Back To School Quiz #5

1. In an earlier “Back to School” segment, we worked through the math of calculating your minimum price when you choose to buy put options. Let’s assume that you do it – you buy 920 November soybean puts (the right to sell) in the spring to set a minimum price on your soybean production in the fall. Between now and harvest, which way would you like to see prices trend?

Higher

Lower

I find that a remarkable number of people can be confused by this simple question. We buy a put option and think, “Lower prices will make the put more valuable.” This is true, but the put option is there as insurance against the lower price scenario. What we really want is wildly higher prices, where the put expires worthless but the grain produced is worth much more at harvest.

Explanation

I find that a remarkable number of people can be confused by this simple question. We buy a put option and think, “Lower prices will make the put more valuable.” This is true, but the put option is there as insurance against the lower price scenario. What we really want is wildly higher prices, where the put expires worthless but the grain produced is worth much more at harvest.

2. Buying put options (the right to sell futures) is one way to establish a minimum price. Let’s assume that Nov’10 soybean futures are trading at $9.30, and you decide to pay 52 cents per bushel for a 920 put. You expect a harvest soybean basis of 60 cents under the November contract. What is your minimum expected price for soybeans at harvest?

A. $9.30

B. $9.20

C. $8.70

D. $8.08

Answer (d): The formula for calculating a minimum price is simple. Start with the strike price ($9.20), adjust it for your expected harvest basis (60 cents under) and subtract the cost of the put (52 cents). In this example, if you sold futures directly, you would have an expected price of $8.70 but no upside potential. Buying a put leads to a lower minimum but retains your upside potential.

Explanation

Answer (d): The formula for calculating a minimum price is simple. Start with the strike price ($9.20), adjust it for your expected harvest basis (60 cents under) and subtract the cost of the put (52 cents). In this example, if you sold futures directly, you would have an expected price of $8.70 but no upside potential. Buying a put leads to a lower minimum but retains your upside potential.

3. A traditional definition of hedging is the use of futures as a temporary substitute for a later transaction in the cash market. What is cross-hedging?

Hedging that involves the use of put options

Hedging of a commodity that has no futures contract

Hedging when you woke up on the wrong side of the bed

Many important commodities like barley and sunflowers do not have an active futures market. If you wish to manage price risks on these commodities, you might use a closely related futures market. Examples of cross-hedging include feed barley and corn futures, and sunflowers and soybean futures. For a cross-hedge to be effective, there must be a high correlation between the cash price and the related futures contract. So do your homework before attempting a cross-hedge.

Explanation

Many important commodities like barley and sunflowers do not have an active futures market. If you wish to manage price risks on these commodities, you might use a closely related futures market. Examples of cross-hedging include feed barley and corn futures, and sunflowers and soybean futures. For a cross-hedge to be effective, there must be a high correlation between the cash price and the related futures contract. So do your homework before attempting a cross-hedge.

4. What do you call a futures trading strategy involving the simultaneous purchase of a nearby futures contract and sale of a deferred contract in the same commodity?

Short straddle

Bear spread

Bull spread

Intercommodity spread

To buy nearby and sell deferred is a bull spread. The bull spread gets it’s name from the tendency for carrying charges to narrow in a bull market. Traders love trading the spreads – spreads are generally less volatile than flat price movements and the margin requirements are lower.

Explanation

To buy nearby and sell deferred is a bull spread. The bull spread gets it’s name from the tendency for carrying charges to narrow in a bull market. Traders love trading the spreads – spreads are generally less volatile than flat price movements and the margin requirements are lower.

5. 2009 was quite a year for corn yields in this country. The U.S. average corn yield set a record at nearly 165 bushels per acre. This question should give you some perspective on just how rapidly corn yields have grown. What was the first year when the U.S. average corn yield topped 120 bushels per acre?

1986

1987

1992

1995

The U.S. recorded record corn yields in 1986 and 1987, but average yields in both years fell just shy of 120 bushels per acre. In 1992, we not only blew through the 120 bpa mark, but the 130 bpa mark too, averaging about 131 bushels per acre. By the way, 1995 was the last year we had an average corn yield less than 120 bushels per acre.

Explanation

The U.S. recorded record corn yields in 1986 and 1987, but average yields in both years fell just shy of 120 bushels per acre. In 1992, we not only blew through the 120 bpa mark, but the 130 bpa mark too, averaging about 131 bushels per acre. By the way, 1995 was the last year we had an average corn yield less than 120 bushels per acre.

6. When was the last year that December corn futures had a higher price on October 1 than on May 1?

2008

2006

2004

2002

We have to go back to 2002 – eight crop years – to find a year when December corn futures were higher priced at the start of October than they were at the start of May. The tendency for new crop December corn futures to decline from spring to harvest is one of the strongest seasonal tendencies you can find in any commodity, grain or otherwise. I want to thank Jeremy Frost of Midwest Cooperatives in Pierre, SD for suggesting this quiz question.

Explanation

We have to go back to 2002 – eight crop years – to find a year when December corn futures were higher priced at the start of October than they were at the start of May. The tendency for new crop December corn futures to decline from spring to harvest is one of the strongest seasonal tendencies you can find in any commodity, grain or otherwise. I want to thank Jeremy Frost of Midwest Cooperatives in Pierre, SD for suggesting this quiz question.