This blog article takes a look at managing downside price risk exposure for a wool grower using forward contracts and minimum price contracts.
There are two predominant strategies to reduce the effect of price volatility when selling physical wool for a date in the future. These are by using a forward contract or using a minimum price contract (MPC).
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 July the price of a 21-micron wool forward contract for an October settlement is relatively high at 1,400c 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 1,400c for 5,000kg of wool to be delivered to the broker in October. This means that the grower will receive a total of $70,000 for his wool. There are two scenarios that could happen when October 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 MPC gives the grower the right but not the obligation to sell an underlying commodity (in this case wool) at a specified price. A MPC works in a similar way to your car insurance. That is, to enter into a MPC, you only pay the premium. Purchasing ‘insurance’ trades the possibility of a large but uncertain loss for a small but certain cost – the insurance premium. The benefit with a MPC is that you can lock in the downside price, but the topside price remains open.
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.
Let’s look at another example
In July, the grower enters into a MPC, by paying a 30c premium, that has a strike price of 1,400c. This means that a minimum floor price of 1,370¢ will be created by subtracting the premium from the strike price. Again there are two scenarios for October.
It can be seen that 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 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 taken into account when considering each strategy.