Agricultural Marketing ECON 337: Agricultural Marketing Lee Schulz Associate Professor lschulz@iastate.edu 515-294-3356 Chad Hart Associate Professor chart@iastate.edu 515-294-9911 1

Rolling a hedge Definition To continue to hedge for additional months beyond the expiration of the original contract Done by offsetting original contract Simultaneously taking new position in a more distant month The forward price of the hedge is switched to a more distant maturity

Rolling a hedge When would you do this? Have storage facilities and flexible cash-flow See an opportunity to obtain additional returns from storage

Rolling a hedge: Example Producer is planning to sell corn in December On June 2nd, he hedges using Dec. futures Sell Dec. Futures = $2.85/bu Expected basis for Dec. = -$0.20/bu Expected spot price at time of maturity = $2.65/bu ($2.85 – $0.20)

Rolling a hedge: Example On Nov. 16th Dec. futures price = $2.38 Mar. futures price = $2.52 Dec.-Mar. spread =-$0.14 Expected basis for Mar. =-$0.15 Storage costs = $0.03/month

Rolling a hedge: Example Offset Dec. futures Buy back Dec. futures for $2.38 Producer rolls hedge to March Sell Mar. futures for $2.52 Stores grain from December to March Cost to store until March: $0.03 X 3mo = $0.09/bu

Rolling a hedge: Example Put it all together: Overall revenue: $2.66 + $0.47 - $0.38 = $2.75 June 2nd Nov 16th Mar 14th Net Cash Crop is growing -- Sold physical 2.75 2.75 - .09 = 2.66 Futures Dec Sold Dec 2.85 Bought Dec 2.38 2.85 – 2.38 = 0.47 Mar Sold Mar 2.52 Bought Mar 2.90 2.52 – 2.90 = -0.38

Rolling a hedge: Example Put it all together: Overall revenue: $2.66 + $0.47 - $0.38 = $2.75 June 2nd Nov 16th Mar 14th Net Cash -- Sold physical 2.75 2.75 - .09 = 2.66 Futures Dec Sold Dec 2.85 Bought Dec 2.38 2.85 – 2.38 = 0.47 Mar Sold Mar 2.52 Bought Mar 2.90 2.52 – 2.90 = -0.38

Rolling a hedge: Example Put it all together: Overall revenue: $2.66 + $0.47 - $0.38 = $2.75 June 2nd Nov 16th Mar 14th Net Cash -- Sold physical 2.75 2.75 - .09 = 2.66 Futures Dec Sold Dec 2.85 Bought Dec 2.38 2.85 – 2.38 = 0.47 Mar Sold Mar 2.52 Bought Mar 2.90 2.52 – 2.90 = -0.38

Rolling a hedge: Example Put it all together: Overall revenue: $2.66 + $0.47 - $0.38 = $2.75 June 2nd Nov 16th Mar 14th Net Cash -- Sold physical 2.75 2.75 - .09 = 2.66 Futures Dec Sold Dec 2.85 Bought Dec 2.38 2.85 – 2.38 = 0.47 Mar Sold Mar 2.52 Bought Mar 2.90 2.52 – 2.90 = -0.38

Rolling a hedge: Example Suppose he didn’t roll the hedge i.e., he offset his Dec. futures position and sold in the cash market in December (Like the examples we’ve had before today)

Rolling a hedge: Example Overall revenue: $0.47 + $2.18 = $2.65/bu June 2nd Dec 14th Net Cash -- Sold physical 2.18 Futures Dec Sold Dec 2.85 Bought Dec 2.38 2.85 – 2.38 = 0.47 Mar 2.65

Rolling a hedge: Example By rolling the hedge forward, made $2.75 - $2.65 = $0.10/bu more than he would have if he just closed out his position in December Net Price = Original Futures Price – Storage Costs + New Futures Price Difference + New Basis Risky decision because don’t know realized MAR basis at the time of rolling the hedge If contemplating rolling hedge in DEC, know all components of equation except B2, need to speculate on this value to decide if better off storing or not DEC/MAR spread is major factor in decision. If market offers enough premium, can probably risk basis fluctuation and roll the hedge

Rolling a hedge forward: Review Rolling a hedge forward is exchanging your current position for one in the more distant future Another way to bet on basis If basis narrows (or increases ) the short hedge (or example) makes money Rolling the hedge forward allows you to take advantage of basis changes when you have already taken a position

Calendar Spreads Can be done with futures or options Taking long and short positions in the same market for different months Looking to benefit from price changes between the months Figuring nearby prices move more quickly than deferred prices

Bull Spread Buy futures in the nearby month and sell futures in the deferred month Target when futures prices are rising Pays off when nearby futures prices rise faster than deferred futures prices

Bull Spread: Example On March 1, I’m feeling bullish about lean hog futures July 2019 futures @ $77.975/cwt. Dec. 2019 futures @ $64.525/cwt. For a bull spread, I buy 1 July futures and sell 1 Dec. futures on March 1

Bull Spread: Example On March 29, I want to get out of my bull spread July 2019 futures @ $92.200/cwt. Dec. 2019 futures @ $72.975/cwt. So I sell 1 July futures and buy 1 Dec. futures on March 29

Bull Spread: Example July Futures Dec. Futures Spread March 1 $77.975 $64.525 $13.450 March 29 $92.200 $72.975 $19.225 July Futures Dec. Futures March 1 -$77.975 $64.525 March 29 $92.200 -$72.975 $14.225 -$8.450 $5.775

Bear Spread Sell futures in the nearby month and buy futures in the deferred month Target when futures prices are falling Pays off when nearby futures prices fall faster than deferred futures prices

Bear Spread: Example On March 1, I’m feeling bearish about corn futures July 2019 futures @ $3.815/bu Dec. 2019 futures @ $3.9425/bu For a bear spread, I sell 1 July futures and buy 1 Dec. futures on March 1

Bear Spread: Example On March 29, I want to get out of my bear spread July 2019 futures @ $3.6625/bu Dec. 2019 futures @ $3.8475/bu So I buy 1 July futures and sell 1 Dec. futures on March 29

Bear Spread: Example July Futures Dec. Futures Spread March 1 $3.8150 $3.9425 $0.1275 March 29 $3.6625 $3.8475 $0.1850 July Futures Dec. Futures March 1 $3.8150 -$3.9425 March 29 -$3.6625 $3.8475 $0.1525 -$0.0950 $0.0575

Class web site: http://www2.econ.iastate.edu/faculty/hart/Classes/econ337/Spring2019/