FUTURES: SPECULATION Types of speculators: –Short term Scalpers Day traders –Long term

FUTURES: SPECULATION Types of speculators: –“Spreaders” Spread –Price difference between two different markets or commodities »Spreads across commodities: Steers vs. corn, soybeans vs. soyoil and soymeal »Spreads across time: Corn December vs. July futures

FUTURES: SPECULATION “ Spreaders” simultaneously buy and selling in two related markets in the expectation of making a profit when positions are offset

FUTURES: SPECULATION Example of spreading: –Suppose on April 15 th : KCBT HRW December wheat futures price is $4.07/bu CBOT SRW December wheat futures price is $4.04/bu –Suppose a person is bullish about the KCBT-CBOT spread (e.g., he believes spread will rise to $0.10/bu) –Trading strategy for bullish speculator on the spread: 1.Go “long” (i.e., buy) the spread now at $0.03/bu 2.“Offset” (i.e., sell back) the spread sometime before December (hopefully, for more than $0.03/bu) Spread KCBT-CBOT = $4.07/bu – $4.04/bu = $0.03/bu

FUTURES: SPREADING EXAMPLE Correct forecast scenario, prices rise KCBT CBOT Spread Apr. 15 $0.03/bu

FUTURES: SPREADING EXAMPLE Correct forecast scenario, prices rise KCBT CBOT Spread Apr. 15 $0.03/bu Sep. 20 Sell back $0.10/bu

FUTURES: SPREADING EXAMPLE Correct forecast scenario, prices rise KCBT CBOT Spread Apr. 15 $0.03/bu Sep. 20 Sell back $0.10/bu Gain (Loss) $0.50/bu ( – $0.43/bu) NET GAIN $0.07/bu (minus broker commissions)

FUTURES: SPREADING EXAMPLE Correct forecast scenario, prices fall KCBT CBOT Spread Apr. 15 $0.03/bu

FUTURES: SPREADING EXAMPLE Correct forecast scenario, prices fall KCBT CBOT Spread Apr. 15 $0.03/bu Sep. 20 Sell back $0.10/bu

FUTURES: SPREADING EXAMPLE Correct forecast scenario, prices fall KCBT CBOT Spread Apr. 15 $0.03/bu Sep. 20 Sell back $0.10/bu Gain (Loss) ( – $0.50/bu) $0.57/bu NET GAIN $0.07/bu (minus broker commissions)

Basis BASIS = Cash - Futures –Local Spot Price – Futures Price Cash = Basis + Futures –Provides a forecast of cash prices –Basis is more predictable than futures

BASIS: GENERALITIES Basis reflects factors that affect local cash price relative to futures price at delivery point –Local supply and demand factors Yield Quality Storage availability Processing capacity Rail car availability Consumption

FUTURES: DEFINITIONS

BASIS: GENERALITIES Spot and futures tend to move together. Futures price converges to spot price (at delivery location) as maturity gets closer Hence: –Basis converges to zero (at delivery location) as maturity gets closer

BASIS: GENERALITIES

For storable commodities at delivery location: Current Futures Price  Current Spot price + Storage Cost Hence: –Basis  - Storage Cost

BASIS: GENERALITIES Basis generally follows seasonal patterns –Grains typically widest at harvest then narrow until the next harvest –Livestock varies, but follows the tendencies Seasonal spot price Converging at expiration

FUTURES: DEFINITIONS There is a BASIS for each futures contract and for each location If futures contract not specified, basis implicitly calculated using “nearby” contract month

Hedging definition Holding equal and opposite positions in the cash and futures markets The substitution of a futures contract for a later cash-market transaction

HEDGING Manage risk –Risk: A chance of an unfavorable outcome Risk Management –Management is not avoidance No risk, no reward Too much risk and you may not be in business to receive the reward

Why Hedge? Two major types of risks –Production risk Yield, efficiency, death loss, fire, spoilage –Price risk For most commodity producers and handlers, price risk is greater than production risk

HEDGING Risk Management –Production Management practices Crop insurance –Price Alternative contractual arrangements Hedging with futures –Buying or selling futures contracts to protect from losses due to adverse movements in spot prices

FUTURES: HEDGING Hedgers: –Either “produce” or “consume” the commodity –Face “spot price risk” Risk of losses from unfavorable spot price movements –Buy or sell futures in an attempt to reduce their spot price risk

Short Hedgers Producers with a commodity to sell at some point in the future –Are hurt by a price decline Short hedgers 1Sell the futures contract initially 2Buy the futures contract (offset) when they sell the physical commodity

SHORT HEDGE: WHY DOES IT WORK?

Long Hedgers Processors or feeders that plan to buy a commodity in the future –Are hurt by a price increase Long hedgers 1Buy the futures initially 2Sell the futures contract (offset) when they buy the physical commodity

LONG HEDGE: WHY DOES IT WORK?

FUTURES: HEDGING Short (Selling) Hedge –Protects from FALL in spot price –“Locks in” a SELLING price Long (Buying) Hedge –Protects from RISE in spot price –“Locks in” a PURCHASING price

Preharvest short hedge example A farmer will have 50,000 bushels of corn to sell after harvest –The farmer is long the cash market Damaged by a price decline

Preharvest short hedge example To have an equal and opposite hedge the farmer would sell 10 corn futures contracts that expires near the expected marketing time. –The farmer would short the futures The futures position would benefit from a price decline

Preharvest short hedge example Step 1: Know cost of production Step 2: Convert futures price to local price using the basis For this farmer the historic basis for December corn is $0.25 under the board. Currently Dec corn trading at$2.50 Local basis-.25 Commission -.01 Expected hedge price$2.24

Preharvest short hedge example Step 3: Call broker and place order to sell 10 Dec Corn contracts at the market Step 4: Broker calls to confirm fill Step 5: Send margin money to broker

Preharvest short hedge example It is now November and the farmer harvests 50,000 bu of corn and delivers it to the local elevator. Prices could have gone up or down Basis could be wider or narrower than expected

Hedging example Higher Prices Dec Corn futures =$3.00 Basis as expected-$0.25 Cash corn$2.75 Futures position loss $ $0.51 Net price$2.24

Hedging example Lower Prices Dec Corn futures =$2.20 Basis as expected-$0.25 Cash corn$1.95 Futures position gain $ $0.29 Net price$2.24

Hedging example Basis Change Dec Corn futures =$2.20 Basis is wider-$0.30 Cash corn$1.90 Futures position gain $ $0.29 Net price$2.19 Expected $2.24 and received $2.19 Difference is due to basis change

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. Basis estimation is critical to successful hedging

Long Hedge Example An ethanol plant needs corn year around and wants to protect itself from higher corn prices in July. It is short the cash market. –Will be hurt by a corn price increase Will take a long futures position, buy July corn –Will benefit from higher July corn prices

Long Hedge Example Currently July corn trading at$2.70 Local basis-.25 Commission +.01 Expected hedge price$2.46 Call Broker and buy July corn at $2.70

Long Hedge Example It is now July and prices went up. Call broker and sell July corn to offset: Currently July corn trading at$2.90 Local basis-.25 Cash price$2.65 Futures position gain $ $0.19 Net price $2.46

Long Hedge Example It is now July and prices went down. Call broker and sell July corn to offset: Currently July corn trading at$2.30 Local basis-.25 Cash price$2.05 Futures position loss $ $0.41 Net price $2.46

SHORT HEDGE Example 1: MIDDLEMEN “Storage” Hedge: –It is March. You own a grain elevator and must decide whether to buy and store soybeans until July Current soybeans spot price = $5.75/bu Storage cost = $0.13/bu

SHORT HEDGE Example 1: MIDDLEMEN Soybean Contract Months: March May July August September November January Current August futures = $6.30/bu Expected July basis = $0.25/bu UNDER August Expected Local Spot Price Next July = $6.30/bu + ( – $0.25/bu) = $6.05/bu

SHORT HEDGE Example 1: MIDDLEMEN Storage is expected to be profitable BUT Risky because price of soybeans may fall Decision: Storage and short hedge Expected profits from storage = $6.05/bu – $5.75/bu – $0.13/bu = $0.17/bu

SHORT HEDGE Example 1: MIDDLEMEN SPOT FUTURES BASIS ACTIVITY ACTIVITY MAR $5.75 Sell $6.30 Expected -$0.25

SHORT HEDGE Example 1: MIDDLEMEN Scenario 1: Prices FALL SPOT FUTURES BASIS ACTIVITY ACTIVITY MAR $5.75 Sell $6.30 Expected -$0.25 JUL $4.25 Buy $4.50 Actual -$0.25

SHORT HEDGE Example 1: MIDDLEMEN Scenario 1: Prices FALL SPOT FUTURES BASIS ACTIVITY ACTIVITY MAR $5.75 Sell $6.30 Expected -$0.25 JUL $4.25 Buy $4.50 Actual -$0.25 Spot Price +Futures Gain (Loss) = Net Selling Price $ $1.80 = $6.05 as expected

SHORT HEDGE Example 1: MIDDLEMEN Scenario 2: Prices RISE SPOT FUTURES BASIS ACTIVITY ACTIVITY MAR $5.75 Sell $6.30 Expected -$0.25 JUL $7.50 Buy $7.75 Actual -$0.25

SHORT HEDGE Example 1: MIDDLEMEN Scenario 2: Prices RISE SPOT FUTURES BASIS ACTIVITY ACTIVITY MAR $5.75 Sell $6.30 Expected -$0.25 JUL $7.50 Buy $7.75 Actual -$0.25 Spot Price +Futures Gain (Loss) = Net Selling Price $ (-$1.45) = $6.05 as expected

The Storage Hedge Gain from a narrowing basis Futures increased less than cash Watch for historically wide basis to begin storage hedge in hope that the basis will narrow The futures position protects against falling prices during storage period

NOTE ON HEDGING!!! Short Hedge: –Net SELLING Price = Spot Price + Futures Gain (Loss) Long Hedge: –Net BUYING Price = Spot Price - Futures Gain (Loss)