By Matt Dalgleish | Source: Riemann, ACA, AWI, AWEX, Trade
Analysis of all wool forward trades settled on the Riemann platform since mid-2015 shows that 45% of trades settled in the grower’s favour and 55% settled in the wool buyer’s favour. Recent subscriber queries regarding the value of using minimum price contracts, which may allow the grower to benefit in a potential price rise while having the safety of an agreed minimum price, prompted us to undertake a review these two wool price hedging tools.
Minimum price contracts, for those that are more familiar with financial derivative products, are essentially an option contract. These contracts give the owner of the option (usually the grower) the right to choose if they want to sell wool on a future date at a price (known as the strike price) which was agreed upon when the option is purchased. If at the maturity of the option, the strike price is above the physical price set at the auction market the grower can choose to sell at the higher strike price. In contrast, if the strike price of the option is below the physical price the grower can ignore the option contract and sell their wool at the higher auction price.
To read more about options visit our Options glossary
The attraction of this type of option contract, unlike a forward sale contract, is that the grower can participate in any upside in price but has the downside protected. However, there is a catch. The grower has to pay a non-refundable premium (think insurance premium) in order to have this benefit. In addition, the strike price will usually be set at a level that is lower than the prevailing market price at the time the option is purchased. This scenario is referred to as being an “out of the money” option.
An example of this would be a 21-micron option purchased in May 2016 for maturity in July 2016 at a premium cost of 45¢ that has a strike price of 1390¢ when the current auction market is trading at 1410¢. The option is “out of the money” by 20¢ since the auction market has to fall by that amount in order to reach the strike price.
In other words, this option has no real protective value until the auction price moves below the strike price. The value in this option has to do with how much time is left until maturity and wool price volatility. The grower pays the 45¢ premium cost in the hope that the wool price is volatile enough on the topside to be higher by 45¢, or more, than 1410¢ when the option matures in July 2016. Similarly, if the wool price is volatile enough on the downside to be 65¢, or more, lower than 1410¢ by the July 2016 maturity then the outcome of the option purchase has been worthwhile.
Figure 1 compares potential outcomes for the grower using either wool forwards or minimum price contracts according to data collected via the Riemann trading platform, AWI weekly reports and trade sources. Option and forward trade outcomes have been segmented according to the maturity of the contracts. The blue column represents forward trades that settled in the grower’s favour (i.e. the auction price at settlement was below the forward price). The orange column represents forward trades that settled in the wool buyer’s favour (i.e. the auction price at settlement was above the forward price). The black dash is the average forward outcome across all trades for that maturity.
Overlaid on figure 1 is average option outcome data for each maturity segment collected from AWI reports (yellow dots) and option outcome curves (green lines) sourced from wool trade participants. After taking into account the premium cost of the option and how far “out of the money” the options were we can see how effective using options is compared to forward sales. The real benefit of the options is being able to participate in upside price movements when the movement is extreme enough to recover the premium cost outlaid to purchase the option.
Clearly, on average, forward sales outcomes appear to be a better hedge strategy than using options. However, there are times of extreme wool price volatility when options have been more beneficial. The area shown by the orange column that is below the relevant options points indicate those times when the wool auction price rallied strongly enough so that the premium cost was recuperated and the grower enjoyed a higher net sale price by hedging with a minimum price contract.
So why aren’t minimum price contracts as good as they sound? It is all down to how these option contracts are priced. In order to calculate a premium cost of the option three things need to be taken into consideration. How much the option is “out of the money”, the wool price volatility and the time to maturity. Generally speaking, the longer to maturity the higher the premium cost of the option will be as it becomes harder to predict future price movements the further away the time horizon, as highlighted by the falling slope on the option outcome curves (green lines) on figure 1.
Analysis of the option premium prices that were used to generate the option outcome curves indicates that the wool price volatility level used to price the premium cost ranges from 22-25% annual volatility. Figure 2 highlights the wool price for 21-micron and is overlaid with an annual volatility calculation. Annualised volatility can change over time according to the wool price moves and over the last decade has ranged between 10-25% volatility. Premium costs for most minimum price contracts appear to be using volatility levels at the high end of the usual range which has the effect of making the options overpriced, apart from the rare occasions when price volatility is at extreme levels.
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