Markets can be volatile, however there are a number of tools which are available to reduce the risk of adverse price movements.
There are two predominant strategies to reduce the effect of price volatility when selling wool. These are by using a forward contract or using a minimum price contract (MPC). In this article we examine the MPC, and how it can be used by producers.
A forward contract is where you agree to sell your wool to a buyer in advance of actually trading the physical product. This allows you to lock in a certain margin that you want to achieve in advance.
Let’s look at an example.
In October the price of a 21-micron wool forward contract for a February settlement is relatively high at 2100¢ and a wool grower wants to take advantage of this high price. Therefore, he goes to his wool broker to arrange a forward contract. In the contract it is specified that the grower will receive 2100¢ for 5,000kg of wool to be delivered to the broker in January and sold at auction in February. This means that the grower will receive a total of $105,000 for his wool. There are two scenarios that could happen when February comes.
The result of the forward contract is that the grower can only receive what he locked in. While this is good when the market is falling and works in favour of the grower, when the market is rising it works in favour of the buyer.
An MPC works in favour of the grower in both cases, as it locks in the downside price by creating a floor, but if the market rises then he can still receive the higher price.
So how does this work?
A minimum price contract (MPC) gives the grower the right but not the obligation to sell their wool at a specified price at a future date. The MPC works in a similar way to your car insurance. That is, to lock in the MPC, you only pay the premium fee.
Purchasing ‘insurance’ allows the grower to swap the possibility of a large but uncertain loss for a small but certain cost – the cost of the premium fee. The benefit with the MPC is that a grower can lock in the downside price, but the topside price remains open.
Let’s look at another example.
In October, the grower enters into a MPC, by paying a 50¢ premium fee, that has a strike price of 2100¢. This means that a minimum floor price of 2050¢ will be created by subtracting the premium from the strike price. Again, there are two scenarios for February.
This means that the grower is covered if the price drops by creating a minimum floor price, but if the market rises they can take advantage of the higher price, unlike a forward contract.
Figure 1 outlines the overall price outcome of each strategy.
By paying the premium lets the grower lock in a “worst case” minimum price for the wool; similar to how an insurance premium will give you a certain amount of coverage if something unexpected happens.
The grower continues to participate when the market price is rising and will achieve a higher overall price than the strike price from the MPC. However, when the market is falling, the grower is protected by locking in a minimum floor price, which guaranteed by the MPC.
An MPC can work to greater effect when the market is highly volatile such as when there are large changes in price over a relatively short period of time. When the market is fairly stable, then the cost of the premium may not be recuperated in the price received for the wool, in which case a forward contract may be a better option.
In all instances an individual grower’s appetite for risk needs to be considered when considering each strategy.
For more information talk to your wool broker. Alternatively, you can contact Mecardo on firstname.lastname@example.org or by phone 1300 987 742.