Chapter 2

We shall assume that you have bought from a refiner through your broker a supply of actual sugar at 6.00. While your sugar is in transit or before it has been shipped by refiners, the market advances to 8.00, at which point it apparently is steady. You now have a _theoretical_ gain of 2.00--that is, if you were to sell your sugar at once, you would have an _actual_ profit of 2.00; but you do not sell because your sugar is in transit or you need it for your trade. However, you do want to preserve and protect this favorable position of having your sugar 2.00 below the market at the time you want to sell it. So you sell the same quantity of futures on the Exchange at 8.00.

Three things may occur--the market may decline, or it may continue to advance, or it may remain steady. You have accomplished your purpose in any case (see Chart 2).

By the time you sell your sugar (or at the time of its delivery) it becomes necessary for you to cover your hedge and if the market has declined from 8.00 (at which point you hedged) and stands at 6.00 again, your hedging operations considered alone would net you an actual profit of 2.00. Your original sugar cost was 6.00. Your profit on your hedge was 2.00, so that you would figure your actual sugar cost at 4.00. You would have accomplished your purpose of getting your sugar 2.00 under the market at the time of selling it (or at the time of its delivery). That is, your delay in selling your sugar has cost you practically nothing, even though the market has declined.

If the market has advanced to 10.00, when it becomes necessary for you to cover your hedge (at the time of selling your sugar or when it is delivered) your hedging operations considered alone would net you a _loss_ of 2.00. You would buy in futures at 10.00, which you sold at 8.00. Your original sugar cost was 6.00, your loss on your hedge was 2.00, so that you would figure your actual sugar cost at 8.00. But the market at that time was 10.00, so that you have accomplished your purpose of getting your sugar 2.00 under the market at the time of selling it (or at the time of delivery). In other words, you would make the same profit as though you had re-sold your sugar to second-hands originally, instead of hedging, but had you followed this course, you might not have had sugar in stock for your regular trade.

On the other hand, when it becomes necessary for you to cover your hedge, if the market has remained steady and is again at 8.00, the two futures transactions cancel themselves without profit or loss. Your original cost of 6.00, therefore, stands as your actual sugar cost at the time of selling (or at the time of delivery). This is 2.00 under the market and you have accomplished your purpose.

HEDGING _to establish and limit a loss on an unfavorable purchase_.

This operation is identical in its working with the previous example, except that you have a different end in view.

CHART 3

HEDGING to establish and limit a loss on an unfavorable purchase ------------+--------+---------------+-------+----------+----------+------- Initial | | Transactions| Subsequent Transactions | Result ------------+--------+---------------+-------+----------+----------+------- | Hedge | Condition of | Price | Result | Figure | In | | market when | you | of | actual | each | | you "cover" | pay | hedge | sugar | case | | your hedge | for | and | cost | the | | |futures| covering | this | same | | | to | operation| way | | | | cover | | | | | | hedge | | | ------------+--------+---------------+-------+----------+----------+------- You buy | | | | |Price paid| actual sugar| | | | |for actual| at 6.00 but | | | | |sugar less| before you | | | | |hedging | have | |It has declined| | A profit |profit | received it | |to 4.00 | 4.00 | of 1.00 |6-1=5.00 | (or before | | | | | | you sell it)| | | | | | the price | | | | | | declines to | | | | | | 5.00 | | | | | | | | | | | | You now have| | | | |Price paid|Your your sugar | | | | |for actual|sugar at 1.00 | | | | |sugar plus|cost is above the |You sell| | | |hedging |1.00 market |futures |It has advanced| |A loss of |loss |above |at 5.00 |to 6.00 | 6.00 |1.00 |6+1=7.00 |the | | | | | |market You feel | |It stands at | |No profit,| | that the | |5.00 | 5.00 |no loss | 6.00 | market may | | | | | | decline | | | | | | still | | | | | | further and | | | | | | increase | | | | | | this loss, | | | | | | so-- | | | | | | ------------+--------+---------------+-------+----------+----------+-------

Let us say that you purchase actual sugar at 6.00. If the market declines to 5.00 after your original purchase at 6.00, you have a _loss_ of 1.00, in the value of your sugar. Facing the possibility of a further decline and desiring to _limit_ this loss to 1.00, you hedge by selling futures. In this case you should limit your _loss_ to 1.00 just as effectively as in the previous example you preserved your _gain_ of 2.00, and by the same course of procedure. (See Chart 3.)

By the time it is necessary for you to cover your hedge by buying an equivalent amount of futures, the market may have declined still further, say to 4.00. You sold at 5.00, you bought at 4.00, profit on that operation, 1.00. Subtract this profit from your original cost (6.00) and figure your sugar cost at 5.00. In other words, although the market went still lower, you succeeded in limiting your loss to 1.00, as compared with the market price at the time of the delivery of your sugar (or at the time you sell it). Had you omitted the hedge, your actual sugar cost would have been 6.00, which was 2.00 above the market.

After your original purchase at 6.00, and market decline to 5.00 (at which point you hedged), the market might advance again to 6.00, or remain steady at 5.00, but the operation is no different from that previously described, and you in each case attain the same result.

Buying of Sugar Futures

Refiners do not make a practice of taking orders more than thirty days in advance of actual delivery--but there are obviously times when it is advisable to cover one's requirements for a longer period. A jobber may do this on the Exchange where he will always find a seller at _some_ price for the quantity he desires.

This privilege is particularly valuable to:

1. Jobbers who believe that the market price of Sugar is going higher and who desire to cover their future requirements beyond the delay period which refiners will extend.

2. Jobbers, who desire to sell to manufacturing customers for future delivery at a fixed price so that these manufacturing customers may determine their selling price, may do so by the use of the Exchange.

_1. Buying of sugar futures--Based upon the expectation of higher prices_

No doubt many jobbers will recall occasions when anticipating their requirements seemed obviously advisable, perhaps almost imperative. Such a jobber would be one who believed in the market. His action would be based on his opinion of the market. He might note in January, let us say, that the price of May or July futures is favorable. He would like to get his May or July sugar at about that figure. You yourself probably can recollect many times in the past, when the general market was in such a strong position fundamentally that anticipating your requirements seemed advisable. You decided to buy a considerable quantity only to find that refiners would not sell you to the extent that you wished to purchase. When covering your future requirements on the Exchange, you can buy any quantity desired.

Consider also on how many occasions when you wanted and _needed_ a definite future month of shipment, you have been told that "_as soon as possible_" was the only acceptable basis.

Or have you had the experience of placing an order and waiting twenty-four or thirty-six hours without knowing if the refiner would accept your order? Meanwhile the market might have advanced, and, if your order had been declined, you would have had to pay an even higher price for your sugar. The facilities of the exchange offer opportunities for protecting requirements _quickly_ and without the uncertainty and delay sometimes encountered from refiners.

A jobber must anticipate the market in order to take full advantage of it, and in this connection it should be borne in mind that the Sugar Exchange, as in the case of practically all exchanges, usually anticipates either favorable or unfavorable developments in the market for the actual commodity. Consequently, prompt action is necessary when either a higher or lower market is expected, as the Exchange market will usually be the first to reflect changing conditions.

Suppose you feel that the price of sugar is low and probably going higher. You try to anticipate your requirements for some time to come, but find that refiners will not sell for more than thirty days.

You can go on the Exchange and buy futures in the quantity and month desired. Assume then, that you pay 6.00 for your futures. Now, whatever happens in the sugar market, you know you can get the quantity of sugar desired at about 6.00 (see Chart 4).

The market will advance, decline or hold steady.

Say the market advances. When it seems advisable to close out your Exchange contract and buy actual sugar, the price may have gone up to 8.00. You will then sell your futures at about 8.00, go into the market and buy actual sugar at the same price, assuming, of course, that the actual market has advanced in relative proportion--which is likely. Although actual sugar has cost you 2.00 more than you had figured, you have made 2.00 on your futures. Profit and loss cancel each other. Your sugar cost is 6.00.

On the other hand, suppose the market declines after you have bought futures at 6.00, and goes down to 4.00, when it seems advisable to close out your Exchange contract. You sell your futures at 4.00, a loss of 2.00. But you will also buy your actual sugar at 4.00, which is 2.00 lower than you had planned. Your actual sugar cost was therefore 6.00, which is the price you had figured was favorable.

If the price still is at 6.00 when you desire to liquidate, you would sell your futures and buy your actual sugar at about the same price. Thus you have neither gained nor lost, but you have been sure of getting sugar at 6.00, which is the price you felt was low.

The time to buy actual sugar is generally when the market becomes strong and an advance in the price of the actual commodity seems imminent; but the time to buy sugar futures is before the strength develops. The future market invariably discounts declines and anticipates advances.

_2. Buying of Sugar Futures to protect profits on advance sales to customers_

While it may not be an established custom, we know numerous instances where jobbers have sold sugars in small quantities for future delivery. The examples to which we refer are small manufacturers buying sugar locally, who, when the market appears in a strong condition desire to be assured of their regular supply of sugar at a specified price. Under such conditions we have known jobbers to sell them sugar for delivery over several months. If at any time you are placed in a similar position, and desire to take care of your customers in this manner, without incurring too great a risk, the Exchange offers exceptional opportunities for protection, as, of course, you would be able to buy sugar for delivery in any month you desire, even as far in advance as one year.

It is clear that if you sell at a specified price for delivery at a certain time, your only protection is your belief that you'll be able to buy sugar cheaply enough to make a profit.

CHART 4

BUYING SUGAR FUTURES

1. Based on the expectation of higher prices. 2. To establish costs, pre-determine selling prices and protect profits on advance sales. ---------------------------------------------------------------------------- Initial | | | Transactions | Subsequent Transactions |Sugar Cost | Result -------------+------+----------+--------+-------+------+------------+------- | |Condition | Price |Result |Price | Figure it | In | |of market | you | of | you | this way |each | | when you | would |selling| pay | |case | |buy actual| obtain | your | for | |the | | sugar |for your|futures|actual| |same | | |futures | |sugar | | -------------+------+----------+--------+-------+------+------------+------- | | | | | |Price paid |Your | | | | | |for actual |sugar | | | |A | |sugar less |cost is You buy Sugar|When |If it has | |profit | |hedging |6.00 Futures at |you |advanced | |of | |profit |as pre- 6.00 to cover|buy |to 8.00 | 8.00 |2.00 | 8.00 |8-2=6 |deter- future |actual| | | | | |mined requirements;|sugar,| | |A | |Price paid | fix your |you |If it has | |loss | |for actual | price and |sell |declined | |of | |sugar plus | take orders |your |to | | | |hedging loss| on the basis |fu- |4.00 | 4.00 |2.00 | 4.00 |4+2=6 | of 6¢ sugar |tures | | | | | | | |If it is | |No | | | | |still at | |profit,| | | | |6.00 | 6.00 |no loss| 6.00 | 6.00 | -------------+------+----------+--------+-------+------+------------+-------

It is equally clear that if a manufacturer names a price and takes advance orders without pre-determining his sugar cost, his profit is a matter of guesswork. He is not going to know the cost of his manufactured product until he buys his sugar.

Assume that you have contracted to deliver sugar to a manufacturer or to any customer at a definite date and a specified price, without buying sugar to cover your requirements. If the price of sugar is favorable when you deliver it, you are fortunate and net a profit. But sugar may have advanced to a point where you are forced to pay such a price that your profit is lower than it should be. In fact there may not be any profit at all.

By conservative, wise use of the Sugar Exchange, most of this risk and uncertainty can be eliminated and both you and your customer can go ahead with your plans with your prices determined through a known sugar cost.

Suppose that in March or April, for example, the market appears strong and you find that some of your manufacturing customers are anxious to be assured of an adequate supply of sugar at a definite price. In such a case, if these advance orders called for a sufficient volume, and provided Exchange prices were favorable, you could take care of your trade's future requirements at a fixed price, without yourself taking a speculative position. We also believe that buyers making these arrangements with any of their trade would be justified in requesting the same proportionate marginal protection which it is necessary for jobbers themselves to give the seller on the Exchange. There will no doubt be many occasions when it would be worth while to solicit orders on this basis.

With your own sugar cost fixed by the use of the Exchange, you could take proper care of these buyers without worrying about subsequent fluctuations of the market, as you would know that your sugar cost would be about the price paid for your futures which, let us say, is 6.00. (See Chart 4.)

The market may advance so that by September, sugar is selling at 8.00. (You are now making deliveries to your trade as contracted). So you sell your futures at 8.00, go into the market and buy actual sugar for about the same figure, assuming, of course, that actual sugar has also advanced in relative proportion, which is likely. You pay 2.00 more for your actual sugar than you had figured but you have profited to the extent of 2.00 on the sale of futures. Profit and loss cancel each other and you have your sugar at 6.00. In other words, although the market is now 8.00 you are delivering 6.00 sugar to your customers, with a profit to yourself.

If the market declines after your original purchase at 6.00 so that in September sugar is selling at 4.00, you will sell your futures at 4.00, taking a loss of 2.00. But you will buy your actual sugar at about 4.00, also, which is 2.00 lower than you planned for. This gain of 2.00, while not to be termed an actual profit, may certainly be considered as canceling the loss on the sale of your futures, so that the cost of your sugar is really 6.00, your original price.

Another way of looking at this is to add the loss of 2.00 on the sale of your futures to 4.00, the cost of your actual sugar, making 6.00, the price upon which you had based your plans. If you had waited, you would have been able to get your sugar for 4.00, but by buying it ahead you have had the benefits of protection and the elimination of speculation and risk.

If the market remains steady after your June purchase, or after various fluctuations, returns to 6.00 by September, you sell your futures at 6.00 and buy spot sugar for about the same amount. Thus you have neither gained nor lost, but you have been protected in your sugar cost.

This is essentially a "playing-safe" operation. It results in profit insurance for the jobber who is willing to sacrifice the possibility of a speculative gain on advance sales to customers. It is thoroughly sound business policy and is neither expensive nor difficult to carry out.

Point of Delivery

Although Chicago is the delivery point in all Exchange contracts for refined sugar, it should be plainly understood that the Exchange is for anyone, anywhere. Whether located in Chicago, or in Rochester, Baltimore, New York or even San Francisco, a jobber can advantageously use the Exchange.

Deliveries of Refined Sugar Futures will be made only from the Exchange-licensed warehouses in Chicago. But, regardless of the prospective buyer's location, the delivery point is not of any material importance as it is an established fact that in operations on all exchanges the percentage of actual deliveries taken is exceptionally small. In fact, the examples used in this booklet are all based on the supposition that the buyer may find it more convenient _not_ to take delivery.

The usual procedure followed in sugar exchange operations is for the buyer to close out his exchange transaction prior to the period calling for delivery and purchasing actual sugar from the refiners, executing both transactions practically simultaneously.

Possibly the most important problem in connection with the organization of any commodity exchange is to reduce the possibility of corners, however remote, to the smallest possible degree.

In the case under discussion, the Chicago delivery point, by virtue of its accessibility for producers and consumers from all parts of the country, operates to that end.

Practically every refiner of cane sugars in the East and West, as well as the Southern refiners, carries large stocks in Chicago, and its favorable location in connection with the beet sugar industry also makes it highly desirable. Its situation in regard to the offerings of the Louisiana producers is also an additional protection and advantage of considerable importance.

The Exchange-licensed warehouses in Chicago are under the direct and constant supervision of Exchange representatives. Facilities are provided for testing and grading sugar so as to maintain Exchange quality standards.

When are Refiners' Prices and Exchange Quotations in line?

Since exchange quotations for refined sugar futures are net cash ex-exchange-licensed warehouse, Chicago, while refiners' quotations are f.o.b. refinery, less 2% for cash, it is obvious that there must be a difference between refiners' prices and exchange quotations.

It is equally obvious that the differential should approximate the freight rate between Chicago and the Seaboard, where the refiners are located, with allowance also for the cash discount. When the markets are in line such is the case. Conversely, when the differential is higher or lower, the markets are out of line.

Therefore, in order to tell whether the markets are out of line, or to what extent, it is necessary to determine on a differential to represent the normal difference between the two markets. There is no one figure, however, that will satisfy all conditions at all times, for the reason that there are various freight rates between the Seaboard and Chicago. It is inaccurate, for instance, to use 63¢ as the basis for the normal differential. The 63¢ rate is one rate--the all-rail freight rate from New York to Chicago.

Other important routes and rates are as follows:

Routing: Freight Rate:

New Orleans--Chicago (barge and rail) $0.50[1] New York--Chicago (rail and lake) .58 New Orleans--Chicago (all rail) .60 Philadelphia--Chicago (all rail) .61 New York--Chicago (all rail) .63 Savannah--Chicago (all rail) .63 Boston--Chicago (all rail) .63

[1] The cheapest routing (48¢) takes about two weeks' more time in transit than the New York all-rail routing (63¢). Interest charges on finances involved, etc., for this extra period will bring the expense of this routing to approximately 50¢.

After a study of the amounts of sugar shipped over these various routes we have arrived at an arbitrary figure to represent the normal differential between refiners' prices and exchange quotations. We believe that 57¢ will serve as a safe basis for calculation, but 58¢ or 59¢ might be equally--or more--accurate. In fact, anyone is entitled to an opinion. 57¢ is our opinion. It is not an average of freight rates, but is an arbitrary figure.