© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 5 Fundamentals of Futures Hedging

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Futures Contracts Introduction Futures contracts have long been the standard for price risk management. Futures contracts have long been the standard for price risk management. In a simple contract, two people decide to trade something. One agrees to sell and one to buy at a specific price and time. In a simple contract, two people decide to trade something. One agrees to sell and one to buy at a specific price and time. Futures contracts are simple contracts. Futures contracts are simple contracts. With the understanding of a few terms and concepts, anyone can hedge or speculate with futures contracts. With the understanding of a few terms and concepts, anyone can hedge or speculate with futures contracts.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Futures Contracts A futures contract is nothing more than a forward contract traded on an organized exchange. A futures contract is nothing more than a forward contract traded on an organized exchange. It is open to all buyers and sellers. It is open to all buyers and sellers. It is an agreement between the buyer to accept delivery of a product from the seller with standardized terms. It is an agreement between the buyer to accept delivery of a product from the seller with standardized terms. The buyer and seller are immediately able to retrade the contract after the contract is completed. The buyer and seller are immediately able to retrade the contract after the contract is completed.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Standardization and Leverage Figure 5-1 shows the major agricultural commodities and the specifications on each contract. Figure 5-1 shows the major agricultural commodities and the specifications on each contract. Standardization gives futures contracts the ability to be retraded easily. Standardization gives futures contracts the ability to be retraded easily. The market is also very liquid allowing buyers and sellers easy entry and exit of the market. The market is also very liquid allowing buyers and sellers easy entry and exit of the market.(continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Standardization and Leverage (continued) Leverage Leverage –The full value of a contract generally does not have to be advanced to get control of the contract. –Only a portion of the value has to be posted to gain control; this portion is called the margin. –The margin is normally roughly 10 percent of the contract value and is set by each exchange.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Margin Calls If the contract’s value changes, the buyer is responsible for the additional losses—known as the margin call. If the contract’s value changes, the buyer is responsible for the additional losses—known as the margin call. The margin will have a prespecified value called the maintenance margin. This value is approximately 75 percent of the value of the initial margin. The margin will have a prespecified value called the maintenance margin. This value is approximately 75 percent of the value of the initial margin. The difference between the maintenance margin and margin level is the amount of money that is allowed to be lost before additional money is requested. The difference between the maintenance margin and margin level is the amount of money that is allowed to be lost before additional money is requested. The trader can also gain paper profits as shown in Table 5-2. The trader can also gain paper profits as shown in Table 5-2.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Concept of Counterbalance Hedging is the process of counterbalance—one action is offset by another. Hedging is the process of counterbalance—one action is offset by another. Hedging is an attempt to overcome some aspect of risk with another action; therefore the two actions must be opposite. Hedging is an attempt to overcome some aspect of risk with another action; therefore the two actions must be opposite. Hedging entails having opposite cash and futures positions. Hedging entails having opposite cash and futures positions. The hope is that the losses exactly cover the gains. The hope is that the losses exactly cover the gains. Table 5-3 shows the effect of counterbalance in a hedge. Table 5-3 shows the effect of counterbalance in a hedge.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation An initial sell position is called a short hedge—used to protect against declining spot (cash) market values. An initial sell position is called a short hedge—used to protect against declining spot (cash) market values. An initial buy position in the futures market is known as a long hedge—used to protect against increasing spot (cash) market values. An initial buy position in the futures market is known as a long hedge—used to protect against increasing spot (cash) market values. The example in Table 5-3 is a perfect short hedge. This type of hedge is widely used in agriculture. The example in Table 5-3 is a perfect short hedge. This type of hedge is widely used in agriculture. Table 5-4 shows a long hedge used by a food company. Table 5-4 shows a long hedge used by a food company.(continued) Two Types of Hedges

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Two Types of Hedges (continued) Short hedges are also known as bear hedges or sell hedges. Short hedges are also known as bear hedges or sell hedges. Long hedges are also known as bull hedges or buy hedges. Long hedges are also known as bull hedges or buy hedges.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Absolute Price Movements When the price of an item changes in the cash market, the price activity is called an absolute price movement. When the price of an item changes in the cash market, the price activity is called an absolute price movement. Figure 5-2 demonstrates the movements for the corn market. Figure 5-2 demonstrates the movements for the corn market. These movements are the source of price risk that producers face. These movements are the source of price risk that producers face.(continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Absolute Price Movements (continued) Historical price information can be used to calculate certain statistical values to help analyze the risk of the movements. Historical price information can be used to calculate certain statistical values to help analyze the risk of the movements. Futures contracts have their own absolute price movements. Futures contracts have their own absolute price movements. Figure 5-3 exhibits futures price movements for corn. Figure 5-3 exhibits futures price movements for corn.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Relative Price Movements Due to the need for counterbalance, cash and futures absolute price movements exist side by side. Due to the need for counterbalance, cash and futures absolute price movements exist side by side. The importance in hedging is how the two prices relate to each other. The importance in hedging is how the two prices relate to each other. Figure 5-4 shows relative price movements between cash and futures corn prices. Figure 5-4 shows relative price movements between cash and futures corn prices. The risk of relative price movements is known as basis risk. The risk of relative price movements is known as basis risk. Hedging removes the risk of absolute price movements and replaces it with basis risk. Hedging removes the risk of absolute price movements and replaces it with basis risk.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Basis Basis values exist for every cash market. Basis values exist for every cash market. Basis is the most important aspect of hedging to understand. Basis is the most important aspect of hedging to understand. Basis is defined as the difference between the futures price and the cash price. Basis is defined as the difference between the futures price and the cash price. Markets that have futures prices that are higher than cash prices are in contango—positive basis. Markets that have futures prices that are higher than cash prices are in contango—positive basis. Markets that have the cash or spot price higher than futures prices are in backwardation—negative basis. Markets that have the cash or spot price higher than futures prices are in backwardation—negative basis.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Perfect Hedges A perfect hedge eliminates the cash market risk and has no basis risk effects. A perfect hedge eliminates the cash market risk and has no basis risk effects. Tables 5-5 and 5-6 reveal the effects of a perfect hedge with a cash price decrease and increase respectively. Tables 5-5 and 5-6 reveal the effects of a perfect hedge with a cash price decrease and increase respectively. If the beginning basis remains the same as the ending basis, then it was a perfect hedge. If the beginning basis remains the same as the ending basis, then it was a perfect hedge. Hedgers really want imperfect hedges; in the examples given, the hedger would have been just as well off without hedging. Hedgers really want imperfect hedges; in the examples given, the hedger would have been just as well off without hedging.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Imperfect Hedges Imperfect hedges have a beginning basis and an ending basis that are different. Imperfect hedges have a beginning basis and an ending basis that are different. Table 5-7 shows a basis change that results in a net gain for the hedger. Table 5-7 shows a basis change that results in a net gain for the hedger. Price direction is unimportant, only relative movements between the cash and futures markets— basis—matters. Price direction is unimportant, only relative movements between the cash and futures markets— basis—matters.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Imperfect Hedges (continued) Table 5-8 shows a basis that has deteriorated, resulting in a net loss for the hedger. Table 5-8 shows a basis that has deteriorated, resulting in a net loss for the hedger. Table 5-9 shows the results of a feed company in a long hedge with an improving basis on their hedge. Table 5-9 shows the results of a feed company in a long hedge with an improving basis on their hedge. Short hedgers want the basis to narrow, and long hedgers want the basis to widen. Short hedgers want the basis to narrow, and long hedgers want the basis to widen.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Net Hedged Prices The net hedged selling price (NHSP) is equal to the final cash selling price (FCSP) plus the net futures gain/loss (NF). The net hedged selling price (NHSP) is equal to the final cash selling price (FCSP) plus the net futures gain/loss (NF). The NHSP for Figure 5-8 would be $1.98 per bushel. The NHSP for Figure 5-8 would be $1.98 per bushel. The net hedged buying price (NHBP) is equal to the final cash buying price (FCBP) less the net futures gain/loss (NF). The net hedged buying price (NHBP) is equal to the final cash buying price (FCBP) less the net futures gain/loss (NF). Using this formula in Table 5-9 results in a NHBP of $1.98 per bushel. Using this formula in Table 5-9 results in a NHBP of $1.98 per bushel.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Futures in the Grain Market and Basis Factors Traders in grain range from a wheat farm hedger to complex trading giants like Cargill. Traders in grain range from a wheat farm hedger to complex trading giants like Cargill. Higher value uses for these major crops necessitate a higher understanding of price risk management. Higher value uses for these major crops necessitate a higher understanding of price risk management. A factor that influences basis is the seasonality of crops. A factor that influences basis is the seasonality of crops. Seasonal movements create changes in prices and thus changes in basis. Seasonal movements create changes in prices and thus changes in basis.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Cost of Carry Model The cost of carry is the term used to reflect not only the physical cost of storage but financial costs as well. The cost of carry is the term used to reflect not only the physical cost of storage but financial costs as well. The model is given as the price in next time period equals the price in time period t plus the cost of carry from t to the next time period t+1. The model is given as the price in next time period equals the price in time period t plus the cost of carry from t to the next time period t+1. See Figure 5-6. See Figure 5-6.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Basis COC, COT, and Grain Basis Model Basis and the Cost of Carry. Basis and the Cost of Carry. Basis and the Cost of Transportation. Basis and the Cost of Transportation. See Figure 5-7. See Figure 5-7. The basis for grain crops and oilseed is the basis at time t is equal to the futures price at time t+n less the cash price at time t. The basis for grain crops and oilseed is the basis at time t is equal to the futures price at time t+n less the cash price at time t. Estimates of basis value are very important to hedgers. Estimates of basis value are very important to hedgers.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Production Hedge Production hedges need futures positions that are short initially so that a price decrease will yield a gain in the futures position. Production hedges need futures positions that are short initially so that a price decrease will yield a gain in the futures position. Regardless of the product or time, production price risk will always be short hedges. Regardless of the product or time, production price risk will always be short hedges. Wheat producer example, Table Wheat producer example, Table –This example has the farmer under-hedged by 2,000 bushels. If there had been a price increase, then the farmer would have gained in the cash market and had a loss in the futures market, as shown in Table If there had been a price increase, then the farmer would have gained in the cash market and had a loss in the futures market, as shown in Table 5-11.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation The Decision to Over- or Under-Hedge A hedger should under-hedge if he believes there is a strong probability of cash prices moving in his favor rather than against him. He should over-hedge if the chance that cash prices will move against him is greater than the chance that prices will move in his favor. A hedger should under-hedge if he believes there is a strong probability of cash prices moving in his favor rather than against him. He should over-hedge if the chance that cash prices will move against him is greater than the chance that prices will move in his favor.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Storage Hedge Grain and oilseed crops can be stored for long periods of time and often are being stored by grain elevators. Grain and oilseed crops can be stored for long periods of time and often are being stored by grain elevators. Grain elevators run the risk of declining prices after purchase of the grain or seed. Grain elevators run the risk of declining prices after purchase of the grain or seed. Storage hedges are short hedges. Storage hedges are short hedges. Table 5-12 summarizes a grain merchant using a storage hedge. Table 5-12 summarizes a grain merchant using a storage hedge.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Forward Pricing Hedging Grain merchants, food processors, and feed processors have the opportunity to forward price grain and oilseeds. Grain merchants, food processors, and feed processors have the opportunity to forward price grain and oilseeds. This type of processor must be a long hedger. This type of processor must be a long hedger. Table 5-13 illustrates the hedge by a cereal manufacturer. Table 5-13 illustrates the hedge by a cereal manufacturer.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Basis Traders and Basis Contracts Once a hedge is properly placed, all that really matters is the movement in basis. Once a hedge is properly placed, all that really matters is the movement in basis. Grain traders will make offers at “under” or “off,” meaning the cash price is below the futures price. If they offer “on” or “over,” then they are offering above the futures price. Grain traders will make offers at “under” or “off,” meaning the cash price is below the futures price. If they offer “on” or “over,” then they are offering above the futures price. Table 5-14 illustrates a basis trade with a grain merchant. Table 5-14 illustrates a basis trade with a grain merchant.(continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Basis Traders and Basis Contracts (continued) A basis contract must have A basis contract must have –the futures contract. –a negotiated differential for the cash commodity relative to the futures price. –an ending point. –knowledge of when the title passes and how storage costs are handled.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Call Contracts A call provision added to a basis contract specifies that the contract holder must call the broker of the contract provider to stipulate the day the basis contract will be exercised. Call contracts allow certain hedgers to fix both sides of a trade. A call provision added to a basis contract specifies that the contract holder must call the broker of the contract provider to stipulate the day the basis contract will be exercised. Call contracts allow certain hedgers to fix both sides of a trade. An example of this is illustrated in Tables 5-15 and An example of this is illustrated in Tables 5-15 and In a seller’s call, the call responsibility lies with the producer. In a seller’s call, the call responsibility lies with the producer. In a buyer’s call, the call responsibility lies with the processor. In a buyer’s call, the call responsibility lies with the processor.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Crush Hedges Soybeans go through a crush process that separates the raw beans into meal and oil. Soybeans go through a crush process that separates the raw beans into meal and oil. Crush yields are reported on a regular basis. The difference between the value of the meal and oil and the price of the soybeans is called the crush margin. Crush yields are reported on a regular basis. The difference between the value of the meal and oil and the price of the soybeans is called the crush margin. A processor will enter into a type of hedge called putting on crush when the crush margin is greater than the cost of crushing. A processor will enter into a type of hedge called putting on crush when the crush margin is greater than the cost of crushing. The reverse crush hedge is used when the margin is less than the cost. The reverse crush hedge is used when the margin is less than the cost. See Tables 5-17 and See Tables 5-17 and 5-18.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Using Futures in the Livestock Industry Livestock has a rich history in the futures industry. Livestock has a rich history in the futures industry. Live animals cannot be stored for more than a few days before the growth and aging process changes their form. Live animals cannot be stored for more than a few days before the growth and aging process changes their form. Live animal futures have a basis that does not follow the cost of carry model for price differences. Live animal futures have a basis that does not follow the cost of carry model for price differences. Expectations of future supply and demand are the basis components of live animal futures. Expectations of future supply and demand are the basis components of live animal futures. Traders resort to empirical data to get trends and patterns. See Figure 5-8. Traders resort to empirical data to get trends and patterns. See Figure 5-8.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Production Hedges Live animals go through a growing process that subjects them to the risk of price decline. Live animals go through a growing process that subjects them to the risk of price decline. Only slaughter-ready animals can be hedged in the hog market. Feeder and live animals can be hedged in the cattle market. Only slaughter-ready animals can be hedged in the hog market. Feeder and live animals can be hedged in the cattle market. See Table 5-19, Hog Production Hedge See Table 5-19, Hog Production Hedge See Table 5-20, Cow-Calf Hedge See Table 5-20, Cow-Calf Hedge –Cross hedge: a hedge whereby the cash and futures specifications do not match exactly (continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Production Hedges (continued) See Table 5-21, Feedlot Hedge See Table 5-21, Feedlot Hedge –Total hedging: the process of a manufacturer that hedges all available outputs and inputs See Table 5-22, Dairy Processor Hedge See Table 5-22, Dairy Processor Hedge –Margin-based hedging: fixing the profit margin in advance by hedging

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Using Nonagricultural Futures in Agriculture Agribusinesses use large amounts of credit and therefore have credit risks pertaining to changes in interest rates. Agribusinesses use large amounts of credit and therefore have credit risks pertaining to changes in interest rates. Also agribusinesses that deal overseas have foreign exchange risks. Also agribusinesses that deal overseas have foreign exchange risks. Interest Rate Risk Interest Rate Risk –Several contracts exist on interest rates (see Figure 5-9). These contracts can be used to mitigate certain risks with interest rates via cross hedging. These contracts can be used to mitigate certain risks with interest rates via cross hedging. –See Table (continued) (continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Using Nonagricultural Futures in Agriculture (continued) Foreign Currency Risk Foreign Currency Risk –The dollar changes value in relation to other currencies on a continuous basis. –The exchange rates reflect the price of one unit of currency necessary to buy one unit of another currency. Table 5-24 presents an example of a U.S. cotton merchant dealing with a Mexican mill. Table 5-24 presents an example of a U.S. cotton merchant dealing with a Mexican mill. If the dealer forward sells cotton for delivery in two weeks, he covers his risk. If the dealer forward sells cotton for delivery in two weeks, he covers his risk. Proper hedging can counterbalance the currency risk. Proper hedging can counterbalance the currency risk.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Synopsis Futures contracts allow agricultural businesses and producers to manage the risk of price change. Futures contracts allow agricultural businesses and producers to manage the risk of price change. Contracts are simple to use to protect against increasing or decreasing prices. Contracts are simple to use to protect against increasing or decreasing prices. The down side is that if the price moves in favor of the hedger, then the hedge will take the gain away. The down side is that if the price moves in favor of the hedger, then the hedge will take the gain away. To compensate, futures hedgers use basis trades and speculate on when is the best time to place a hedge, called selective hedging. To compensate, futures hedgers use basis trades and speculate on when is the best time to place a hedge, called selective hedging. It is critical to understand the fundamentals of future hedging as it is 90 percent of all price risk management. It is critical to understand the fundamentals of future hedging as it is 90 percent of all price risk management.