Commodity Challenge Chapter 10: Selling futures to hedge the value of grain held in storage

Hedging To buy or sell a futures contract on a commodity exchange as a temporary substitute for an intended later transaction in the cash market.

Short Hedge The sales of futures contracts against cash ownership, including inventory, expected production and/or forward purchases. The short hedge protects the hedger against falling prices.

Rolling a hedge Buying or selling futures to remove a hedge position in one contract, and simultaneously buying or selling futures to re-establish the hedge position in a deferred contract. Example: A hedger who sold May futures against corn held in storage might consider rolling the hedge forward in the spring, i.e. buy back the May futures position, and sell July futures.

Selling futures contracts against grain held in storage DateCashFuturesBasis OctoberHarvest 100,000 bu. of corn. Local bid is $4.85/ bu. Decide to hold grain in storage and sell July contracts. With Dec $5.25/bus, and July $5.55/bu., sell 20 contracts of July futures. Futures $5.65/bu. Harvest basis -0.40Z, or -0.70N (70 under July). Expect basis to reach -$0.20N by spring. Expected spring price: $5.35/bu., or $5.55 futures + (-$0.20 basis)

Short Hedge Formula for the expected selling price for a commodity when using a short hedge with futures. _____________________ + _____________ – ___ = ____________ futures price (when sold) + expected basis – fees = expected price

Different scenarios Let’s help this producer unwind the hedge in the spring (sell cash corn and buy back futures) under three different scenarios. Calculate the final price per bushel for corn. (Ignore brokerage costs.)

Scenario #1: Lower prices DateCashFuturesBasis May Sell corn to local elevator. Lift the hedge – buy back July corn $4.92/bu. Actual spring basis is 12 cents under the July contract. ResultReceive cash price of $4.80/bu. Futures profit of 63 cents/bu. ($5.55 – 4.92) Final price for corn of $5.43/bu.

How did we calculate $5.43/bu.?

Two ways to calculate the final result 1.Cash selling price at harvest, + or – the gain or loss in futures, or 2.Original futures selling price + actual harvest basis (see formula)

Two ways to calculate the final result 1.Cash selling price in spring, + or – the gain or loss in futures, or $4.80 May sale futures profit = $5.43

Two ways to calculate the final result 2.Original futures selling price + actual spring basis (see formula) $5.55 futures sale + (-0.12 basis) = $5.43 This is the way a hedger does it!

Bonus question When we “put on the hedge” at harvest, we expected a final price of $5.35/bu. Our actual price was $5.43/bu. Why did we do 8 cents better than expected?

Answer The actual basis in May (-$0.12/bu. or 12 cents under) was 8 cents higher than expected (20 cents under) Basis is not 100% predictable!

Scenario #2: Higher prices DateCashFuturesBasis May Sell corn to local elevator. Lift the hedge – buy back July corn $5.92/bu. Actual spring basis is 24 cents under the Dec contract. ResultReceive cash price of $5.68/bu. Futures loss of 37 cents/bu. ($5.55 – 5.92) Final price for corn of $5.31/bu.

How did we calculate $5.31/bu.?

Two ways to calculate the final result 1.Cash selling price in spring, + or – the gain or loss in futures, or $5.68 May sale futures loss = $5.31

Two ways to calculate the final result 2.Original futures selling price + actual spring basis (see formula) $5.55 futures sale + (-0.24 basis) = $5.31 This is the way a hedger does it!

Bonus question When we “put on the hedge” at harvest, we expected a final price of $5.35/bu. Our actual price was $5.31/bu. Why did we do 4 cents worse than expected? The actual basis in spring (-$0.24/bu. or 24 cents under) was 4 cents lower than expected (20 cents under)

Scenario #3: The basis is - $0.24/bu. in spring DateCashFuturesBasis May Sell corn to local elevator. Lift the hedge – buy back July corn futures Actual spring basis is 24 cents under the July contract. ResultReceive cash price of ? Futures gain or loss ? Final price for corn of $5.31/bu.

Two ways to calculate the final result 2.Original futures selling price + actual spring basis (see formula) $5.55 futures sale + (-0.24 basis) = $5.31 This is the way a hedger does it!

Selling futures contracts against grain held in storage 1.The storage hedge works best when carrying charges are large and basis wide at harvest 2.Sometimes called “selling the carry”

Summary 1.Farmers can use a short hedge, or storage hedge, after harvest, to establish a price for their grain 2.Risk is reduced to basis risk 3.The short hedge formula… _____________________ + _____________ + ___ = ____________ futures price (when sold) + expected basis - fees = expected price