SWAPs help hedge future trades
GroundCover™ Issue: 57
Farmers are being offered an increasingly complex range of alternatives for selling their grain, requiring careful analysis. this report by tom basnett from Agrisk Management explains the use of grain SWAPs
Grain SWAPs are a futures contract converted into Australian dollars (AUD) and are attractive to many growers because the "basis" for the price is not locked in. This allows a grower to potentially take advantage of a strengthening position.
Using SWAPs, growers can separately lock the three elements of grain prices - currency, grain futures and basis. The products are used when one of the elements is favourable, and there is an opportunity for the others to improve before harvest.
Wheat SWAPs are calculated by converting the US dollar (USD) Chicago Futures contract from cents per bushel into dollars per tonne and then converting into an AUD value.
If a SWAP is sold at $200 per tonne and the price falls to $150/t at harvest, then $50/t is paid to the grower. If the price rises to $250/t, then the grower pays $50/t.
However, before using SWAPs it is important to understand basis - the difference between cash prices in Australia and the SWAP price on any given day. For example, if the AWB Multi V today is $160/t (delivered harvest), and the December 2005 Wheat SWAP is $170/t, the AWB Multi V basis is therefore $160 minus $170 - in other words, minus $10 ($10 under). On any given day, a price (forward or cash) can be represented by a pie chart.
Traditionally, basis for wheat will strengthen going into harvest. Forward wheat cash prices offered by traders usually consist of poor basis levels early in the year. Cash prices have generally consisted of stronger basis levels during our harvest period.
Traders use this swing in basis to their advantage. Their aim is to buy basis at a low level (for example, minus $20) and sell basis at a higher level (for example, minus $5). The main component of the price (futures and forex or the SWAP) is hedged by the trader to minimise exposed to futures and foreign exchange movements.
However, as mentioned, a benefit of using SWAPs instead of forward cash contracts is that basis is not locked in. When you sell for cash, all components of the price (futures, forex and basis) are locked in. That is, you sell the whole "pie" when you sell for cash. When you sell a SWAP, the basis remains unsold and you are then able to take advantage of strengthening basis levels.
Figure 1 illustrates AWB Multi V price versus March 2005 Wheat SWAP from January to December 2004.
It can be seen at the beginning of the year that the forward cash price was trading at a large discount to the March 2005 SWAP. That is, basis levels were weak early in the year. Then, as we moved into harvest, cash prices began trading at a good premium to the March 2005 SWAP. That is, basis levels were much stronger.
We will now consider two scenarios: Selling forward (multi V) and hedging by selling a SWAP
Strategy 1: Selling forward
Grower 1 sold a parcel of grain in May 2004 for $200 at port. By harvest, the cash price had fallen to $156 (ie, a fall of $44). Grower 1 had sold his wheat at a good number early in the year and the price fell.
Strategy 2: Hedging by selling a SWAP
Grower 2 recognised an opportunity when the cash price hit $200 in May but decided the basis level ($20 under) was poor and he would therefore sell wheat SWAPs instead of a Multi V. This grower sold December 2004 CBOT Wheat SWAPs at $220.
On 30 November, grower 2 sold the physical wheat for $156. On the same day, the December 2004 SWAP settled at $135 (if harvest was earlier the grower would then "buy back" the SWAP). The bank paid this grower $220 - $135 = $85. The net price for Grower 2 was therefore:
APW1 cash price = $156
plus gain from SWAP position =$85
($220 - $135)
net price = $241/tonne
Grower 2 hedged the main components of the price (futures and forex) by selling a SWAP and was able to participate in a strengthening basis. This grower was $41 per tonne better off than Grower 1 because basis swung $41/t in their favour.
Under the first strategy, Grower 1, who sold physical wheat, effectively sold basis to the trader for minus $20. Having bought basis for minus $20, the trader then sold basis for plus $21 at harvest.
Grower 2 refused to sell the poor basis early in the year and was able to participate in a $41 swing in basis. Instead of the trader winning on this strengthening basis, Grower 2 participated and put this money into his/her pocket.
2004 was an outstanding year for using SWAPs and rarely does basis strengthen $41/t unless we slip into a drought. Traders and end-users were forced to strengthen their bids at harvest to keep wheat away from the AWB Pool, which had good hedging gains (both futures and currency) built in compared to the international market.
In 2002 (see Figure 2), cash numbers around $200 at port existed early in the year. Many growers saw this as an opportunity to price some wheat and we have all heard the washout stories and losses that ensued. Growers who sold forward were exposed to an extreme swing in basis. Growers who hedged using SWAPs were forced to cash-settle a losing hedge (because the SWAP price increased) but were able to participate in an increasing basis.
Obviously 2002 was a year when not locking in anything was the preferable option. However, SWAPs fared better than selling forward because while cash prices increased $150/t, the SWAP increased only $80/t. While the grower who hedged had a losing SWAP position of $80, this grower had not locked in basis and was able to participate when basis levels exploded. Furthermore, if the crop was lost, the cost to unwind the SWAP was far less than the forward contract.
The following year, 2003, showed that there will be opportunities when basis levels appear attractive and selling physical cash forward may be the preferred option. Sometimes there are opportunities when basis is strong, and managing risk by using forward contracts may give a better outcome than hedging using SWAPs. These opportunities crop up now then and are common in years following a drought, when consumers are still feeling the pinch and are therefore willing to bid up the basis to secure grain before harvest.
Traders are not always taking a risk when they bid a strong basis in this instance, because they may be simply buying and selling the grain (and therefore the basis) back-to-back with another counter-party.
[Photo: Brett Stevenson discusses Market Check Grain, an Agrisk service, with John Hickson at Boomi in northern NSW]