exam 3 study

options

options

method to hedge commodity price risk

-right to buy or sell a futures contract at a certain price by expiry date

predetermined options elements

-underlying asset

-strike price

-expiry date

options expire..

prior to corresponding futures month it corresponds with

i.e august expiry for September futures position

premium

only options variable, determined by bids and offers, paid by buyer and received by seller

options participants

• call buyer (long) call seller (short)

• put buyer (long) put seller (short)

buyers of options

-option holders

-risk is premium

-has the right to take a futures position with no required margin

Has right to offset, exercise, or allow to expire

sellers of options

-writers/grantors

-receive premiums> assume futures price change risk

-has obligation until expiry date or when contract is offset

put

right to sell at strike price until expiry date

call

right to buy at strike price until expiry date

strike price

price at which a call or put can be exercised

intrinsic value

value of option if exercised

option value

total of intrinsic and time value

put option profitable when..

strike price>futures price

call option profitable when..

strike price<current futures price

time value

remainder value of option premium once intrinsic value has been taken taken out

time decay

-decline in time value as fewer days remain until option expires

-premium for an option will drop in time value as expiry gets closer

intrinsic call value

futures price-call options strike price

intrinsic put value

put option strike price-futures price

time value

premium-intrinsic value

in the money

-has intrinsic value, option is profitable

put strike price>futures

calls strike price<futures

out of the money

\-option is not profitable and does not have intrinsic value

put strike price<futures

call strike price>futures

at the money

puts and calls strike price=futures prices

option choices

-exercise

-let expire

-offset prior to expiry

under-filling

don’t forward contract 100% of expected product

quality

discounts for lesser grades

forward contract components

-pricing

-title transfer

-delivery

-settlement

forward contract advantages

-can establish favorable price for future delivery

-protect against unfavorable basis movement

forward contract disadvantages

-border closes

-forego upward market shifts

-magnified production risks

basis contract

basis is fixed is contract, along with date, quality, time, quantity

-price locked in on a later date

basis contract advantage

-protects against increased transport costs

-accounts for local supply and demand

-storage costs- bank rates

-handling fees-elevator fees

forward priced contract

-establishes price and basis

-exchange rate can be source of issues

forward basis contract

-basis set, price tbd

methods of price fall protection

-short hedge

-buy put option

short hedge price fall protection

-Sell=short

-benefits from strengthening basis

put option price fall protection

-exercise put option if prices fall>gives you short futures position

-offset position> short cash and long futures position

option combinations price fall protection

basis contract+put

forward contract+call

basis contract+put

-price fall protection

-set basis with contract

-set strike price with put

-prices fall, use

-prices rise, allow to expire

forward contract+call

-price fall protection

-product committed to price

-call opens opportunity

-when product is delivered and cash collected, we can also exercise option

-prices increase> exercise option by buying futures and receiving hedge profit

-prices decrease>protected by contract

higher input cost production methods

-long futures

-Call option

long futures input cost protection

-buy=long

-profit/loss from hedge offsets csh mkt losses

-benefits from weakening basis

call option input cost protection

-buy call option

-prices rise>exercise call for long futures

-offset futures

options combinations for input cost protection

-basis contract+call

-forward contract+put

basis contract+call

-input price rise protection

-sets basis and then buys call

-prices rise>exercise contract

-prices fall>allow expiry

forward contract+put

-input price rise protection

-sets price and basis then buys put

-opens opportunity to profit from lower price

-prices lower>exercise option and sell at lower price and make hedge profit

-prices raise>locked in at original price