Spreads: Critical Mechanics

• Bear Spreads – The contract you sell (the nearby month) should coincide with a long physical ownership position. For example: if you long the basis then the “short leg” of the spread should be in the contract that represents that basis ownership period. Basis & Spreads: Critical Mechanics (cont.)

• Bull Spreads – The contract you buy (the nearby month) should coincide with a short cash basis situation. For example: if you are open on basis in the nearby period, then the “long leg” of the spread should be in the nearby futures contract. Basis & Spreads: Critical Mechanics (cont.)

• Use extreme caution when bear spreading one crop year (selling) against the next crop (buying) – this spread can be extremely volatile and unpredictable. • Option strategies can be used successfully to represent one “leg” of the spread. Basis & Spreads: Key Steps

• Identify the seasonal pattern for basis and spreads. • Identify previous years that had similar fundamentals. • Review the timing of positions with similar years. END

Commodity & Ingredient Hedging, LLC www.cihedging.com 312-596-7755