Lee Melvill - Need Some Help

[lakenheath]

Here is what I am looking at:

I would like to grow 1000 acres of HRSW. I would also like to hedge my foreign exchange risk. So here is how I look at it. All things equal, if the price demand for our HRSW remains at $4.00 US a swing in the CDN dollar will effect us as follows:

$4.00/bu US = $4.60 CDN (at .87 dollar)
$4.00/bu US = $4.12 CDN (at .97 dollar)

Basically a drop of $.48/bu if the dollar goes up to $.97.

So if I assume the the 1000 acres of HRSW will average 35 bushels per acre then I would want to be looking at protecting a possible loss of 35,000 bu x $.48 = $16,800 due to an increasing CDN dollar.

That being said (realizing the above example is over-simplified), how does a person do the math of purchasing a "call option" on the CDN dollar to protect this potential $16,800 loss. What would a producer be looking at for cost of the option, and where would we find this information?

[chaffmeister]

Hope you don’t mind – I thought I’d wade in on this.

With 35,000 bu at a US-based price of 4.00 USD, your expected crop is an asset you valued at 140,000 USD that you want to protect. (At 0.87, this is worth 161,000 CAD.)

CAD futures and options contracts are 100,000 CAD per contract, so let’s go with 2 contracts covering 200,000 CAD. If you buy 2 Dec CAD futures at 0.87 USD and the market climbs to 0.97, you will gain 20,000 USD. At 0.97, this is equal to 20,618.50 CAD.

Over the same time, your crop that was worth 161,000 CAD would be worth only 144,330 CAD – a drop of 16,670 CAD. So, all netted out (hedge and crop), you’d be ahead by about 4,000 CAD. In other words, your hedge worked – you’d have an excess gain because you hedged more than the crop value.

Now, if the exchange rate dropped to say 0.77, you’d lose 20,000 USD on your hedge (once converted back to CAD at 0.77, it would be about 26,000 CAD). Also, you’d likely get a margin call.

At the same time, your crop would have gained in value by about 20,800 CAD (to about 181,800 CAD). Your net hedge would be a loss of 5,200 CAD.

There are two reasons this is not a perfect hedge: (1) You’re hedging a $160,000 asset with a $200,000 hedge, and (2) as the exchange rate changes, your gain or loss in CAD changes as well. So, as the CAD goes up, your USD returns from the hedge are less once they are converted back to CAD – and, as the CAD goes down, your USD losses from the hedge are more, once they are converted back.

Now let’s try options – which are what you wanted in the first place. Based on today’s close, a Dec 87cent call option is worth 0.0215 per dollar; so this will cost you 2,150 USD per contract. To buy two (to get 200,000 CAD coverage), it would cost you 4,300 USD. At today’s spot rate of 0.8616, this works out to about 5,000 CAD.

If you hold these two contracts to expiry and the underlying market (Dec futures) is then 0.97, you will have gained 20,000 USD on your hedge, or about 20,600 CAD (converted back to Canadian at 0.97). But this came at a cost of 5,000 CAD, so your gross hedge gain would be 15,600 CAD. Your crop will have dropped in value by about 16,700 CAD so your net hedge would be a loss of 1,100 CAD.

If the exchange rate doesn’t change materially while you hold the options, you are only out the option premium of 4,300 USD (5,000 CAD).

If the exchange rate goes to say 0.77, then your crop should have increased in value by 20,800 CAD and your option would be worthless so you would have forfeited your premium of 5,000 CAD, for a net gain of 15,800 CAD.

Canadian dollar futures and options are traded at Chicago Mercantile Exchange (CME).

Any broker can set this up for you. The calculations above do not include brokerage fees.


One more idea. To reduce the cost of the option hedge, you could do this:
1. Buy 2 Dec 87 calls at 0.0215, for a total cost of 4,300 USD
2. Sell 2 Dec 85 puts at 0.0145, for a total gain of 2,900 USD

Your net option cost will be 1,400 USD, or 2,900 USD less than just buying the calls.
Your coverage as the exchange rate moves higher is the same.
Your coverage as the exchange rate moves lower has changed, though. If the exchange rate moves below 85 cents, then you will basically have locked in a rate of 85 cents. Good or bad? It's your call.

[GrainVac]

Chaff
That was one of the better examples and certainly the best explanation I have ever seen, even better than my prof in my Finance 301 class at University, but then again maybe that's cause I'm a farm boy and currency exchange and hedging only makes sense when you include bushels in the formula!

[Incognito]

Now its my turn to be a fan...

Congrats...

[WRAPper]

Very nice good job chaff

[chaffmeister]

Happy to do it.
Hope it helps y'all.

[lakenheath]

Chaff....thanks.....very in-depth....i appreciate that very much!.....

[melvill]

Sorry I couldn't help you lakenheath but you were in very capable hands with chaffmeister.

Thanks for your help chaff.

[lakenheath]

One more question. What does it cost to open an account at the Chicago Mercantile Exchange?

[chaffmeister]

What you want to do is open an account with a broker that deals in futures and options - currencies in particular. (You don't open an account at the CME or any other exchange. Opening an account with a broker gives you access to whatever instuments and exchanges you want.)

You will need to place on deposit some cash to open the account. Each will have their own minimum - figure on $10,000. (Some will accept equities or bonds as collateral on the strength o which they lend you the required money for your positions.

I'm not sure of who's still in the brokerage business but I think there's Union Securities, Man Financial (was Refco), RBC - Dominion Securities, Scotia Capital, FC Stone, RJ O'Brien and likely others. Perhaps Lee will have a more complete list along with some local contacts for you.

If you want to chat directly, drop me an email at drooper409@hotmail.com.

[chaffmeister]

Awesome question Lakenheath!! I was wondering the same thing.

Even better answer Chaf!!

[melvill]

Chaffmeister, thanks again for your help.

There's a list of commodity brokers on the Alberta Ag website at:

www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/sis1015?opendocument

[melvill]

Lee, would you happen to know of some brokers in Sask??

[melvill]

toughgoofit, did you look at the list of brokers on the website above? Those companies will likely have office and brokers in Saskatchewan, too, although I haven't checked.

Don't be too concerned about dealing with a broker that's local unless it's important that you be able to "eye-ball" the person before doing business. My experience is that many producers deal with a broker that they've only ever talked to on the phone.

You could search the Sask Tel yellow pages at www.mysask.com and look for "Commodity Brokers" or even "Brokers".