1. Studies in Agriculture
SAB – 103
Wednesday: 7.00 pm – 8.40 pm
Fall 2016
Instructor: Sankalp Sharma

2. Who am I?

3. A word on my teaching philosophy

4. About this class In class expectation Out of class expectation
Homework
Grading

5. No cellphones or laptops during the class !!
In-class Expectation
Key to learning: interaction
Review previous class’ notes before class (same file will be updated)
Attend all classes (cannot emphasize enough)
Ask questions…
But don’t be a troll!
No cellphones or laptops during the class !!

6. Out-of-class Expectation
No gains without practice.
Reading not enough, you must practice problems.
Form groups to practice.
Understand concept, memorization won’t help you.

7. Homework Frequently assigned. Usually only one question.
A random student will be asked to solve the HW on the board.

8. Grading Exams will be long and difficult.
Everything taught in class is fair game.
But grading will be easy.
40% midterm, 40% final, 20% HW, (bonus: 20% class interaction)

9. Questions?

10. The Road Map Ahead Understanding the nature of risk
What is risk management
Introduction to agricultural futures and forwards markets
Hedging Risk using Futures Markets
Introduction to Basis
Hedging with Basis
Discussion on Options

11. Understanding the nature of risk
What is risk?
What is uncertainty?
What is the difference between the two?
Types of risk
What is risk management?
- Types of risk management strategies.

12. What is risk management?
Strategies available to negate risk:
Good on-farm practices
Foward Contracts
Futures Contracts
Options
Hedging

13. Introduction to agricultural futures and forwards markets
What is a forward contract?
What is a futures contract?
What is the difference between the two?
Brief History of Futures market.
Mechanics
Futures prices
Futures market participation
Price risk

14. Hedging Risk Using Futures Markets
- Understanding the core concept - Margins - Local vs Futures Market - Hedging Local Market Price Risk - Offsetting price risk

15. Basis
Introduction
What do we mean by “basis”
Basis risk

16. Options Types of options Options positions Underlying assets Trading
Margins

17. But today let’s begin with…

18. - So what do we mean by “risk” in agriculture?

19. How is risk different from Uncertainty?

20. How is risk different from Uncertainty?
- You can assign a “probability”, there is prior information - Uncertainty, no prior information.

21. For our purposes, we will focus only on risk

22. Types of risk
- Poor on-farm practices - Limited market information - Yield risk through weather (drought, hail, excess rainfall) - Price risk (including input price risk)

23. What can be done to mitigate said “risk”?
“Mitigate” risk  Also defined as risk management. - Crop insurance - Market options (hedging, futures and forward market) - Government programs (such as the Conservation Reserve Program)

24. What causes people to manage risk?
- Because people are reluctant to take gambles - People care about “losses” more than they care about “winning”. - This behavior is known as “risk aversion”.

25. Introduction to Agricultural Futures Markets
Futures markets for commodities have been an important method for agricultural producers to hedge revenue risk, which can be very high.
Reasons to hedge:
They may have to face fluctuations in demand for their goods.
Risky events that can substantially affect their output.
Both of the above can affect output prices.
By allowing producers to “lock in” a price far in advance, futures markets can be used to remove the risk of fluctuating and unknown sale prices.

26. Basic Intuition: Futures markets
You are a commodity producer, which you will harvest in the future.
Long-story-short, you don’t want to lose money on it.
Find somebody with whom you can lock in “contract”.
Somebody with whom you can agree upon a price and quantity.

27. Brief history of agricultural futures markets
A futures market is a designated location used to assist agribusiness and farmers discover prospective prices for a commodity.
Agricultural markets appeared in mid 1800s.
Chicago Board of Trade – 1848
Chicago Mercantile Exchange (1874). Formally, known as the “Chicago Egg and Butter Board”.
First Corn futures contract written in 1851.

28. Why did markets come about?
Transportation distances increased, causing higher price volatility followed.
No central information source.
No standardized trading rules and methods.

29. Futures Markets
They are used to create and trade futures contracts between a buyer and seller of a commodity.
Futures contract are a statement signifying a promise between a seller and a buyer (two sides are required to trade).

30. What does a futures contract look like?
An obligation of the seller to deliver a commodity to a specified point- of-delivery at a future time.
An obligation of the buyer to pay a fixed price and pick up the commodity at the pre-specified point-of-delivery.
An expiration date (time of delivery).
Remember, futures contracts can be traded by a trader who has no position in the actual physical or cash commodity.

31. Examples: Commodities
Examples include: - Corn - Wheat - Cocoa - Live cattle - Feeder Cattle

32. Examples: General
Natural Gas
US Dollars
US Treasury Bond

33. Commodity futures markets – contract price info:
Chicago Board of Trade Minneapolis Grain Exchange (dark northern spring wheat) Kansas City Board of Trade (hard red winter wheat) Wall Street Journal - Market Data

34. Futures Contracts
Futures contract provide a very structured and standardized method for buyers and sellers to determine the terms of an exchange.
Each futures contract is exactly the same except for the price of exchange established by the buyer and seller.

35. Futures Contracts:
The following describe the standardizations that exist in each futures contract:
Measures:
bushels: Corn, Wheat, Soybeans, etc.
- 40,000 lbs live cattle.
- 50,000 lbs feeder cattle.

36. Futures Contracts
2) Quality: (say for Wheat) #2 Soft Red Winter (SRW) – CBOT #2 Hard Red Winter (HRW) – KCBT (Kansas City Board of Trade) #2 Hard Red Spring (HRS) – MGX (Minnesota Grain Exchange) 3) Delivery Location: For Example: Chicago and Burns Harbor, Indiana

37. Futures Contracts
4) Contract end date: - 15th day in the contract month. - Last day of the contract month  Live cattle - Last Thursday of the contract month  Feeder cattle 5) Pricing units - Cents per bushel (tick: 0.25 cents) - Cents per pound (tick: cents per pound)

38. Brief tangent to understand the difference between: Futures and Forward Contract
A futures contract is standardized.
A forward contract works exactly the same way, except it is not standardized.
It is a privately negotiated contract for a transaction that occurs in the future.

39. Sample Futures Contract: Commodity
Commodity: Crop Quantity: 5000 bushels Quality: #2 Yellow at contract price Delivery Location: Lockport-Seneca.

40. Sample Futures Contract: Cattle
Cattle: Live Quantity: 40,000 pounds Quality: 55% choice, 45% select, Yield grade 3 live steers. Delivery Location: - Approved slaughter plant corresponding to the stockyards, the cattle are at. - Approved slaughter plant within 200 miles of the feedlot from which the cattle originate.

41. But what is a Cash-Market?
- Prices offered or received via private negotiations between two parties, may be an elevator, grain merchandiser, etc.

42. A word on Prices
Prices in the futures markets, unlike cash (spot) markets, are limited as to the daily price movements.
Price movement limits attempt to prevent panicked trading and lessen the likelihood of a market crash
Price movements also include minimum price movements, referred to as a “tick”
- A tick is the smallest price change allowed by the exchange that may occur from one price to another
- For example, the minimum tick for Chicago corn is ¼ cent per bushel
- So, if corn last traded at $2.32 / bushel, the minimum price change that may be traded is 2.32 ¼ or 2.31 ¾

43. Purchasing a Futures Contract.
(Extremely important that you understand this!) Every contract requires two parties: A seller and a buyer

44. Who is a Seller?
A party that promises to deliver the designated quantity of a commodity.
Selling a contract is known as taking a short position. If the delivery date comes and the seller can’t deliver, they are short of the commodity.

45. Who is a Buyer?
A party that promises to take delivery of a specified quantity of commodity.
In exchange, they will pay a fixed price.
Buying a contract is known as taking a long position.
If delivery date comes and the buyer has a commodity they may not want (or too much of it), they are long in the commodity.

46. Offsetting Contracts
Typically, only few contracts have sellers and buyers who can actually deliver or take on a commodity.
Instead of delivering or taking on a commodity, a party can offset a short or long position by purchasing an opposite contract.
Short position  offset by buying a contract (long position).
Long position  offset by selling a contract (short position).

47. Offsetting Contracts
Offsetting releases an individual from the responsibility of either buying or selling a contract.
The only obligation that the individual is required to meet is any difference in the price of the two contracts.
For example, if one contract was bought at $5.00/bu and another was sold at $4.50/bu, the individual would be responsible to pay $0.50/bu (more on this later).

48. Homework 1
- Emperor Palpatine has 3 futures contract for the following commodities. His positions at the beginning of the contract were: 1) He sold 1 Corn Futures contract at $4.00/bu 2) He sold 1 SR Wheat Futures contract at $5.60/bu 3) He bought 1 HR Wheat Futures contract at $4.70/bu

49. Homework 1: Continued
- Tell me, how should he should offset his positions for each of the contracts above, given that the price now of corn and SR wheat futures contract is $5.00/bu and the price of HR Wheat futures is $5.50/bu?

50. Next class….

51. Mechanics of the Futures Market
Day to Day operations of the futures market:
Markets open between 9 a.m to 2 p.m
- open outcry
- electronic exchange.
2) Buying and selling occurs simultaneously. But each contract must have exactly one buyer and one seller.

52. Mechanics of the Futures Market
3) Two types of participants:
Exchange Members
Non-members: Most of these can participate through brokers.
4) Clearinghouse, overlooks positions and notifies buyers/sellers of obligations.
- Matches open positions (buyers with sellers).

53. Futures Contracts
Are a promise to pay/receive a fixed price at some future time.
But buying/selling a contract is not free.
Any time a transaction takes place, a margin requirement is necessary.
A margin requirement is an amount of money required as a payment in order to purchase or sell a contract.

54. Margin Typically, 5%-20% of a contract’s value.
Margin payments differ for speculators and those that actually have the commodity.
Along with assurance, provides coverage for potential losses if price fluctuations occur.
At daily market closing, all participants are marked-to-market (more on this later).
Margin Deposit=𝑀𝑎𝑟𝑔𝑖𝑛 𝑑𝑒𝑝𝑜𝑠𝑖𝑡×𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠× 𝑠𝑖𝑧𝑒 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡×𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡.

55. Example of Futures Market Participation
Consider the following scenario:
Current date: November 1.
July SRW wheat futures contract: $5.50/bu
You believe that the actual price in July will be $4.00/bu.

56. Understanding notation of a “futures price”?
What does a “July Futures price” mean in November?

57. So in the example: What position should you take?
- Should you sell a contract (short position) or buy one (long position)?

58. Enter the following positions, if:
Sell a contract (short position) if you expect the actual price to drop.
2) Buy a contract (long position) if you expect the price to rise.

59. Let’s understand this more formally.
A short position benefits when the price drops:
In the example, we had taken a short-position by selling a contract at $5.50/bu.
Obligation of the contract: This implies that at the delivery date, you have agreed to sell 5,000 bushels of a commodity at $5.50/bu.
- If in July the price of the commodity drops to $4.00/bu, you can buy that commodity at $4.00/bu.
- Sell it at $5.50/bu because that is the price at which you established the original futures contract.

60. If you took a long position
… You lost money! $1.50 for each contract.

61. Long Position (Buy Contract)
A long position benefits when the price rises:
In the example, suppose we had taken a long-position by selling a contract at $5.50/bu.
Obligation of the contract: This implies that at the delivery date, you have agreed to buy 5,000 bushels of a commodity at $5.50/bu.
- Suppose in July the price of the commodity went up to $6.00/bu, you can buy that commodity at $5.50/bu, through the contract.
- Sell it at $6.60/bu in the cash market to make a profit.

62. In the example given:
The best strategy is to take a short position because you believe that in seven months (July) the price/bu will be lower than it is today.
You are counting on the fact that you will be able to buy the commodity at $4.00/bu in July,
and then sell at $5.50/bu using your futures contract.

63. Question: Entering the market
Now that you have decided which contract will be most beneficial, you need to enter the futures market.
Suppose you want to sell ten (10) July contracts of Wheat.
Find the total funds needed to enter in the contract?
Commission 1% fee.
Margin deposit = 10%

64. Funds needed?
Margin Deposit=𝑀𝑎𝑟𝑔𝑖𝑛 𝑑𝑒𝑝𝑜𝑠𝑖𝑡×𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠× 𝑠𝑖𝑧𝑒 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡×𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡. 𝑀𝑎𝑟𝑔𝑖𝑛=10%×10×5000×$5.50=$27500 Commission fee = $0.01×50000=$500 Total funds: $500+$27500=$28,000

65. Actions at delivery time
After seven months, you are near the delivery time in July. At this point, you have two options:
1. Deliver on the contract:
Find someone who is selling wheat, purchase the wheat and deliver the wheat to the delivery location.
2. Take a long position on an offsetting contract by buying a July contract at the going price.

66. Actions for Delivery Time
Suppose that you don't actually have the wheat, so you are required to choose option 2.
In July, you discover that a better than usual harvest leads to excess supply of wheat and a drop in the price of wheat.
This is reflected in the price of the July futures contracts being offered in July at $4.00/bu.
This outcome is exactly what you had anticipated!

67. Calculating profit
-You purchase (take an offsetting long position) July contract at $4.00/bu and realize the following profit: $5.50−$4.00 ×10×5000=$75,000 But what is his actual profit?

68. Calculating profit
-You purchase (take an offsetting long position) July contract at $4.00/bu and realize the following profit: $5.50−$4.00 ×10×5000=$75,000 But what is his actual profit? Don’t forget the margin deposit. 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡=$75000−$

69. More examples
1) You believe that the price of corn will rise in September to $4.50/bu. It is currently July and the price of futures contracts is $4.25. Do you go short or long? What is your gain/loss? 2) The USDA comes out with a report that the soybean harvest in September will be well below expectations. Using an EDM calculation, you find that prices will change by 25%. One soybean contract is 5,000 bushels and the current price is $8.00/bu. Which position do you take? Profit/loss?

70. Homework 2
From a friend working in the U.S. Senate, you found out that there is a policy in the works that will place a tax on feedlot operators. This policy will go into effect in December. You know that this policy will change the price of fed cattle by 10$. A fed cattle contract is 40,000 pounds, and the price in June is $1.00/lb.
Decide which position you should take given that you know the information.
Decide how much you will prot per unit (bushel or pound).
Decide how many contracts you should buy/sell in order to profit by at least $20,000.

71. Solution

72. Midterm: Next Week – November 2nd 2016
No phones in the exam room
Exam length 1 hour.
6.30 pm to 7.30 pm.
Everything covered in class up till today.
Understanding the concepts is the key to getting a good score.

73. Market Risks - Price variability
Thus far we have looked at cases where the farmer/speculator has a sense of what happens to the prices.
Doing so on a regular basis (or even once) can be extremely difficult.
Because prices are established by thousands of people acting to maximize their own welfare.
Thus, prices are subject to many unexpected fluctuations.

74. So as an example:
Suppose you sold a contract at $4.00/bu, instead of prices dropping they increased to $6.50. Your loss: ($ $6.50) × 10 × 5000 = - $50,000 - Small, unpredictable price movements can make a substantial difference in whether you lose/win and how much you lose/win.

75. Can you be Placed out of the market?
Short Answer: Yes!!
But how does that happen?
When entering the futures market, you are required to pay a margin requirement.
Usually 5% - 20% of the futures contract value.
- It provides assurance that there exists a line of credit that can be used to finance changes in the value of the futures contract.

76. Placed out of market Here’s the key point:
The margin account is recalculated at the end of each trading day to accurately reflect price changes.
What if price changes?
Each day, very high probability that the closing price for a particular futures contract will be different than the opening price.
How do the losses and profits get paid?

77. Marking-to-market
Process of determining the financial positions of all market participants after the market closes.
All remaining futures contracts are recalculated to reflect the closing price.
Remember you had put up the margin amount.
That’s what gets recalculated at the end of each day.

78. Step-by-step process
Typical futures market day-to-day operations: Day 1 You sell (take a short position) a July futures contract for 100,000 bushels of wheat at $3.50/bu. You pay 10% into the margin account: What is the value?

79. Step-by-step process
Typical futures market day-to-day operations: Day 1 You sell (take a short position) a July futures contract for 100,000 bushels of wheat at $3.50/bu. You pay 10% into the margin account: Margin Value: $35,000

80. Step-by-step process Day 2:
July wheat futures prices fall to $3.40/bu.
Profit/loss amount:?

81. Step-by-step process Day 2:
July wheat futures prices fall to $3.40/bu.
Since you are short, a decrease in price implies that you profit by $0.10/bu.
Total Amount of profit: ($0.10/bu x 100,000) = $10,000 more.
So $10,000 is deposited into your margin account at the end of the day?
How much do you have in your margin account now?

82. Step-by-step process Day 2:
July wheat futures prices fall to $3.40/bu.
Since you are short, a decrease in price implies that you profit by $0.10/bu.
Total Amount of profit: ($0.10/bu x 100,000) = $10,000 more.
So $10,000 is deposited into your margin account at the end of the day.
Margin: $35,000+$10,000 = $45,000

83. So, $10,000 is deposited into your margin account at the end of Day 2.
However, this implies that your contract has been marked to market.
- It is now a contract that would require you to sell at $3.40/bu, not $3.50/bu.

84. Step-by-step process Day 3 July wheat futures prices rise to $3.45/bu.
Since you are short, an increase in prices implies that you lose by $0.05/bu.
- In other words, your futures contract is now worth ($0.05/bu 100,000) = $5,000 less.
So, $5,000 is taken out of your margin account at the end of Day 3.
However, this implies that your contract has been marked to market.
It is now a contract that would require you to sell at $3.45/bu, not $3.40/bu.

85. Price Paths Matter
Suppose that in December you sell a July wheat contract at $3.50/bu. For 100,000 bushels of wheat.
You expect the price to go down to $3.00/bu
However, the price path matters: Complete the following table:
Timeline
Open Price
Close Price
Change in Margin Account
Margin Account
Current: $35,000
Week 1
$3.50
$3.55 ?
Week 2
$3.65
Week 3
$4.05
Week 4
$4.50

86. Price Paths Matter
Suppose that in December you sell a July wheat contract at $3.50/bu. For 100,000 bushels of wheat.
You expect the price to go down to $3.00/bu
However, the price path matters: Complete the following table:
Timeline
Open Price
Close Price
Change in Margin Account
Margin Account
Current: $35,000
Week 1
$3.50
$3.55
- 5000
30,000
Week 2
$3.65
- 10,000
20,000
Week 3
$4.05
- 40,000
Out of market
Week 4
$4.50
- 15,000

87. Placed out of market Inherent risk of futures trading.
Liquidity is a key problem, investors face.
Graphical representation.

88. Hedging Risk Using Futures Markets
The idea is to lower price risk, but not eliminate it.
A brief refresher:
Sell (short) hedge:
The sale of a futures contract as a temporary substitute for an anticipated future sale of a cash commodity.
Examples:
Feedlot sells fat cattle at appropriate weight
Wheat farmer sells wheat after harvest
A feed mill sells soybean meal after grinding

89. Hedging - Refresher Buy (long) hedge
the purchase of a futures contract as a temporary substitute for an anticipated future purchase of a cash commodity.
Examples:
Feedlot buys feeder cattle to place on feed
A feed mill buys raw soybeans to grind

90. Hedging - Refresher
The goal is to lock in an approximate future price in order to eliminate risk exposure to interim price fluctuations
Interim price fluctuations involve prices changing during the production of the commodity
While cattle are growing
While wheat is growing

91. Hedging - Rules
Initial cash position is opposite the initial futures position.
Final cash position is the same as the initial futures position.
Price risk
Cash price drops: sell
Cash price rises - buy

92. Understanding hedging using: T-Diagram
Cash Futures
Initial Cash
Initial Futures
Final Cash
Final Futures

93. Hedging: Rule 1 Cash Futures Sell Cash Buy Futures Opposite Buy Cash
Sell Futures

94. Hedging: Rule 2 Cash Futures Price of feeder cattle may increase
Buy FC Futures
Buy feeder cattle
Sell Futures

95. More intuition: Local Vs Futures Markets
In the basic example of participating in futures markets, we assumed that the participant was a speculator.
Typically, speculators do not have the actual commodity and participate in futures markets for one reason: profit.
When we discuss the use of futures markets as a hedging tool, we are talking about agricultural producers who are either:
involved in producing the commodity
purchasing the commodity (eg: grain elevators)

96. Participation occurs in: - Local market (eg: Billings, Great Falls (Montana)) - Futures Market (eg: MGEX, KSBT, CBOT)

97. Definitions:
Local Market: used to sell or buy the physical commodity. Farmers deliver commodities to the local market and sell at the price offered in that local market.
For agricultural producers, it is the fluctuation of prices in the local market that are the source of risk.
Futures market: Used to hedge the risk that exists due to the fluctuation of prices in local markets.
Typically used to offset the position that the agricultural producer has in the local market.

98. The price that you observe in a local market is the price at which an agricultural producer can sell a commodity.
The price observed in a futures market is the price at which the “market" expects the commodity to be sold at the time that the futures contract expires.
Typically, the local price and the futures contract price are not the same. (Basis  we will get to this later)

99. We will assume that at delivery time, the price of a commodity in the local market and the futures market is exactly the same.

100. Positions in the local market
When you want to figure out what position you are in your local market, ask yourself this question:
If the price in the local market drops, do I benefit or do I lose?
If you own the commodity, then a drop in price is not beneficial, you cannot sell it for as much as you could before the price drop.
So, if you don't benefit when the local market price drops, then you are naturally long. Conversely, you benefit if price rises.
If you consume the commodity, then a drop in price is beneficial, because you purchase it for a lesser price and reduce your costs.
So, if you do benet when the local market price drops, then you are naturally short. Conversely, you lose if price rises.

101. Hedging: Offsetting Price Risk
Suppose, price of a July wheat futures contract in November is $4.50/bu.
To hedge the risk of price drops, the operator sells (goes short) 20 July contracts at $4.50/bu.
In July, the operator will sell the wheat on the local market at the July price and buy back (goes long) the 20 contracts at the July futures contract price.

102. Analysis of positions:
Local market - the per unit equity is the difference between the price at which a commodity was sold on the local market and the cost.
𝐸𝑞𝑢𝑖𝑡 𝑦 𝑙𝑜𝑐𝑎𝑙 =𝐿𝑜𝑐𝑎𝑙 𝐶𝑎𝑠ℎ 𝑃𝑟𝑖𝑐𝑒 −𝐶𝑜𝑠𝑡
Futures market - the per unit equity calculation depends on which position was taken in the futures market:

103. Short position - the difference between the price at which a futures contract was sold and the price at the time that the futures contract was offset: 𝐹 𝐽𝑢𝑙𝑦 𝑁𝑜𝑣 − 𝐹 𝐽𝑢𝑙𝑦 𝐽𝑢𝑙𝑦
Long position - the difference between the price at which a futures contract was offset and the price at which a contract was bought:
𝐹 𝐽𝑢𝑙𝑦 𝐽𝑢𝑙𝑦 − 𝐹 𝐽𝑢𝑙𝑦 𝑁𝑜𝑣

104. Consider that there are five possible prices in July: $4. 00, $4
Consider that there are five possible prices in July: $4.00, $4.25, $4.50, $4.75, $5.00 (each price is per bushel).
Let Futures price be $4.50
Setup table:

105. You can see that in each case, the operator gets a $0.50/bu payoff.
This is regardless of the price fluctuating in the local and futures markets.
Thus, by hedging the local price risk with a futures contract, the operator guarantees a positive net equity.

106. Graph

107. Another problem:
1) Assume that you are employed by the Grains Galore Exporting Company, and you have just negotiated to sell 10 million bushels of corn to India at a price of $4.25/bu. However, the delivery will not occur until September, six months from now. You will sell the grain to a transporter at a local port at the September local market price. How can you guarantee a profit for GGEC if the September corn futures contract is currently trading at $4.00/bu? Describe how you can use the futures market, your position in the futures market, and the number of contracts you would need to sell or buy. In September, describe how you would fulfill your obligations in the futures market and regarding your negotiated deal with India. What would be your per unit equity? How much will you earn in total?

109. Homework
Q) You are feedlot operator. You will need to purchase feeder cattle in June and you will do so on the local market at the going price. Suppose you know that you can sell the fed cattle at $1.50/lb, but you want to o set any price risks. To do so, you use the futures market. Answer the following:
What position are you in the local market?
What position should you take in the futures market to oset the price risk?
Suppose the current futures contract price for feeder cattle is $1.25/lb. Construct a table that illustrates your per pound equity if the June contract price is one of the following: $1.05/lb., $1.15/lb., $1.25/lb., $1.35/lb., $1.50/lb.

110. The price in the local and futures markets is exactly the same.
Basis
In analyzing how to hedge price risk, we assumed that at the time that a futures contract expires:
The price in the local and futures markets is exactly the same.

111. Why are they different?
In reality, perfect convergence is rare, because there are always factors that can contribute to differences between local and futures contract prices.
Locational differentials.
Delivery point locations.
Storage costs.
Speculators in the market.
We need to analyze how imperfect price convergence affects an agricultural producer's ability to hedge risk. To do so, we introduce the concept of basis.

112. Introduction to Basis
Basis is the uninsurable changes in price that may prevent creating a perfect risk hedge using a futures market. 𝐵𝑎𝑠𝑖𝑠=𝐿𝑜𝑐𝑎𝑙 𝐶𝑎𝑠ℎ 𝑃𝑟𝑖𝑐𝑒 −𝑁𝑒𝑎𝑟𝑏𝑦 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑃𝑟𝑖𝑐𝑒 𝐵=𝑃−𝐹

113. Uses of Basis Forecasting local prices
𝐸 𝑃 𝑡+1 =𝐹+ 𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐𝑎𝑙 𝐵𝑎𝑠𝑖𝑠 𝑡+1
Market Price for Storage
basis can be used to determine whether it is profitable to store a commodity or sell it today.
Is it profitable to store until some future selling date?
Is it profitable to sell at the current local price?

114. Market Price for Storage
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝑠𝑡𝑜𝑟𝑎𝑔𝑒=𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐 𝑒 𝑚𝑜𝑛𝑡ℎ −𝐿𝑜𝑐𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 Expected local price in a particular month: 𝐸 𝐿𝑜𝑐𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 𝑚𝑜𝑛𝑡ℎ =𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐 𝑒 𝑚𝑜𝑛𝑡ℎ +𝐸 𝐵𝑎𝑠𝑖𝑠 𝑚𝑜𝑛𝑡ℎ When is it profitable to store? If: 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐 𝑒 𝑚𝑜𝑛𝑡ℎ −Current Local Price >𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝑠𝑡𝑜𝑟𝑎𝑔𝑒 When is it profitable to sell? If: 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐 𝑒 𝑚𝑜𝑛𝑡ℎ −Current Local Price ≤𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝑠𝑡𝑜𝑟𝑎𝑔𝑒

115. Example of hedging with Basis
Basis incorporates transaction costs that have to do with transporting a commodity from a contractual delivery location to the final destination.
Q: Suppose that you are an operator of a milling company in St. Louis, MO. The grain that you purchase on the local market is SRW wheat, which is sold on the CBOT, and barged from Toledo, OH at a price of $0.50/bu. You receive the wheat in July.

116. 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒=𝐶𝐵𝑂𝑇 𝐽𝑢𝑙𝑦 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒+𝐵𝑎𝑠𝑖𝑠
𝑃 𝐽𝑢𝑙𝑦 =𝐹+𝐵
Suppose July contract price of wheat is $5.00/bu.
Then you can guarantee paying $5.50/bu for the wheat in July by establishing a long hedge.

117. Calculations Local Cash Market: You pay: $5.30 + $0.50 = $5.80/bu
Futures Market
Long Hedge: Equity = $5.30−$5.00=$0.30/𝑏𝑢
Total amount paid for wheat:
$5.80−$0.30=$5.50/𝑏𝑢

118. Basis Risk
Basis still has variability: : Increase in basis  increase local price  increase net costs. Decrease in basis  decrease local price  decrease net costs. Basis variability is less than price variability! Which is why you should still futures market to hedge price risk!