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Analysis of Hedging and Other Operations in Wool and Wool Top Futures

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Analysis of Hedging and Other Operations in Wool and Wool Top Futures 2 8 2 5 2 8 11111 . 2 5 1.0 :~ ""1 . :~ 11111 . 11111 . ~ ~3.2 I 1.0 .2 I~ ~1P·2 .2 LI.l III I" ~ I~ ~ m~ w ~ :i I~ :z m~ ... " &;I &..1,;, ... " II 1.1 111.1 ... a.:. .... 125 11111 . 11111 1.4 1111,1.6 111111. 25 111111. 4 1111,1.6 MICROCOPY RESOLUTION TEST CHART MICROCOPY RESOLUTION TEST CHART NATIONAL BUREAU OF STANDARDS·J963·A NATIONAL BUREAU OF SlANDARDS·I%3·A \-<., ~ 30 1,.\ f;3-t l;;2bO ANALYSIS OFREDGING AND ,OTBEBOPEBATIONS · IN W;OOL AND WOOL TOP FUTURES , :JTechnical Bulleti.nNo. 1260 Economic Research Service UNITED STATES .DEPARTMENTOF AGRICULTURE • Explanatory Note This bulletin is one of a group relating to price risks for agricultural products and protection afforded by trading in futures markets. It shows the nature and extent of price risks for wool and wool products and protection afforded by trading in futures markets under cha~?"ed conditions brought about by the National ·Wool Act of 1954. AlSO, it e:.\.-pands research to include data on spot prices of Australian wool, wool tops made from Australian wool, and wool top futures in J~onclon. Further, it updates a similal' i'eport, Price Risks for ·Wool and TV"ool Products and .1.11.eans of Reducing Them, based on data for the 8 :rears 1947-54, and published in 1957 as L.S. Department of Agriculture Technical Bulletin No. 1163. During this 8-year period, prices of wool fluctuated within nalTOW ranges near Government price support levels, except in 1950 and 1951 when they fluctuated ;vell above th~ price sup.,po~t levellar?"ely as a res~t of developme~ts In Korea. Silice the NatIOnal WOOl Act of 19a4 became effective on April 1, 1955, an incentive paTment program has been in effect which provides for determination of wool prices in the "open market." These prices are supplemented by incentive payments, if necessary, to bring the national average price up to the incentive level. A similar report relating to cotton and cotton products, Price Risb for Cotton and Cotton P.roduct8 and Mean8 of Reducing Them, based on analyses of data relating to cotton and selected cotton yarns and fabrics for the crop years 1936--41 and 1948-53, was published in 1955 as Technical Bulletin No. 1119. A.. similar report relating to grain, Analysis of Hedging and Other Opcmtions in Grain Futures, based on analyses of data relating to wheat, corn, and oats for t,he period 1924-25 to 1940-41 was pub­ lished in 1948 as Technical Bulletin No. 971. Contents .Fa!:c Summary and conclusions _______________ 4 __________ • __ "___ __ 1 Introduction_____________ . _______ • _______________ • ___ :; Purpose of Lhis bulletin___________________________ • _ _ ;) nlethod of procedure and scope of study____ ..,::..______ __ 5 Risks from changes in spot prices _________ .__ _ ____ ___ __ _ _ _ _ _ 7 Extent of market interesls____________________________ _ _ _ 7 Extent of eh:Luges in spot prices____________________ 8 Gains and losses from chauge.:; in spot prices_____ _ _ _ __ I(l Relatiou of spot prices to prices of futures contracts___ _ 17 Spot-futures price reilltion;;hipd___________________ __ 17 lcaetors affecting spot-futurcs price rclationships____ . _ 21 Risks .from ch!lng~s in basis ______ • _____________________ • _ _ _ 25 Extent of changcs in basis. _______________ 0 _________ .. _ 25 Gains llnd l()s~es from ('hllJlges ill bllSis___ _ _ _ _________ "' _ _ :30 Protection aITordcd by futuI"C!; uti hedges________________ ._..___ :~,~ Price risks usually greater t hall basis l'isks ________ • __ • ___ • _ a(\ .l:huois risks sornclinH's greater than prj(;c risks_ • _________ •• .i/ l1nins fi.nd losses froIn tntn~(crring bedgcs_. _.. ,.. ......... __ ...... __ .... _.. " 5R Gains iUld losses [loOm straddte lrtlllSI1CtiOU8_____________________ llO .Futures trading aud iluctUlltio(l;'< in priem; ______________ .. _____ _ 77 Tradition!ll theory of stabilizing influt~u<:ll. __ • I I l.JimiLntio.ns to stabilizing in(lullncc ________ . _ 78 Elfccls of futures trading OLl .£1trm prices tLnd on cO~t5 of wool producls______ -•-. -. ___ . __ .. _•• __ _ _ _ _ 82 Literat(ll-e cited ... 0 - - _ ••• _. _ 8,{ Appendix_____ _ 8(; Jal1lmry 19G2 --------.--------.~~ ~---- For sRI~ h" the gur~riutend~ut or J)or'IIUl~ut~, r-. !". GU'WIlIlH'nt Prlntin~ Ollke • 1\-II.~b!Ugtou 25, n. ('. - ['ric',. :1" "'nIs ii Analysis of Hedging and Other Operations in Wool and Wool Top Futures By L. D. HOWELL, agricultural economist Marketing Economics Division Economic Research Service Summary und Conclusions Futures exchanges are an integral Producers, merchants, manufac­ part of the market mechanism for turers, and others can hedge their ~wool and wool tops. Direct use of long- or short-market interest in futlll'es tnt,cling in 1lUlrketing these wool or wool products by offsetting products is confmed chiefly to sales or purc~ases of futmescon­ hedging operations. But trading tracts. '.I'hey may use iutmes in futures maT have important in­ markets in obtn.ining direct hedges, fluences on the breadth and liquid­ or they may obtn.in essentialJy the ity of the market, on the stability same protection by bu:yingor sell­ and le,el of prices, and on margins ing on call. SmaH dealers, farmers, and costs of marketing. nnd ranchmen a.s a rule do not Prices of wool, wool tops, and hedge their wool; most of them sen wool yarns and fabrics at times promptly and pass on the risks from fluctuate widely over relatively ChflJlges in prices to larger dealers, short periods. Holding these prod­ merehflJlts, or manuIncturers. ucts from the time they are ren,ely Effectiveness of futures trading for mark('t until the:r nx(' Jlc('decl by in reducing or offsetting risks from consumers iJlvolves risk of Joss from C'lH1J1ges in spot prices of wool de­ declines in ]lriees. But j t also in­ peJlcls mainly upon the extent to volves the possibility of gains from which these chunges are associated advances in priees. Information with similar cllu.Jlges in prices of presented in tllis bul1etin shows the futures contmcts. ~ During the 5 nature and extent of tIle risks from yen,rs ended ~far\?'h 1960, more than changes in these prices after J)rice tbree-fourths of the changes o,~er support programs for wooL were 16-week periods in spot prices of (liscontinucd in 1955, and protec­ \\'001 nnd wool tops in Boston, and tion ufforded by trncling in futures. in wholesale prices of worsted wenv­ Losses and gains from changes jng yarn over 4-mon tit periods, in prices of wool and wool tops weTe assocint.ecl with similar changes over 16-\yeek periods mny he grea.ter in prices of Jutures t'ontrn.<:ts. Bo­ than totnl costs of tn.king wooL from rn,lIse of tile yalue added by .111anu­ farms and randles n.nd cle1iYering it In,cture n.ncl otlH'r fn,eLoeR, . cbanges to topmakers or mills. An al ternn.­ in prices of \\'001 fabrics werc not n.s tive to the 'uJ1certainty of taking a closely related to elw,nges in prices gain or n, loss on these commodities of wool top futures contmcts as is to use fu tures con tl'iwts as hedges. were chnnges in priccs of wool, wool tops( and wOl'sted weaving Ohangcs over 4-month periods in yarn. prices of the quantity of worsted Relation of spot prices of wool weaving yarn obtainable fl'om a and wool products to prir.es of pound of wool, dUTing the 5 years futures contracts is affected by ended with .March 1960, averaged several factors. Abnormally large 79 percent greater than c11anges market supplies of wool .and wool in spread between these prices products, when relatively smaller and prices of wool top futures in supplies are anticipated, tend to New York. Proportions of the depress spot prices in relation to gains and losses from these cbonges prices of futures contracts, particu­ in prices thn,t could have been larly for the more distant months. offset by the use of wool top futures Shorto,ges of these commodities im­ in Now York as hedges averngcd mediately available, along with about 82 percent. The C01'1'e­ prospects of relatively larger sup­ sponding proportions fot' the 8 plies, tend to mise spot prices in years ended with 1954 were 22 and relation to prices of futm'es con­ 58 percent, respectiydy. During tracts, particularly for the more both periods, changes over 4-month distant months. periods in prices of the quantity Disparities between changes in of worsted suiting obtailll1ble from spot prices of wool and wool prod­ a pound of wool averaged less than ucts and in prices of futures con­ the changes in the spread betweell tracts at times result in consider­ these prices alld prices of wool able changes in spot-futUTes price top futures. spreads, referred to as basis. Gains Gains and losses from trans­ • and losses from changes in basis ferring heuge.~ and from straddle are .not offset by the normal hedg­ transactions (for description of ing procedure. A practical con­ straddle operations see page GO) sideration, in evaluating the useful­ may be used to supplement or offset nesS of futures contracts as hedges gains Qnd losses from changes .ill against losses from changes in spot spot prices and in bl1sis. Losses prices, is concerned with determin­ on sales on call, and on long-hedged ing how the risks from changes in positions, based on futm'cs contracts spot prices compare with risks from that arc relatively high in price, changes in basis.
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