Basis is the price difference between the cash price and the futures price for a particular commodity. Basis varies from one location to another, so it is specific to a particular cash market. Freight, handling, storage and quality, as well as local supply and demand factors typically affect the basis price.
Local Cash Price – Futures Price = Basis
A basis contract allows marketers to specify or “lock in” the value of the basis or difference between the local cash price and the futures price for a commodity, delivered to a specific location, on a particular date. A basis contract is also known as a “Fix Price Later (FPL)” contract. This is because the futures price portion of the full delivered price remains open to fluctuate until its value is fixed either at or ahead of delivery.
A bear spread is a position that includes an order to sell a nearby futures contract and buy a deferred futures contract. A bear spread can gain in value when nearby futures are decreasing at a faster rate or increasing at a slower rate relative to deferred futures. Bear spreads are commonly used to assist in managing the risk of a weakening basis – after buying the basis with a supplier.
A bull spread is a position that includes an order to buy a nearby futures contract and sell a deferred futures contract. A bull spread can gain in value when nearby futures are increasing at a faster rate or decreasing at a slower rate relative as compared to deferred futures. Bull spreads are commonly used to assist in managing the risk of a strengthening basis – ahead of actually buying the basis with a supplier.
An option contract giving its owner the right, but not the obligation, to buy the underlying asset at the strike price for a specified time.
The cash market represents the specific, local marketplace in which suppliers sell and users buy a physical commodity based on negotiated terms including quality, quantity, delivery time, and location. The prices of cash commodity market transactions are typically quoted for either “spot” or “forward” contracts.
Coverage in the risk management process refers to the scope of protection, usually measured in percent of the operational risk, provided by a marketing strategy.
For example, if the operation will be marketing 10,000 bushels of corn, and has already signed a contract to physically sell 5,000 bushels of corn, they are covered on 50% of the production. This operation can consider various strategies to lock-in coverage on the remaining 50% of the corn.
A forward cash contract calls for future delivery of a commodity and agrees to both the futures price as well as the basis for that specific delivery date. The negotiated grade, quantity, delivery location and time are specified and price is set based off a relationship to the appropriate deferred futures contract. This would represent the contract which would be the nearby month during the scheduled delivery period. In contrast to cash contracts, futures contracts are highly standardized with respect to quality, quantity, delivery time, and location. They are considered “benchmark” prices for the particular commodity because they represent the broad value at large, independent of local supply and demand factors.
A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a commodity at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
A hedge to arrive cash contract calls for future delivery of a commodity that agrees to just the futures price for that specific date. The negotiated grade, quantity, delivery location and time are specified and price is set based off a relationship to the appropriate deferred futures contract. This would represent the contract which would be the nearby month during the scheduled delivery period. In contrast to cash contracts, futures contracts are highly standardized with respect to quality, quantity, delivery time, and location. They are considered “benchmark” prices for the particular commodity because they represent the broad value at large, independent of local supply and demand factors.
A practice that reduces the risk of holding one asset, by taking a position in a related asset. Hedging is based on the principle that cash market prices and futures market prices tend to move up and down together. This movement is not necessarily identical, but it usually is close enough that it is possible to lessen the risk of a loss in the cash market by taking an opposite position in the futures market.
A hedge is the buying or selling of a futures contract for protection against the possibility of a price change in the physical commodity that the business is planning to buy or sell. There are two types of hedges: a long hedge and a short hedge.
Intrinsic value is the component of an option premium that represents the value between where the underlying futures price is relative to an option’s strike price. Call options have intrinsic value if the strike price is below where the futures are trading while a put option has intrinsic value if the strike price is above where the futures are trading. The amount of intrinsic value is the exact difference between the futures price and strike price.
An example of this would be:
March 2014 corn futures trading at $4.50 per bushel
March 2014 $4.00 call option premium = $0.60 cents
In this example, the intrinsic value is $0.50 and the remaining value is time value.
A long hedge is the buying of a futures contract to protect the purchase price of a commodity the business is planning to buy. Most hedges are liquidated or offset prior to delivery or expiration. The long hedger can offset their futures contract by subsequently selling a contract with the same delivery month.
In financial and commodities markets, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk represented by his position to his counterparty (most often his broker).
The collateral can be in the form of cash or securities, and it is deposited in a margin account. On U.S. futures exchanges, “margin” was formally called a performance bond.
Marketing can be defined as the commercial functions involved in transferring goods from producer to consumer. Agricultural marketing is where the producer, the processor, the distributor and the consumer meet.
After items such as taxes and interest payments are accounted for, you’re left with net profit (more commonly known as net income), near the bottom of the statement. Dividing a companies’ net profit by its gross revenue yields a net profit margin. This number reflects how much of every dollar of sales a company keeps as profit — the rock-bottom fundamental view of its fiscal strength.
To liquidate a position by entering an equivalent but opposite transaction in the same delivery month. Offsetting cancels the obligation of making (or taking) physical delivery of the underlying commodity.
The open market margin is a similar calculation but does not factor in gains and losses from cash or futures and options positions. It reflects the profit margin projected independent of any contracting or risk management. Comparing the net margin to the open margin therefore allows one to evaluate the effectiveness of their risk management strategy at any given point in time.
A contract that gives its owner the right, but not the obligation, to either buy or sell a commodity at a specified price, or strike price, for a specified period of time.
Premium is another word for the price of an option.
A margin or profit margin represents the profit left behind after you take out costs. In our risk management models, the margin represents a forward looking calculation that takes into account the estimated cost of production, the projected cost of feed and finally the projected earnings from sales.
An option contract giving its owner the right, but not the obligation, to sell the underlying asset at the strike price for a specified time.
In futures trading, the settlement price is an official price established at the end of each trading day that uses the range of closing prices for a particular contract.
A short hedge is the selling of a futures contract to protect the sale price of a commodity the business is planning to sell.
Commodity speculators have no inherent cash market price exposure and simply buy or sell futures contracts in an effort to make a profit. Simply put, speculators buy futures or options if they believe prices will increase or they can sell futures or options if they believe prices will fall. They may realize a profit if their expectations occur or a loss if they don’t occur. They fill the role of providing liquidity to the marketplace.
A spot cash contract involves a prompt or near term delivery of a commodity. The negotiated grade, quantity, and delivery, location are specified and price is set based off a relationship to the nearby futures contract, that is, the contract closest to expiration.
A spread involves two transactions that simultaneously take one long position (buying) and one short position (selling) on two different contracts. A futures spread simply refers to the difference in value between two futures contracts. For hedgers, futures spreads are used to manage basis risk.
A strike price is the fixed price at which the owner of an option can purchase, in the case of a call, or sell, in the case of a put, the underlying commodity. The strike price is often called the exercise price. The strike price is a standardized feature of the contract and is set by the exchange.
Time value is the remainder of an option’s premium after subtracting any intrinsic value. The premium associated with time value is determined by a few key factors: time remaining until expiration of the option contract, volatility of the underlying futures contract, and the cost of money (interest rates). The more time until the option expires, the more premium the seller will require. The higher the volatility of the underlying futures contract would also lead to increased premiums as uncertainty of whether the option will have intrinsic value at expiration is elevated. Similarly, lower the volatility equates to lower the premiums.
Volatility measures the relative rate at which price moves up and down. Volatility is measured by calculating the annualized standard deviation of daily change in price. If the price moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility.
Window contract describes a class of cash contracts that set a minimum and maximum commodity price for the duration of the contract.