1. CME Group Futures, Options, and the Cattle Crush
September 12, 2017
Joanna Litchfield
Agricultural Business Line Management

2. Disclaimer
Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract's value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade. All references to options refer to options on futures. Any research views expressed those of the individual author and do not necessarily represent the views of the CME Group or its affiliates. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. All examples are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official rulebook of the organizations. Current rules should be consulted in all cases concerning contract specifications CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Globex and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. NYMEX, New York Mercantile Exchange and ClearPort are registered trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. All other trademarks are the property of their respective owners. Copyright © 2017 CME Group. All rights reserved.

3. Chicago Merchantile Exchange (CME) Chicago Board of Trade (CBOT)
New York Merchantile Exchange (NYMEX)
Commodity Exchange (COMEX)
Kansas City Board of Trade (KCBT)
World’s leading derivatives exchange – we can get into what that means in a couple of minutes – but we are made up of several smaller exchanges that all merged or were purchased to become CME Group.

4. How CME Group Evolved Over Time
From unstructured street corners, to a formalized trading location, to a global marketplace.
In the 19th century agriculture migrates West. All over the Midwest, farmers plant corn and then haul their harvest to cities like Chicago, to try to sell. Merchants are scattered throughout the city and commerce is decentralized. So, do you think all farmers received equal treatment? A merchant on one corner is not necessarily offering the same price for corn as another merchant across town, so farmers have no idea what their corn is actually worth and may end up taking a lower price than another farmer. Conversely, a merchant might overpay for the corn they buy relative to another buyer.
Then, 12 Chicago businessmen had a better idea: A Centralized Marketplace Where Price Can Be Discovered in an Open and Transparent Manner. The idea was that everyone would know the price and have access to market information. Everyone may participate in the price discovery process, meaning buyers and sellers can come together and prices are openly posted. The Chicago Board of Trade was formed in 1848.

5. This development allowed more people equal access to prices and liquidity through a central limit order book.

6. What are Futures?
Legally binding agreement to accept delivery of or make delivery of a standardized quantity and quality of a commodity to a standardized place during a standardized time period for a price discovered in an organized futures exchange.

7. CME Group offers many agricultural commodity contracts.
Example of a Futures Contract
CME Group offers many agricultural commodity contracts.
Example of our corn contract.
You can see it is standardized to a certain:
Quantity – 5,000 bushels (or ~127 metric tons).
Quality – certain discounts or premiums apply for anything not No. 2 yellow within a specified foreign material and damage range.
Time period – March, May, July, September, and December deliveries.

8. Options on Futures
Contract between two parties that conveys a RIGHT but not an obligation to buy or sell a specific commodity at a specific price within a specific time period for a premium. Buy a Call: Right to Buy Futures Buy a Put: Right to Sell Futures

9. Tools to Manage Price Risk
Futures
– Allow you to lock in a futures price level
– Simple, requires margin deposit
Options on Futures
– Price protection with flexibility
– Benefit from upside or downside
– Analogous to insurance, long options does not require margin deposits

10. Futures provide three key functions:
Purpose of Futures and Options
Futures provide three key functions:
Price Discovery
Centralized place to price commodities
Price Risk Management
Hedge with futures and options
Efficient Commodity Allocation
Nearby/Sell versus Future/Store
Futures serves 2 main purposes – price discover and price risk management.
But commodities are special and futures also serves a third purpose – effectively allocating a commodity grown once per year to supply the world over a longer period.

11. Futures provide transparency.
Price Discovery
Futures provide transparency.
Market for discovering price determined by buyers and sellers.
CME Group publishes intraday and settlement prices at the market close for all our contracts.
Allows everyone in the cash industry – farmers, processors, end users – an idea of the current (and future!) values of these commodities.
Go most places in the world and ask, “What’s the Price of Corn?” and most will tell you their price relative to Chicago.
Price discovery – how does everyone know what “the price of corn” is? How can people find that out?
We create a marketplace for buyers and sellers of a commodity to post bids and offers, which effectively determines the value of corn. Not only can you see the current value of corn, but we price contracts out for several years so you can see what the expected value of corn is as well.
Of course, the price of corn here isn’t the same as the price in Iowa or in Arkansas or around the globe. But people look to the CBOT price and determine their price relative to our price. They’ll say “20 over Chicago” which means their corn is 20 cents per bushel more expensive than the CBOT price.
That difference is called basis.

12. The Great Chicago Flood.
Price Discovery Example
The Great Chicago Flood.
The Story of the 1992 Great Chicago Tunnel Flood and the Evansville Corn Rail Market.
What happens when there isn’t a way to see the price of corn?
Bid-ask spread went from 3 cents before the flood to 13 cents during the flood. That means the difference between what someone was willing to buy at versus sell for went from 3 cents per bushel to 13 cents per bushel because no one had a centralized place to determine the actual commodity value.
Source: Chicago Tribune

13. Futures provide a place to offset your risk.
Price Risk Management
Futures provide a place to offset your risk.
Futures Markets are used by agricultural market participants to hedge against adverse price movements.
Cash price and futures price are highly correlated.
Futures effectively “lock in” prices you will pay or receive.
Grower will sell futures, because if the price goes down he can buy “back” while processors will buy futures because if the price goes up they can sell them.
Let’s say I am a corn farmer and I planted my corn in the late spring. I’m getting worried because I’m hearing that there are reports that there is going to be a huge surplus of corn this year, so I think prices for corn are going to fall. Since it is my job to sell corn, I want the highest price possible. If I do nothing but sit back and wait for the corn to grow and harvest it, I could lose money. If in July, corn was going for $4 per bushel, but prices go down once I harvest and try to sell it. So I am only getting $3.55 per bushel. I stand to lose 45 cents per bushel without hedging.
However, if I thought to myself, I would like to hedge my risk and offset in the futures market, I could have saved myself money – even made money! I can go to the Exchange and sell futures contracts at $4 per bushel. Come December, when prices have gone down, I can buy futures contracts at only $3.50 per bushel. So I just made 50 cents per bushel. On the whole, hedging not only covered my losses but it also made me money. This obviously won’t always be the case, but since cash prices and futures prices tend to move together, a loss in the cash market will be helped by a gain in the futures market.
The other side is the same – if I am an ethanol processor and know that I’ll need corn to make my product, I am worried about the price of corn going up. So I buy futures, then sell them when I buy my cash corn.

14. Protecting your Profitability
Price Risk Management
Protecting your Profitability
If You Are Not Hedging,
You are Speculating

15. Managing Volatility

16. Futures provide a signal to farmers.
Efficient Commodity Allocation
Futures provide a signal to farmers.
Unique to commodity markets, because they are products produced once annually that need to be allocated throughout an entire year.
The price spreads between these different delivery months represents the return from storage.
When supplies are sufficient, the spreads are wide, and the market pays warehouses and farmers to store. However, when supplies are tight, the market penalizes storage.
This is unique to commodity markets.
Look at corn, which is planted and harvested once per year – here in early fall. So what stops farmers from taking 100% of their harvested corn and bringing it to market right away? Or what prevents them from storing 100% of it and deciding to sell it later?
Our futures markets tell farmers what they can expect the price to be in 3 months, 6 months, 12 months. So they can look at their cost of storage, and at the expected price down the road, to determine if it is economical for them to sell their grain or to hold onto it. If the market is well supplied and wants to signal to farmers to hold onto their corn, the price in 6 months will be significantly higher than the price today. If the market is in need of supply and wants to signal to farmers to sell their corn, the price today might even be higher than the price in the future, so no farmer would be incentivized to pay additional storage costs and hold his corn for later.

17. Beef Cattle Production

18. Take a “Short” Position
Using Futures
The “Cattle Crush”
Two Primary Inputs:
One Primary Output:
1) Corn
1) Live Cattle
2) Feeder Cattle
Take a “Long” Position
Take a “Short” Position

19. Cattle Crush
Example
Cattle Crush = (6 * Live Cattle) – (3 * Feeder Cattle) – (2 * Corn) Futures Contract Sizes: Live Cattle Futures: 40,000 pounds Feeder Cattle Futures: 50,000 pounds Corn Futures: 5,000 bushels

20. Cattle Crush
Example
Cattle Crush = (6 * Live Cattle) – (3 * Feeder Cattle) – (2 * Corn)
On February 25, the closing prices for the specific contracts were as follows:
August 2017 Live Cattle: $131.68/cwt
April 2017 Feeder Cattle: $ /cwt
May 2017 Corn: $4.6125/bu.
This implies the following cattle crush:
Cattle Crush = (6*400*131.68) – (3*500* ) – (2 * 5000*4.6125)
Crush = $11,108/trade
or $0.278/cwt of live cattle (40k lb.) or $0.222/cwt of feeder cattle (50k lb.)

21. Cattle Crush

22. Thank you