WOOL FUTURES

Wool futures should be used prudently. If you are using them for the first time, limit the volume trades, to gain experience for a small cash outlay.

Using wool futures to guarantee a price is a good strategy for growers who have large commitments and cannot afford the risk of a drop in the market price of wool.
Using futures

Wool futures trading involves a contractual agreement by the wool producer to sell wool at some future date at a predetermined price. By using futures in conjunction with the auction system or direct marketing (or both), you can secure the price you will receive for a certain quantity and quality of wool in the future.

These contracts are sold at the quoted futures price for a particular month. After contracting to sell the wool, the grower buys back (liquidates) the futures contracts at the ruling futures price as near as possible to the time of selling the wool.

Contracts to buy and sell are made on the trading floor of the Sydney Futures Exchange. The futures price quoted is the market's prediction or barometer for the wool price at a particular month in the future.

Set delivery months are February, April, June, August, October and December up to 18 months ahead. If no delivery takes place, there is a cash settlement of the contract. Any outstanding contracts are closed at the end of the month at the Cash Settlement Price. 'The Cash Settlement Price is the 22 micron price indicator published by the Australian Wool Corporation on the day before the last day of trading.

Futures prices are quoted in cents per kg clean for 22 micron wool. Wools that are very different from the contract type are less suitable for hedging, because the prices for these wools may not move in unison with the price movements of the 22 micron contract wools.

A 'Unit of Contract' is 2,500 kg of clean combing wool or about 23 bales of greasy wool. Quotations are shown in ¢/kg clean, with minimum variations of 1.0 ¢/kg. Reports of the quotations appear mainly in eastern States' papers.

All contracts are transacted by licensed brokers, who charge a fee for the service and a deposit of about $750 per contract. The fee is determined by the broker and is presently quoted up to $50 per bought and sold contract.

The futures broker can call for margin payments from the wool producer if the futures market moves adversely in relation to the contract price. If a contract is sold for 550 ¢/kg clean, and the market moves up to 570 ¢/kg clean, the broker may call for $500 margin per contract to cover this movement. The margins are returned to the wool producer if the market moves back to the original price, or are recouped at the time of liquidating the futures contracts.
The object and mechanism of the futures hedge

The price guarantee mechanism is based on the assumption that the futures price and the cash price for wool will be similar at the time the wool is sold.

If the physical market is higher than the futures selling price, the wool producer must buy back the futures contracts at a price that is higher than the original sale price. The producer will lose on the futures trading contracts. However, the cash price for the wool sold will have risen above the contracted hedge price by an amount about equal to the loss on the futures trading. The guaranteed price will have been achieved.

If the physical market is lower than the contracted futures price, there will be a profit on the futures trading about equal to the reduced income from the sale of wool. Again the wool producer receives the predicted wool price.

'Hedgers' forego the chance of higher gains to reduce the risks of a downturn in the price of wool. There is unlikely to be any cash advantage for a wool producer who hedges a clip every year.

Growers who can afford to carry some risk will be attracted to hedging during periods when they believe the futures price is higher than the price they will receive on the physical wool market. Because the futures market is influenced by the current wool price, this situation is likely to occur when the wool price is falling. Growers contemplating altering their positions during the year should monitor the market constantly.
Example of a wool producer using wool futures to hedge

To begin the hedging process, calculate the price that will result from the hedge. Because futures prices are quoted in cents per kg clean for 22 micron wool, a conversion to the greasy price is usually necessary to provide the producer with a meaningful price.

Compare the price in cents per kg greasy for the clip sold in March 1991 with the AWC March 1991 clean quote for the 22 micron indicator. If the AWC quote was 470 cents and the wool producer's greasy wool averaged 277 cents then the greasy price was 58.9 per cent of the clean price. Assuming similar seasonal conditions and wool clip quality in 1992, the calculated wool return from an AWC quote of 515 would be 303 ¢/kg greasy.

A wool producer with an estimated clip of 150 bales averaging 185 kg each produces 27,750 kg greasy, or 14,105 kg clean wool at 62 per cent yield. The wool is usually sold in March and in March of the previous year the grower had decided to hedge the clip. April is selected as the hedging month so that we can be sure of selling the wool before the futures contract delivery month.

Calculate the expected income from the clip as follows. In March 1991 the April 1992 futures quote is 515 ¢/kg clean, so in March 1991 the grower considers selling contracts at 515 cents for liquidation on or before April 1992.

Having decided that 303 ¢/kg greasy, less all charges including, the wool levy, is an acceptable price for the wool to be sold in March 1992, the grower then sells four contracts (10,000 kg clean) for April 1992 delivery.
Pay special attention to the following aspects

To estimate the price from last year's clip, assume that the next year's clip will be of the same quality. The futures contracts must be liquidated as near as possible to the time of selling the wool.

The price of the futures and the wool must be similar at the time of sale. Be sure to discuss with your broker the implications if the physical price and the futures price do not come together when the contract is liquidated.

Ensure that the expected quantity of wool to be sold exceeds the amount included in the futures contracts. If the amount contracted exceeds the amount to be delivered, then the excess cover is speculative. This is because the quantity covered by the futures contracts is not matched by the quantity of physical wool. Trading in Wool Futures alone is a speculative rather than a hedging exercise.
Market rises above contract.:

If the wool market rises by 40 ¢/kg clean between the time of selling futures contracts in March 1991 to 555 ¢/kg clean in March 1992 (327 ¢/kg greasy), the wool producer makes a futures loss of 40 ¢/kg clean.

The grower will sell wool as follows.
16,129 kg greasy @ 327 ¢/kg (5 8.9% of 555) $52,740
Loss on futures trading $4,000 plus contract charges $200; -$4,200
Net, wool income $48,540
(Average ¢/kg greasy = 301: ¢/kg clean = 485)

This calculation assumes that the physical and the futures prices are the same when the wool is sold and the contracts are liquidated by buying them back.

The prices actually received will be slightly lower than the above calculation because of the futures selling charges.
Market falls below contract:

Should the market fall by 40 ¢/kg clean to 475 (280 ¢/kg greasy) between selling the contracts in March 1991 and delivery and sale of the wool in March 1992, wool income is as follows.
16129 kg greasy @ 280 ¢/kg (58.9% of 475) $45,160
Profit on futures trading ($4,000) less contract charges $200 -$3,800
Net wool income $48,960
(Average ¢/kg greasy = 303, ¢ /kg clean = 489)

When the physical and futures prices are not the same, the difference is unlikely to be large. To be confident, the original estimated price is set conservatively and to allow for futures selling charges, 10 cents per kg is deducted from the estimated price. This estimated price, 293 ¢/kg greasy, is the price used by the wool producer to decide whether or not to hedge.