PRICE FIXING STRATEGIES

Strategies Through Physical Trading: PRICE FIXING STRATEGIES

Trading without Forward Contracts BUY AND HOLD STRATEGY If coffee prices rise….

lbs

If coffee prices fall….

Delivery Period Price (USD cts/lb)

lbs

Delivery Period Price (USD cts/lb)

BUY

25,000

JULY

140.00

BUY

25,000

JULY

140.00

SELL

(25,000)

OCTOBER

180.00

SELL

(25,000)

AUGUST

125.00

PROFIT & LOSS / lb

40 cents

PROFIT & LOSS / lb

Total lbs of coffee

25,000 lbs

Total lbs of coffee

$10,000

END Result

END Result

Profit:

(15) 25,000 lbs

Loss:

(3,750)

The BACK TO BACK Strategy can lock in an already quantified and known profit or loss, while the BUY & HOLD Strategy is very risky with un-known results

Risk level: High

RISK MANAGEMENT

Strategies thru Physical Trading Fixed Price Forward Contracts (Back to Back Operations)

Other Structured Forward Contracts •Minimum Price Sales Contracts •Price to be Fixed Contracts •Long Term forward Contracts

In all cases strategies through physical trading involve: SELL coffee

Sellers BUY coffee

Buyers

Risk Management with Fixed Price Forward Contracts (Back to Back operations) Back to Back contracts are based on purchase and sales agreements for physical coffee. Trader simultaneously agrees on price and volume for the purchase and sale of the coffee BENEFITS • No up-front cost • Price risk is minimized since both purchase and sale price are known RISKS & CONSTRAINTS • This strategy impacts the traders ability to take advantage of future and eventual positive price movements • Reduces ability to hold coffee to sell at different points in the season (may prevent long term relationships with buyers)

Risk Management with Back to Back Contracts Fixed Price Forward Physical Contracts Fixed Price Forward contracts are agreements to:

1. 2. 3. 4.

Purchase or sell a specified product For a specific forward delivery At a specified and predetermined price Payment is expected at the delivery date

Fixed Price Forward contracts are NOT about “future price discovering/guessing” Fixed Price Forward contracts are about committing today for future delivery

Risk Management with Back to Back Contracts

Fixed Price Forward Physical Contracts July: Buy 25,000 lbs coffee at 140 cents / lb

and: Sign contract with buyer to sell 25,000 lbs coffee at 160 cents / lb for delivery in October – “locking in profit” of 20 cents / lb

October: Deliver 25,000 lbs coffee at 160 cents / lb Profit per lb: 20 cents / lb

Total profit: $5,000

Risk Management with Back to Back Contracts

Fixed Price Forward Physical Contracts lbs

Delivery Period

Price (USD cts/lb)

BUY

25,000

JULY

140.00

SELL

(25,000)

OCTOBER

160.00

PROFIT & LOSS / lb

20 cents

Total lbs of coffee

END Result

25,000 lbs

Profit:

Risk level: LOW

$5000

Risk Management with Back to Back Contracts

Fixed Price Forward Physical Contracts FORWARD contracts are usually Long Term contracts BENEFITS • No up-front cost • Strengthens trade relationships • Provides assured “HOME” for product

•

Can be used as a pre-harvest financing guarantee for the banks

RISKS & CONSTRAINTS • Fixing prices thru long term forward contracts is not necessarily advantageous since this strategy impacts the traders ability to take advantage of future and eventual positive price movements • Counterparty Risk • Default Risk ADDITIONAL ISSUES • BASIS Risk is not covered

Risk Management - Other Structured Forward Contracts

MINIMUM PRICE SALES CONTRACTS •Minimum price sales contracts give a minimum price guarantee commonly known as FLOOR Price

•Sale contract is agreed for delivery at a future date •If the prevailing market price at time of delivery is

higher than the pre-agreed FLOOR price, the seller benefits by being able to sell at the higher price

•If the prevailing market price at time of delivery is

lower than the pre-agreed FLOOR price, the seller is protected by the pre-agreed floor price and does not have to sell at the lower market price

Risk Management - Other Structured Forward Contracts

MINIMUM PRICE SALES CONTRACTS 200

Price fixed at 190.00 cts/lb

190 180 170 160 150 140 130 120 1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Time of establishing the final price 200 190

Price fixed at 160.00 cts/lb

180 170 160 150 140 130 120 1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Risk Management - Other Structured Forward Contracts

MINIMUM PRICE SALES CONTRACTS If coffee prices rise

If coffee prices fall APRIL:

Trader purchases coffee at 150 cents / lb Trader signs minimum price sales contract with buyer for 10,000 lbs coffee to be delivered in September, with a minimum price (“floor”) of 160 cents / lb September: Coffee at 190 cents /lb September: Trader delivers 10,000 lbs of coffee and receives 190 cents/lb Equal to a profit of 40 cents/lb Total profit of: $4,000

September: Coffee at 140 cents / lb September: Trader delivers 10,000 lbs of coffee and receives 160 cents/lb (the price floor) Total profit of: $1,000

Risk Management - Other Structured Forward Contracts

MINIMUM PRICE SALES CONTRACTS •BENEFITS • Can lock in forward sales at minimum price while still providing opportunity to take advantage of favorable price movements • Potentially no-cost if part of a Certification Program ie FAIRTRADE RISKS & CONSTRAINTS • BASIS Risk is not covered • If not provided as part of a Certification Program there might be a cost to the trader for such a contract

Risk Management - Other Structured Forward Contracts

PRICE TO BE FIXED CONTRACTS • With these contracts, the seller or buyer, negotiates flexibility into the contract which will allow them to fix the contract price at a time of his own choosing • Price-to-be fixed Contracts are also referred to as “executable orders” or “on call” contracts • The contract allows either the buyer or the seller to select the date (between establishing the contract and delivering the coffee) when the price for the contract is set (based upon an international price and differential) • A PBTF Contract based on a sellers call enables the trader to monitor the markets and fix the price when they believe the price is most advantageous • There is a risk of a trader speculating on such a contract

Risk Management Other - Structured Forward Contracts

LONG TERM CONTRACTS – FIXED OR FLOATING • These contracts have similar features to the contracts previously mentioned • The main difference is that these contracts a long term – often linking the trader and buyer together for a much longer period of time • Fixing the price on a long term forward contract exposes a trader to significant price risk exposure • Traders may value such a long term contract as it provides a guaranteed buyer for their coffee

• Such contracts can assist a trader in building a stronger business relationship with a key buyer

Risk Management - Other Structured Forward Contracts

SELECTING THE APPROPRIATE STRATEGY •

A trader will often need to sell their coffee to different buyers under different contract types and conditions

•

No one contract type is “best” – but the selection of physical strategies should be based upon the situation / environment that the trader operates within

•

Traders should determine which contract types to utilise based upon a regular review of their position analysis, breakeven price level and marking to market i.e. through their risk analysis

•

Risk created by one contract type may be offset by agreeing a contract with a different structure (i.e. offsetting one contracts exposure against another contract with the opposite exposure)

•

Effective determination of a physical strategy is fully dependent on regular and robust risk assessment

Risk Management - Physical Strategies •

There are a number of different contract types that a coffee trader can utilise to manage risk, these include: 1. 2. 3. 4.

Fixed Price Forward Contracts Minimum Price Sales Contracts Price to be Fixed Sales Contracts (PTBF) Long Term Contracts – Fixed or Floating

•

Every trader will need to select the most appropriate mix of contracts based upon their unique and individual circumstances – this will be a key part of their risk management strategy

•

Many traders will find themselves able to manage a significant part of their exposure to risk using physical trading

•

Clever use of physical trading strategies is dependent upon regular, and thorough risk assessment