Hedging With Futures Cooperative Extension – Ag and Natural Resources Slide Show Courtesy of: Cooperative Extension – Ag and Natural Resources Farm and Risk Management Team Last Update May 1, 2007

Why the Interest in Dairy Futures? Change in federal dairy policy: From 1950 to 1981, the dairy price support was based on parity, and market prices tended to closely match support prices. So market prices were stable and predictable. Since 1981, dairy price support levels have been determined by congress, and by 1990, support prices were below the cost of production for most dairy farms. So market prices are driven by market conditions and are volatile and unpredictable.

Seasonal Milk Price Variation Again, seasonality is emphasized. This long-term average indicates more than $1.20 difference between seasonal price troughs and peaks. Clearly, an $11.50 futures price quote in May means something a lot different than the same price quote in September.

What are Futures Markets and Futures Contracts? Organized auction markets “Commodity” traded is specified commodity or commodity price index at specified time in the future Buy a futures contract  Long  commitment to take delivery Sell a futures contract  Short  commitment to make delivery This begins basic description of how futures trading works. First slide is simple definitions. Stress that there is a legal commitment to take or make delivery – you can’t walk away from your position.

What are Futures Markets and Futures Contracts (2)? For cash settled futures contracts (most dairy contracts), commitment is to make up in cash any difference between the settlement price and the contract price If settlement price ends up higher than contract price, then shorts pay difference (sold low and bought high If settlement price ends up lower than contract price, then longs pay difference (bought high and sold low) Among dairy futures contracts, all but the butter contract are cash settled. Cash settlement involves a different commitment in a mechanical sense, but longs still lose/make money when prices rise/fall and shorts lose/make money when prices fall/rise. This simplified explanation can be useful in understanding long and short positions and consequences at settlement. The way to make money in trading any commodity is to buy low and sell high. The beauty of futures contracts is that you can reverse the normal order of the transactions; that is, you can sell before you buy

What are Futures Markets and Futures Contracts (3) ? Futures contracts can be fulfilled in two ways: Hold to maturity and take or make delivery (deliverable contracts) or cash settle against settlement price. Offset – buy a contract if short or sell a contract if long. This is also known as liquidating a contract or lifting a hedge. Stress that deliverable contracts are nearly always fulfilled by offsetting. If using futures to protect an input price, It is nearly always preferable acquire the commodity in the cash market. You can control quantity, quality, source of supply, timing of delivery, etc. For cash-settled contracts used for hedging purposes, there is no real benefit to offsetting if prices are moving favorably (e.g.. You’ve placed a short hedge and prices are falling). Even if prices are moving against you, remember that if you lift your hedge, you become a speculator in the cash market. So you need to be confident that prices will continue to move in the same direction before you liquidate. Illustrate with situation in 1999 when the BFP rose rapidly in the summer and then fell precipitously in the fall. Many dairy farmers lifted hedges placed in the spring only to find that the announced fall BFP was well below their futures contract price.

Who Trades Futures? Hedgers  Interest in trading futures is to protect cash market price objective Speculators  Interest in trading futures is to make a profit from trading futures Stress this important distinction. But also stress that speculation is not a pejorative term – speculators are essential to futures markets. They enlarge trading and provide liquidity, which helps hedgers make and lift hedges in a timely fashion.

How do you Trade Futures? Open a broker account Place an order with your broker Post performance bond (Margin) How do you select a broker? Note that there will be more on margin later. Margin is assurance that traders will not abandon position and leave brokers holding the bag

Hedging With Futures Take a futures market position that is equivalent to your cash market position at the time the futures contract expires (Dairy Farmer  sell milk in September  take short futures position in September contract) Locks in contract price*, BUT: May receive more or less than if unhedged Example: Feb 3: Expect to market 200,000# of milk in Sept. SELL 1 Sep futures contract @ $14.85 Sep 1: Sell milk at $14.00 Settle futures @ 12.85 $ .85 $12.85 *DOES NOT CONSIDER BASIS, BASIS RISK, OPPORTUNITY COST OF PERFORMANCE BOND (MARGIN) OR BROKER COMMISSIONS Generic example of a short hedge. Things to note:   This example ignores basis and broker commissions, which need to be included in determining a price objective (more later). Futures contracts are “lumpy.” You don’t produce milk in exact multiples of 200,000 pounds per month. So while you can achieve your price objective on the volume of milk you sell that is equivalent to the futures contract volume, any milk you sell in excess of the contract volume is unhedged. In a similar sense, if you sell futures contracts that exceed in volume your cash market sales, you are speculating on the excess. This may not be all bad, but you need to know that you have gone beyond hedging.

Hedging Examples (1) First of two specific hedging examples. Date/Action Feb. 2 Sell 1 Sep Class III @ $14.85. Expected basis is 1.20. Broker commission (round turn) is .05. Expected September farm milk price is $16.00 ($14.85 + $1.20 - $0.05) Case I: Price falls by September; No basis change Oct.1 - Class III price announcement is 14.00 Sell milk to plant @ 15.20 (Class III + 1.20 Basis) +/- Futures gain/loss + .85 (14.85 – 14.00) Commission - .05 = Net milk price 16.00 (Actual basis equal to expected basis) Case II: Price rises by September; Basis WEAKENS ($1.00 instead of expected $1.20) Oct. 1 - Class III price announcement is 15.00 Sell milk to plant @ 16.00 (Class III + 1.00 Basis) +/- Futures gain/loss - 15 (14.85 – 15.00) = Net milk price 15.80 (less than expected by the amount the basis weakened) First of two specific hedging examples. Dates and prices will change to conform with current situation. Illustrates construction of price objective from Class III futures price, basis, and broker commission. (Note that interest on margin is not included, but is a cost factor in hedging) Illustrates outcome differs from objective if basis is different that what is used to calculate price objective

Hedging Examples (2) Second specific hedging example. Date/Action Feb. 2 Sell 1 Sep Class III @ 14.85. Expected basis is 1.20. Broker commission (round turn) is .05. Expected September farm milk price is 16.00 Case I: Price falls by September; Basis STRENGTHENS Sept. 2 Class III price announcement is 13.00 Sell milk to plant @ 14.50 (Class III + 1.50 Basis) +/- Futures gain/loss + 1.85 (14.85 – 13.00) Commission - .05 = Net milk price 16.30 (more than expected by the amount basis strengthened) Case II: Price rises by September; No basis change Sept. 2 Class III price announcement is 16.00 Sell milk to plant @ 17.20 (Class III + 1.20 Basis) +/- Futures gain/loss - 1.15 (14.85 – 16.00) = Net milk price 16.00 (Actual basis = expected basis) Second specific hedging example.

Margin and Margin Calls Need to deposit MARGIN (performance bond) with broker to cover any paper losses when you sell futures contracts If price moves against your position (rises after you’ve sold), then you may need to deposit additional margin There are initial margin and maintenance margin requirements – maintenance margin is smaller Margin requirements are less for hedgers than for speculators Initial margin for hedges is about 3-5 percent of the contract value, depending on exchange and broker Specifics on margin requirements and margin calls.

Example of Long Hedge Date/Action Points to emphasize: May 1: Need 10,000 bushels of corn in December to restock commodity bin. Dec. corn contact on CBT is $3.50/bushel. Buy 2 Dec. futures @ 3.50. Usual local basis in December is (.15). Round-turn broker commission is $50/contract, or $0.01/bushel. Price objective is $3.50 – $0.15 - $0.01 = $3.34/bushel Case I: Corn futures price rice falls by December; Basis STRENGTHENS to zero ($0.15) Dec.1: CBT Dec. futures @3.40. Sell 2 contracts Net Corn Cost Buy corn form local elevator @ 3.40 ($3.40 minus 0.00 basis) +/- Futures gain/loss + 0.10 Commission - .01 = Net corn price 3.49 (price objective + amount basis strengthened) Case II: Corn futures price increases; No basis change Dec. 1: CBT Dec. futures @ 3.80. Sell 2 contracts Buy corn from local elevator @ 3.65 ($3.80 minus 0.15 basis) +/- Futures gain/loss - 0.30 Commission - .01 = Net corn price 3.34 (price objective) Points to emphasize: Basis in this case is the expected difference between the local elevator price and the futures price. Usually negative, as futures price is for Chicago delivery and includes cost of getting the brain to Chicago. Contracts are fulfilled by liquidation. The farmer does not want to take delivery in Chicago

Summary Futures markets: Organized auction markets for futures contracts with well-defined enforced rules of conduct. Futures contracts: Method of buying or selling a commodity “before the fact.” Hedging with futures contracts helps achieve a price objective by offsetting cash market losses with futures market gains. At the same time, hedging offsets cash market gains with futures market losses. “Locking in a price” means just that.