420 400 380 30 320 Effective Price Paid by Mill 340 360 Effective Cost with Put ($/MT) 300 310 330 350 370 390 410 430 450 Source: CME Group calculations Soybean Meal Cash Price in June Scenario 2 Tortilla Purchases on Basis: If Tortilla prices its soymeal parcel as a basis against the Soybean Meal futures price, it can hedge its price risk with either a futures contract or a call option contract. In essence, using a futures contract would effectively allow Tortilla the ability to fix the cost of soymeal, whereas a call option would allow Tortilla the ability to fix the cost of soymeal if soymeal prices rise above a pre-determined price, but allow Tortilla to capture a cost benefit if soymeal prices fall. The potential outcomes from these three examples are illustrated in the charts below. The soymeal cash price and the July futures prices are assumed to be $380 and $385 respectively in March. The first chart shows that, if Tortilla does not conduct any hedging, it would be fully exposed to all soymeal price fluctuations. The second chart shows that, if fully hedged with a futures contract, Tortilla's purchase price will be fixed regardless of market price fluctuations. The third chart shows that, if hedged with a call option, Tortilla's purchase price will be fixed if soymeal prices rise but allow it to pay a lower purchase price if soymeal prices fall. 250 300 Jan-16 Feb-16 Mar Apri 350 SECTION A: STRUCTURED QUESTIONS (100 MARKS) ANSWER ALL QUESTIONS QUESTION 1 (25 MARKS) Case Study: Hedging Soyme al Price Risk for Feed Mills in Vietnam Industry Background Vietnam has a population of over 90 million people and consumes over 6 million metric tons (MT) of soymeal, mostly as animal feed for hogs, the most popular meat consumed in the country. Vietnam is one of the world's largest importers of soymeal, importing over 4.3 million MT2 in 2017, 85% of which was from Argentina and the rest mainly from the U.S. and Brazil. Soymeal production within Vietnam is small, and domestic demand is mostly met by imports. Numerous small- to medium-sized feed mills buy and import most of the soymeal. Risks Associated with Soyme al Imports Vietnam is the world's second biggest soymeal importer (after the EU-27 bloc); the three largest soymeal exporters are Argentina, Brazil and the U.S. The Sino-U.S. trade tariff disagreements that started in April 2018 have had an impact on the global soybean and soymeal trade resulting in the possibility for additional price volatility. Firms involved in importing soymeal into Vietnam may want to consider an active hedge program to guard against unforeseen price volatility. CBOT Soybean Meal Historical Price & Volatility 450 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-12 May-17 Jun-17 Source: Bloomberg, CME Group dato Price (S/bul Oct-17 17 Dec-17 30D Volatility (%) RHS) Jan-19 Feb-79 Mar-19 20 Commodities are a volatile asset class. Soymeal prices were relatively calm in the second half of 2018 despite turbulence caused by the Sino-U.S. trade tariff negotiations. Volatility typically increases from May to July when the U.S. soybean planting season gets underway. When traders buy soymeal from overseas soybean crushers, the cargoes are usually procured as basis contracts where the soymeal is priced against an index such as the CBOT Soybean Meal futures price. The international traders importing soymeal in this manner typically hedge their price risk. The international traders then may sell to local traders, who then on-sell to domestic feed mills either at a fixed price or at a basis to the Soybean Meal futures price. Vietnam is home to many small feed mills, who buy soymeal from traders either at fixed prices or at a basis. Purchases direct from crushers or international traders are typically conducted in USD while purchases from local traders are typically conducted in Vietnamese Dong (VND). For purposes of this case study, currency risk is ignored by assuming that the foreign exchange rate between USD and VND is constant. Therefore, for mills buying at a basis, the main price risk is that soymeal prices may rise between the time of the contract and delivery on the contract. For mills buying on fixed prices, the main price risk is the opportunity cost that prices may decline between the time of the contract and delivery on the contract. Company Profile and Situation Consider an example company and its situation Tortilla is a medium sized feed mill which buys soymeal from international and local traders. It buys in small parcels of 2,000 to 5,000 MT at a time, and its purchases can be at fixed prices or at a basis to the CBOT Soybean Meal futures price. In March, Tortilla placed a purchase order with an international trader for 2,000 MT of soymeal for physical delivery in June. This parcel would be part of a larger 50,000 MT cargo that will be loaded from the Puerto Parana port in Argentina for May shipment, and be delivered to the Phu My-Ba Ria Serece port off Ho Chi Minh City' in June. In March, soymeal was quoted at $380 per MT in the Argentinian cash market for May shipment. Tortilla agreed to buy at a fixed price of $390 payable upon delivery in June. Due to global economic conditions, Argentinian soymeal prices fall by $60 per MT when June arrives. Other feed mills in Vietnam who were actively placing orders for soymeal in June were being quoted $320 per MT, for August shipment. Tortilla wondered if it should have bought on basis instead of at fixed prices. Tortilla did not open a letter of credit at the time it bought the meal, so the firm may face difficulty getting its cargo financed from banks since banks sometimes refuse to finance cargoes if there is a risk that the customer might fail to repay the loan. Case Study The case study considers two alternative scenarios where Tortilla buys at fixed prices or buys at basis and considers risk management strategies that it could have taken to manage price risks that improves on the example above. Scenario Tortilla Purchases at Fixed Prices: If Tortilla purchases soymeal at fixed prices, its main risk is the opportunity cost if prices fall significantly. One way that Tortilla could manage this risk is with a put option on the July Soybean Meal futures contract. The following table illustrates potential outcomes where soymeal prices rise by $60 and fall by $60 compared to an unhedged position. ROSE BY $60 PRICE PER METRIC TON (S/MT) FELL BY $60 Marc Soymeal cash price 380 July futures price 385 July put option at $380 strike 15 June Soymeal cash price July put option at $380 strike Hedged with Put Option 320 440 607 0 Paid for put in March -15 -15 Cash flow from exercising Put +60 0 Paid for soymeal in June -390 -390 Net cost of soymeal purchase -345 -405 Unhedged Case -390 -390 June soymeal cash price -320 -440 In other words, had soymeal prices fallen to $320, Tortilla would have been able to partially capture the cost savings by exercising the put option, and paid an effective price of $345 instead of the contracted fixed price of $390. Had prices risen, Tortilla's cost would be fixed at $405 (S15 above the fixed contract price of $390 due to the cost of the put). Effective Price Paid by Mill Price Paid by Feed M 440 Original Cost ($/MT) 420 400 MO 360 340 320 300 310 330 350 Source: CME Group calculations 440 420 400 380 360 340 320 300 310 330 350 Source: CME Group calculations 370 390 410 430 450 Soybean Meal Cash Price in June Cost with Futures ($/MT) 370 390 410 430 450 Soybean Meal Cash Price in June Effective Price Paid by Mill 440 4201 400 300 360 340 320 300 310 330 300 Source: CME Group calculations Cost with Call ($/MT) 370 390 410 430 450 Soybean Meal Cash Price in June This is illustrated numerically in the table below, for the specific cases where soymeal prices rise by $60 or fall by $60. PRICE PER METRIC TON (S/MT) FELL BY $60 ROSE BY $60 March Soymeal cash price July Futures price 380 385 July Call Option at $390 strike 189 June Soymeal cash price 320 440 July Futures price 320 440 40 July Call Option Exercise Price 0 60 Hedged with Futures Opened Futures position in March -385 -385 Closed Futures position in June +320 +440 Paid for Soymeal in June - 320 -440 Net Cost of Soyme al -385 -385 Hedged with Call Option Paid for Call in March - 18 - 18 Cash Flow from Exercising Call +0 +500 Paid for Soymeal in June -320 - 440 Net Cost of Soyme al -338 -408 Summary: Tortilla's cost of soymeal Unhedged Case -320 -440 Hedged with Futures -385 - 385 Protected with Call Option -338 - 408 Concluding Remarks Tortilla was likely better off using either Futures or Options to hedge its physical exposure compared to leaving its physical trades unhedged. Commodity derivatives were primarily developed to help commercial market participants manage their commodity price risk. A firm buying physical commodity on a basis contract can fix its purchase price by buying futures contracts or can manage its purchase price risk by buying call options. A firm buying physical commodity on a fixed price contract can manage its purchase price risk by buying put options.