FX Markets Drive Increased Hedging Opportunities in Australian Wheat Trades ‒ Part Two: Using FX Options

For the producer, this creates a two-month period of uncertainty as to the revenue that will be achieved. From a price risk management perspective, the producer is exposed to both the price of Australian wheat, priced in USD and the FX rate between the US and Australian dollar as the exporter ultimately earns their revenue in local currency. Both components can be hedged with futures/options.

The producer can manage their exposure to the wheat price using the CBOT Australian Wheat futures contract. In wheat, one futures lot equals 50 metric tons of wheat therefore a total of 600 lots of Australian wheat for May delivery will need to be sold to effectively hedge this position with wheat futures.

The price of the CBOT Australian Wheat futures May contract is 264.50 US dollars per metric ton. By selling 600 lots of futures at this price will hedge the exposure to wheat price fluctuations. With a price of 264.50 US dollars per metric ton established through the use of the Australian Wheat futures hedge, the producer can be confident in achieving a dollar revenue of 274.50 US dollars per metric ton on the sale of the wheat, which includes the agreed premium of 10 USD per metric ton with the miller.

We can also review the use of options to hedge the FX exposure. Buying options can enable the user to hedge against an adverse move in the market but continue to benefit from a favorable move. This preferential exposure comes at a cost, which is the premium that is paid by the buyer of the option to the seller.

Put simply, a call option gives the buyer the right to buy an FX futures contract at a predetermined price. Conversely, a put option gives the buyer the right to sell an FX futures contract at a predetermined price. This is also commonly referred to as the strike price. 

Multiple options positions can be combined to create tailored option strategy positions, which can provide a high degree of flexibility to the user and can hedge against the risk of rising and falling prices, but for the purposes of this analysis, we will look at a straightforward example.

Let’s assume that the exposure to the wheat price is managed in the same way, i.e. by buying 600 wheat futures contracts. The FX component can be hedged using options on the CME Australian Dollar futures contract.

The CME Australian Dollar futures contract has a contract size of AUD 100,000, and prices are quoted in terms of the number of US dollars per Australian dollar. A call option provides the buyer with the right to buy futures, and therefore buying a call option is equivalent to having the right to buy Australian dollars in exchange for US dollars at a fixed FX rate. Other things being equal, a call option will increase in value when the value of the Australian dollar increases.

A put option provides the buyer with the right to sell futures, and therefore buying a put option is equivalent to having the right to sell Australian dollars in exchange for US dollars at a fixed FX rate. Other things being equal, a put option will increase in value when the value of the Australian dollars decreases.

The Australian wheat producer will wish to convert the US dollar proceeds of the sale into Australian dollars, and therefore, will be buying Australian dollars. As can be seen in the futures hedging example, an increase in the value of the Australian dollar would reduce the sale proceeds of the wheat, measured in Australian dollars, whilst a decrease in the value of the Australian dollar would increase the sales proceeds, measured in Australian dollars.

The purchase of a call option on the FX rate would allow the wheat producer to offset the negative impact of an increase in the value of the Australian dollar, whilst being able to benefit from an increase in the value of the wheat resulting from a decrease in the value of the Australian dollar.

For this example, the wheat producer buys a call option which has a strike price close to the current futures price of 0.76545 USD per Australian dollar. The closest strike is 0.7650 USD per Australian dollar. The number of options required to hedge the position is determined in a similar way to futures. Each option is an option on one CME Australian Dollar futures contract which has a contract size of AUD 100,000. The futures price, quoted in US dollars per Australian dollars, is 0.76545. At this exchange rate the purchase cost of US$ 8,235,000 will be AUD 10,758,377. To hedge against adverse movements in the FX exposure, the wheat producer needs to buy 108 call options.

The call option has a premium, which is paid by the buyer at the time of the purchase. Prices for the option are quoted in terms of the number of US dollars per Australian dollar. The price for the 0.7650 call option on the June futures contract is 0.0103. The total premium cost for the option is therefore US$111,240.

This equates to AUD 145,326 at the prevailing spot FX rate.

It should be noted that the June option on the June Australian Dollar futures contract expires a few days before the underlying futures contract. For this example, with delivery of wheat in late May, one possibility could be to hedge this with the June FX options contract.

We can again examine what might happen to this hedged position in different outcomes. To focus on the FX component, let’s again assume that the wheat price is unchanged over the one month period, and review the same movements in the FX rate as with the futures example, but also review the implication of no change in the FX futures price.

In this example, we assume the Australian dollar futures price remains unchanged at 0.76545 USD per Australian dollar. With the wheat price stable at 274.50 US dollars per metric ton, the US dollars proceeds from the sale are 8,235,000 USD, and the return from the wheat futures hedge is 0 USD. In local currency terms, the proceeds are still AUD 10,758,377. However, being close to expiry, the call option giving the right to buy futures at 0.7650 has a low value of 0.0037. Whilst there is no change to the proceeds for the wheat, there is a fall in the value of the option.

In this example, we assume an increase in value from 0.76545 USD per Australian dollar to 0.79545 USD per Australian dollar. With the wheat price stable at 274.50 US dollars per metric ton, the US dollar proceeds from the sale are 8,235,000 USD, and the return from the wheat futures hedge is 0 USD. In local currency terms, the proceeds are AUD 10,352,631 which is lower than anticipated had the exchange rate not changed. Being close to expiry, the call option giving the right to buy futures at 0.76545 is in-the-money and valued at 0.0305. The reduced proceeds for the wheat are therefore partially offset by a gain of premium value of the option.

With a greater increase in the value of the Australian dollar, the proceeds from the wheat valued in Australian dollars would decrease further, but this would be offset by a further gain in the value of the option.

In this example, we assume a decrease in value from 0.76545 USD per Australian dollar to 0.73545 USD per Australian dollar. With the wheat price hedged at 274.50 per US dollars per metric ton, the proceeds from the sale in US dollars is 8,235,000 USD, and the return from the wheat futures hedge is 0 USD. In local currency terms, the proceeds are AUD 11,197,226, which is higher than anticipated had the exchange rate not changed. In this outcome, the call option giving the right to buy futures at 0.76545 is out-of-the-money and has a value of 0.0000 USD per Australian dollar. The option has decreased in value, which partially offsets the increased proceeds from the wheat.

The initial cost of the option has reduced the impact seen from the fall in the value of the Australian dollar. However, with the option already valued at zero, a further decrease in the value of the Australian dollar would result in the value of the sale proceeds increasing without any additional adverse move in the value of the option.

Australian wheat markets remain volatile and hedging price risk remains an important consideration. In addition, the volatility in foreign exchange markets can also be an unpredictable factor that firms are looking to hedge. By hedging foreign exchange risk, companies can look to stabilize anticipated future cash flows which in turn creates greater confidence in business performance.

Salient features of the futures contracts discussed in this article.