A purchasing manager’s guide to offsetting price risk exposure

As a purchasing manager, you might have learned that it’s prudent to “buy when you can, not when you need to.” This saying is pertinent because once input prices start to rise, finding a source at a reasonable price can be challenging. One way to mitigate your risk of increasing costs is to use a financial product to offset your exposure.

A case study: Organic corn prices are rising

Let’s discuss an example. You have noticed that one of the critical inputs into your organic poultry feed has started to rise. You want to set up a contract that will allow you to purchase organic corn before it starts to trend higher. Unfortunately, when you call your supplier, he tells you he is unwilling to sell yet. After speaking to a few merchandisers, you decide that you need an alternative method to cap your potential costs.

When you look at a chart of organic corn prices, you can see that they are poised to break out. A combination of robust demand and the potential loss of supply due to a conflict in the Black Sea could generate a further rise in organic corn prices.

You recall reading an article on the Fastmarkets risk management page. It described financial solutions to your organic corn price concern, which would allow you to eliminate most of your commodity price risks. The concept is called hedging.

A few years ago, you tried to hedge your organic corn risk and contacted a futures exchange. After a brief conversation with a broker, you realized that only conventional corn futures contracts were available on the futures exchange. You also know from your experience buying physical organic corn that the price of organic corn does not move in tandem with conventional corn futures prices.

What is a call spread?

You’ve probably heard that you can hedge specialty grain products, such as organic corn, using a financial derivative called a “call spread”. This financial derivative combines call options that allow you to protect against higher prices. A call spread is a combination of call options where you purchase a lower strike call and simultaneously sell a higher strike call option.

For example, if organic corn prices are about to break out, you might consider purchasing an $11 - $14 call spread to protect yourself from rising costs and more expensive inputs into your organic feed. You can buy price protection for a specific premium as organic corn increases above $11 per bushel and up to $14 per bushel.

You reduce the premium as you use the value you receive from the higher-strike call to pay for the lower strike call.

How are options traded?

You can buy or sell options from an exchange or a market maker. If the product you want to hedge is not on a futures exchange, like organic corn, you can ask a market maker for a price and transact a call spread. These products are considered over-the-counter derivatives. These over-the-counter derivatives are usually financially settled against organic corn prices reported by reputable price reporting agencies, like Fastmarkets. Only cash will change hands, and you will never receive organic corn.

The payout profile

A simple way to visualize a call spread is to look at a payout profile.

organic-corn-call-payout (002).jpg

You can see from the diagram that you have an unrealized loss until the price of organic corn rises above your breakeven level, which is $11 plus the premium you pay for the call spread. You start accruing unrealized profits until the $14, where your earnings are capped. The most you can lose on this hedge is the premium you pay. The most you can earn is the difference between the lower and upper strikes minus the premium.

Summary

The upshot is that it would be best if you hedged when you could, not when needed. One of the best ways to protect yourself from rising organic corn prices is to trade a financial derivative. If you cannot transact the product you want on an exchange, you can work with a market maker to transact an over-the-counter call spread to protect yourself from higher organic corn prices.

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