jamaica may 2011 module 3

PRICE FIXING STRATEGIES

Strategies Through Physical Trading:

PRICE FIXING STRATEGIES

Trading without Forward Contracts

If coffee prices rise…. If coffee prices fall….

lbs Delivery Period Price (USD cts/lb)

BUY 25,000 JULY 140.00

SELL (25,000) OCTOBER 180.00

PROFIT & LOSS / lb 40 cents

Total lbs of coffee 25,000 lbs

END Result Profi t : $10,000


BUY 25,000 JULY 140.00

SELL (25,000) AUGUST 125.00

PROFIT & LOSS / lb (15)


END Result Loss: (3,750)

The BACK TO BACK Strategy can lock in an already quantified and known profit or loss,

while the BUY & HOLD Strategy is very risky with un-known results

BUY AND HOLD STRATEGY

Risk level: High

Strategies thru Physical Trading

RISK

MANAGEMENT

Other Structured Forward Contracts•Minimum Price Sales Contracts

•Price to be Fixed Contracts

•Long Term forward Contracts

Fixed Price Forward Contracts

(Back to Back Operations)

SELL coffee

BUY coffee

Sellers Buyers

In all cases strategies through physical trading involve:

Risk Management with Fixed Price Forward

Contracts

(Back to Back operations)

Back to Back contracts are based on purchase and sales agreements for physical coffee. Trader simultaneously agrees on price and volume for the purchase and sale of the coffee

BENEFITS

• No up-front cost

• Price risk is minimized since both purchase and sale price are known

RISKS & CONSTRAINTS

• This strategy impacts the traders ability to take advantage of future and eventual positive price movements

• Reduces ability to hold coffee to sell at different points in the season (may prevent long term relationships with buyers)

Fixed Price Forward contracts are agreements to:

1. Purchase or sell a specified product

2. For a specific forward delivery

3. At a specified and predetermined price

4. Payment is expected at the delivery date

Fixed Price Forward contracts are NOT about “future price discovering/guessing”

Fixed Price Forward contracts are about committing today for future delivery

Fixed Price Forward Physical Contracts

Risk Management with Back to Back Contracts

July: Buy 25,000 lbs coffee at 140 cents / lb

and:

Sign contract with buyer to sell 25,000 lbs coffee at

160 cents / lb for delivery in October – “locking in

profit” of 20 cents / lb

October:Deliver 25,000 lbs coffee at 160 cents / lb

Profit per lb: 20 cents / lb

Total profit: $5,000



Risk level: LOW


BUY 25,000 JULY 140.00

SELL (25,000) OCTOBER 160.00

PROFIT & LOSS / lb 20 cents


END Result Profit: $5000



FORWARD contracts are usually Long Term contracts

BENEFITS

• No up-front cost

• Strengthens trade relationships

• Provides assured “HOME” for product

• Can be used as a pre-harvest financing guarantee for the banks

RISKS & CONSTRAINTS

• Fixing prices thru long term forward contracts is not necessarily advantageous since this strategy impacts the traders ability to take advantage of future and eventual positive price movements

• Counterparty Risk

• Default Risk

ADDITIONAL ISSUES

• BASIS Risk is not covered



Risk Management - Other Structured Forward Contracts

•Minimum price sales contracts give a minimum price guarantee commonly known as FLOOR Price

•Sale contract is agreed for delivery at a future date

•If the prevailing market price at time of delivery is higher than the pre-agreed FLOOR price, the seller benefits by being able to sell at the higher price

•If the prevailing market price at time of delivery is lower than the pre-agreed FLOOR price, the seller is protected by the pre-agreed floor price and does not have to sell at the lower market price

MINIMUM PRICE SALES CONTRACTS

120

130

140

150

160

170

180

190

200

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Time of establishing the final

price

Price fixed at 190.00 cts/lb

120

130

140

150

160

170

180

190

200

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Price fixed at 160.00 cts/lb



If coffee prices rise If coffee prices fall

APRIL:

Trader purchases coffee at 150 cents / lb

Trader signs minimum price sales contract with buyer for 10,000 lbs coffee to be delivered in September, with a minimum price (“floor”) of

160 cents / lb

September: Coffee at 190 cents /lb September: Coffee at 140 cents / lb

September:

Trader delivers 10,000 lbs of coffee and receives 190

cents/lb

Equal to a profit of 40 cents/lb

Total profit of: $4,000

September:

Trader delivers 10,000 lbs of coffee and receives 160

cents/lb

(the price floor)

Total profit of: $1,000



•BENEFITS

• Can lock in forward sales at minimum price while still providing opportunity to take advantage of favorable price movements

• Potentially no-cost if part of a Certification Program ie FAIRTRADE

RISKS & CONSTRAINTS

• BASIS Risk is not covered

• If not provided as part of a Certification Program there might be a cost to the trader for such a contract



PRICE TO BE FIXED CONTRACTS

• With these contracts, the seller or buyer, negotiates flexibility

into the contract which will allow them to fix the contract

price at a time of his own choosing

• Price-to-be fixed Contracts are also referred to as

“executable orders” or “on call” contracts

• The contract allows either the buyer or the seller to select the

date (between establishing the contract and delivering the

coffee) when the price for the contract is set (based upon an

international price and differential)

• A PBTF Contract based on a sellers call enables the trader to

monitor the markets and fix the price when they believe the

price is most advantageous

• There is a risk of a trader speculating on such a contract


LONG TERM CONTRACTS – FIXED OR FLOATING

• These contracts have similar features to the contracts

previously mentioned

• The main difference is that these contracts a long term –

often linking the trader and buyer together for a much longer

period of time

• Fixing the price on a long term forward contract exposes a

trader to significant price risk exposure

• Traders may value such a long term contract as it provides a

guaranteed buyer for their coffee

• Such contracts can assist a trader in building a stronger

business relationship with a key buyer

Risk Management Other - Structured Forward Contracts

SELECTING THE APPROPRIATE STRATEGY

• A trader will often need to sell their coffee to different buyers under

different contract types and conditions

• No one contract type is “best” – but the selection of physical

strategies should be based upon the situation / environment that the

trader operates within

• Traders should determine which contract types to utilise based upon

a regular review of their position analysis, breakeven price level and

marking to market i.e. through their risk analysis

• Risk created by one contract type may be offset by agreeing a

contract with a different structure (i.e. offsetting one contracts

exposure against another contract with the opposite exposure)

• Effective determination of a physical strategy is fully dependent on

regular and robust risk assessment


Risk Management - Physical Strategies

• There are a number of different contract types that a coffee

trader can utilise to manage risk, these include:

1. Fixed Price Forward Contracts

2. Minimum Price Sales Contracts

3. Price to be Fixed Sales Contracts (PTBF)

4. Long Term Contracts – Fixed or Floating

• Every trader will need to select the most appropriate mix of

contracts based upon their unique and individual circumstances

– this will be a key part of their risk management strategy

• Many traders will find themselves able to manage a significant

part of their exposure to risk using physical trading

• Clever use of physical trading strategies is dependent upon

regular, and thorough risk assessment

jamaica may 2011 module 3

Documents

sale price

coveredfixed price

physical coffee

future delivery fixed

lbs coffee

price fixing strategiestrading

upfront cost price risk

centstotal lbs of coffee