ECON 337: Agricultural Marketing Chad Hart Associate Professor Lee Schulz Assistant Professor

Market Participants  Hedgers are willing to make or take physical delivery because they are producers or users of the commodity  Use futures to protect against a price movement  Cash and futures prices are highly correlated  Hold counterbalancing positions in the two markets to manage the risk of price movement

Hedgers  Farmers, livestock producers  Merchandisers, elevators  Food processors, feed manufacturers  Exporters  Importers What happens if futures market is restricted to only hedgers?

Market Participants  Speculators have no use for the physical commodity  They buy or sell in an attempt to profit from price movements  Add liquidity to the market  May be part of the general public, professional traders or investment managers  Short-term – “day traders”  Long-term – buy or sell and hold

Market Participants  Brokers exercise trade for traders and are paid a flat fee called a commission  Futures are a “zero sum game”  Losers pay winners  Brokers always get paid commission

Hedging  Holding equal and opposite positions in the cash and futures markets  The substitution of a futures contract for a later cash-market transaction  Who can hedge?  Farmers, merchandisers, elevators, processors, exporter/importers

Cash vs. Futures Prices Iowa Corn in 2013

Short Hedgers  Producers with a commodity to sell at some point in the future  Are hurt by a price decline  Sell the futures contract initially  Buy the futures contract (offset) when they sell the physical commodity

Short Hedge Example  A soybean producer will have 25,000 bushels to sell in November  The short hedge is to protect the producer from falling prices between now and November  Since the farmer is producing the soybeans, they are considered long in soybeans

Short Hedge Example  To create an equal and opposite position, the producer would sell 5 November soybean futures contracts  Each contract is for 5,000 bushels  The farmer would short the futures, opposite their long from production  As prices increase (decline), the futures position loses (gains) value

Short Hedge Expected Price  Expected price = Futures prices when I place the hedge + Expected basis at delivery – Broker commission

Short Hedge Example  As of Jan. 21, ($ per bushel) Nov soybean futures$11.09 Historical basis for Nov.$-0.30 Rough commission on trade$-0.01 Expected price$10.78  Come November, the producer is ready to sell soybeans  Prices could be higher or lower  Basis could be narrower or wider than the historical average

Prices Went Up, Hist. Basis  In November, buy back futures at $12.00 per bushel ($ per bushel) Nov soybean futures$12.00 Actual basis for Nov.$-0.30 Local cash price$11.70 Net value from futures$-0.92 ($ $ $0.01) Net price$10.78

Prices Went Down, Hist. Basis  In November, buy back futures at $10.00 per bushel ($ per bushel) Nov soybean futures$10.00 Actual basis for Nov.$-0.30 Local cash price$ 9.70 Net value from futures$ 1.08 ($ $ $0.01) Net price$10.78

Short Hedge Graph Hedging Nov $11.09

Prices Went Down, Basis Change  In November, buy back futures at $10.00 per bushel ($ per bushel) Nov soybean futures$10.00 Actual basis for Nov.$-0.10 Local cash price$ 9.90 Net value from futures$ 1.08 ($ $ $0.01) Net price$10.98  Basis narrowed, net price improved

Long Hedgers  Processors or feeders that plan to buy a commodity in the future  Are hurt by a price increase  Buy the futures initially  Sell the futures contract (offset) when they buy the physical commodity

Long Hedge Example  An ethanol plant will buy 50,000 bushels of corn in December  The long hedge is to protect the ethanol plant from rising corn prices between now and December  Since the plant is using the corn, they are considered short in corn

Long Hedge Example  To create an equal and opposite position, the plant manager would buy 10 December corn futures contracts  Each contract is for 5,000 bushels  The plant manager would long the futures, opposite their short from usage  As prices increase (decline), the futures position gains (loses) value

Long Hedge Expected Price  Expected price = Futures prices when I place the hedge + Expected basis at delivery + Broker commission

Long Hedge Example  As of Jan. 21, ($ per bushel) Dec corn futures$ 4.47 Historical basis for Dec.$ Rough commission on trade$+0.01 Expected local net price$ 4.23  Come December, the plant manager is ready to buy corn to process into ethanol  Prices could be higher or lower  Basis could be narrower or wider than the historical average

Prices Went Up, Hist. Basis  In December, sell back futures at $5.00 per bushel ($ per bushel) Dec corn futures$ 5.00 Actual basis for Dec.$-0.25 Local cash price$ 4.75 Less net value from futures$ ($ $ $0.01) Net cost of corn$ 4.23  Futures gained in value, reducing net cost of corn to the plant

Prices Went Down, Hist. Basis  In December, sell back futures at $3.00 per bushel ($ per bushel) Dec corn futures$ 3.00 Actual basis for Dec.$ Local cash price$ 2.75 Less net value from futures$ ($ $ $0.01) Net cost of corn$ 4.23  Futures lost value, increasing net cost of corn

Long Hedge Graph Hedging Dec $4.47

Prices Went Down, Basis Change  In December, sell back futures at $3.00 per bushel ($ per bushel) Dec corn futures$ 3.00 Actual basis for Dec.$ Local cash price$ 2.90 Less net value from futures$ ($ $ $0.01) Net cost of corn$ 4.38  Basis narrowed, net cost of corn increased

Hedging Results  In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis.  So basis estimation is critical to successful hedging.  Narrowing basis, good for short hedgers, bad for long hedgers  Widening basis, bad for short hedgers, good for long hedgers

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