Hedge overview H Futures provide additional marketing alternatives H Can transfer price risk H Can establish approximate price levels in advance of cash market transactions

HedgingHedging H What are the basics you need to know to be a effective hedger in futures? Volume cash commodity Current futures prices Relevant basis Current basis vs. history

AssignmentAssignment Find the current basis for a commodity at your local market outlet this week, and where you could get past basis data for that location in the last five years.

HedgingHedging H In long run, can futures hedge improve returns? Will it? H In short run, can it reduce risk, or improve returns? H What’s your objective?

HedgingHedging H What should be your criteria for success in hedging? Achieving approximate expected cash price = futures + expected basis Making the maximum profit?

HedgingHedging H Initiation of a position in the futures market that is intended as a temporary substitute for the sale or purchase of the actual commodity at a later date.

HedgingHedging H Use of futures markets to lock-in a purchase or selling price now, even though the physical purchase or sale won’t occur until later. H Usually bushel-bushel or pound- pound hedge, though optimum hedge may be slightly less for grain

Necessary conditions H Cash price must move in parallel 1 : 1 or in fixed ratio e.g. 1.5 : 1 1 : 1 or in fixed ratio e.g. 1.5 : 1 to futures price when futures are converted to cash positions H want to have gains in one market offset in the other market, so expected cash price will be achieved

Hedge ratio H Hedge 1 unit cash product in 1 unit futures if prices move 1:1 H Hedge appropriate ratio if cash prices move more or less than futures (if hams move more 1.2:1 than hogs, buy 20% more pounds in hog contracts to hedge hams)

PRICE TIME CASH FUTURES

Futures/Hedging Terminology Futures/Hedging Terminology H Nearby contract--the contract expiring soon after the cash market transaction H Spread--difference in prices in two contract months H Rollover--shifting futures position from one contract month to another contract month (Feb to April)

BasisBasis H Cash - Futures Price Difference Usually expressed as so much over or under futures [Cash P - Futures P = Basis] for a specific contract month; reflects location and product quality differences and time of delivery for a specific contract month; reflects location and product quality differences and time of delivery

BasisBasis H Cash - Futures Price Differences H Reflects local S & D versus delivery point S & D H Reflects transfer costs between local market and delivery or cash settlement points for futures H Changes when contract changes

BasisBasis H Reflects futures delivery costs/risks H Reflects storage costs sometimes -- in carrying charge markets H Reflects difference in current vs expected price over time prior to contract expiration (especially livestock with seasonal P swings)

BasisBasis H If basis is predictable when commodity will be bought or sold, can accurately translate futures you sell today into net cash price you expect. H Basis variation is usually a lot less than cash price variation, so hedging is less risky.

BasisBasis H Gross return to hedged storage = change in basis Today’s basis versus July futures minus June basis = payment for storage 30 under minus 10 under= 20 cents/bu to cover costs

Useful Hints H Critical in determining cash price expected w/r/t any futures price H Unusually wide basis -- hold cash H Unusually narrow basis -- sell cash H Compare with forward contract basis to determine whether it’s a better deal than hedging

Basis-how to get it H Need cash prices at your market outlet for several years or more H Need nearby futures prices for same time period from brokers, exchanges, etc. H Sometimes basis history from university extension can be adjusted to local conditions

Short Hedge (Selling Hedge) H Intends to sell cash (Physical) commodity in the future. H Initiates a short futures position as a temporary substitute for a later cash market sale. H Price risk = basis change vs. what’s expected.

Short Hedging Mechanics Cash Market Futures Market Transactions Transactions NowSELL LaterSELLBUY

Short Hedging Example: Want to lock in a price for Nov. delivery. Cash Market Futures Market Transactions Transactions May Not Short Dec. Corn Harvested Yet $2.80 (Basis -.20) Later Sell Corn locally Buy Dec. Corn $2.00 $2.20 $2.00 $2.20

Expected Hedge Payoff H Expected net price = Futures price plus basis (equals expected cash price) minus commission (if sale) plus commission (if purchase)

Actual Hedge Payoff Net price equals Cash price plus/minus futures gain/loss plus/minus futures gain/loss plus/minus commission plus/minus commission (determine whether each is going into or out of your pocket to get correct signs)

Which contract to use? H Typically, the contract closest to and ahead of cash market actions e.g. December contract for November feeder cattle sale H Cash and nearby futures will be most closely related, so basis is more predictable

Which contract to use H If nearby contract isn’t used, subject to much greater risk H Spread risk may benefit you if prices are temporarily out of line, and move favorably H Spread risk can be a killer-- e.g. hedging new crop(s) in old crop futures in short crop year

Which contract to use? H Exceptions-- when spread favors a different contract, or expected nearby contract is not trading enough volume H e.g. October-December difference unusually favorable for October H May temporarily hedge in other month, and shift later (involves spread and basis risk)

Short Hedge H Determine expected cash price H Futures price in appropriate contract plus/minus typical basis H If attractive expected price, take futures position to establish approximate selling price later in cash market

Short Hedging Example: Want to lock in a price for Nov. delivery. Cash Market Futures Market Transactions Transactions May Sell Dec. $80 (Basis=0) $80 (Basis=0) Nov Sell cattle Buy Dec. FC $75 $75 $75 $75

Hedge resullts H Expected cash price = $80 per 100 lbs.__________________________ H Sell cash cattle at $75 H Futures gain 5 H Commission -.02 Net sale price $79.98

Basis change H If basis narrows vs. expected H Good for shorts, bad for longs H If basis widens vs. expected H Bad for shorts, good for longs

Long Hedge Example Cash Market Futures Market Cash Market Futures MarketNowLater Cash Price Received: Futures Profit/Loss: Commission: Net Price:

Grain storage hedges H Establish storage returns using: deferred futures - basis (= expected cash price) -current cash price -storage costs (interest, shrink, handling, drying) - commission =net return

Storage hedge problem Calculate storage gain/loss Current May corn futures $2.86 October cash price $2.54 Expected basis -.15 [+ or -.03] Interest rate 10% annual rate Shrink 1%, other extra costs $.04 Commission $.01/bu.

Storage expected result H $2.86 H -.15 basis H -.01*2.71 shrink H - (.10*7/12*2.54) value of early pay H -.01 commission H -.04 handling cost H = 2.48 if hedged vs 2.54 today

Storage hedge actual result H Cash price $2.38 H plus futures gain.33 ( ) H minus commission.01 H minus other costs.04 H minus interest.15 H shrink.03 H = $2.48 October equivalent price

More complicated hedges H Fed cattle margin hedge, using fed cattle, feeder cattle, corn futures H Soybean crush margin hedge, using soybean, oil, meal futures.

Hedging considerations Are there disadvantages to hedging? margin calls and costs lost opportunities quantity risk basis risk broker commission,

Tax Considerations H Hedge individuals - ordinary income, no limits corporations - no limits H Speculation capital gain or loss $3,000 loss limit per year for individuals

Hedging examples H What futures position should I take if I want to hedge: H to establish a selling price for corn at harvest? H to protect against a price decline on corn in storage? H three years’ crops at today’s high prices

Hedging examples H to fix a margin for a cattle feeding operation when use own corn? H to establish a merchandising/storage margin for corn your elevator is buying today? H to establish a purchase price for soybean meal for six months in the future?

Hedging examples H elevator manager establish a purchase price on a price later corn contract purchase she just sold to ADM H to hedge hams you will buy for Christmas sales (fixed, formula P?) H to hedge Pioneer’s seed corn purchases from contract growers

Hedging examples H To set up a forward purchase contract with farmers at the local grain elevator H To set up a forward contract with hog suppliers to IBP H To set up a basis contract for farmers at the local grain elevator

Which contract to use? H Exceptions-- when spread favors a different contract, or nearby is not trading yet H e.g. March-July unusually narrow or wide H May temporarily hedge in another, and shift later (somewhat speculative)

New innovations H Contract changes--examples: H Lean hog, boneless beef, stocker cattle, weather, milk, butter, cheese, nonfat dry milk, whey H Some mini-contracts H Electricity, crude oil, H Delivery changes--soybeans, corn

New innovations H Cash settlement--volume wtd. 3 area average of two days USDA price reports -- 9th and 10th business days of month H Closes after 10 days in delivery month

New innovations H New delivery points--CBOT grains and soybeans --not in Chicago!! H New contracts--boneless beef, butter, cheese, nonfat dry milk, broilers

New innovations H Electronic trading H nights--CME and CBOT H many European exchanges with electronic trading taking over H Will open outcry system continue?

Hedge overview H Offers more marketing alternatives H Can transfer risk H Can improve or reduce returns H Impacts many forward contracts, since that is how contractor often shifts risk

Hedge overview H Results often considered “bad” by farmers H % of producers use futures, and then only sometimes H WHY??

Factors Influencing Forward Positions H Price expectations versus current prices available--likelihood of this position being advantageous H Ability to withstand possible adversities associated with taking or not taking a market position H What are the factors which you should consider?

Forward position influences H Diversification;offsetting risks? H Crop yield or revenue insurance H Quantity risk H Costs of cash flow shortage H How well objectives would be met H Evaluate tradeoffs; determine NET benefit perceived