1. 1 Understanding Basis Definition Influence factors Basics of basis Patterns and trends

2. 2 Basis Basis = Cash – Futures Futures reflect global S&D Basis reflects the local S&D Cash = Futures + Basis

3. 3 Basis basics Specific to time and place Typically use nearby futures Convergence Less variable than cash Relatively predictable

4. 4 Basis Factors Relative storage capacity Transportation availability and cost Time to expiration Quality issues

5. 5 Basis

6. 6 Specific to time and place

7. 7 Iowa Grain Price Report http://www.ams.usda.gov/mnreports/nw_gr110.txt NW_GR110 Fri. Jan. 8, 2010 IA Dept. of Ag-USDA Market News Interior Iowa Daily Grain Prices Closing cash grain bids offered to producers as of 2:30 p.m. Dollars per bushel, delivered to Interior Iowa Country Elevators. Iowa Regions#2 Yellow Corn#1 Yellow Soybeans RangeAvgRangeAvg Northwest3.72 – 3.863.829.55 – 9.649.61 North Central3.82 – 3.913.869.48 – 9.659.59 Northeast3.82 – 3.993.899.48 – 9.749.60 Southwest3.64 – 3.853.779.48 – 9.729.63 South Central3.80 – 3.883.849.57 – 9.759.64 Southeast3.53 – 3.933.829.54 – 9.729.65 Corn basis to STATE AVERAGE PRICE for the CBOT Mar. contract is -.39 Soybean basis to STATE AVERAGE PRICE for the CBOT Mar. contract is -.61

8. 8 Iowa Grain Price Report http://www.ams.usda.gov/mnreports/nw_gr110.txt NW_GR110 Fri. Jan. 8, 2010 IA Dept. of Ag-USDA Market News Interior Iowa Daily Grain Prices Closing cash grain bids offered to producers as of 2:30 p.m. Dollars per bushel, delivered to Interior Iowa Country Elevators. March Futures Closing Price4.2310.22 Iowa Regions#2 Yellow Corn#1 Yellow Soybeans AvgBasis?AvgBasis? Northwest3.829.61 North Central3.869.59 Northeast3.899.60 Southwest3.779.63 South Central3.849.64 Southeast3.829.65

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12. 12 PriceBasis Avg62.550.90 Stdev11.093.61 Min28.77-10.57 Max90.4313.22

13. 13 Specific to time and place http://www.ams.usda.gov/mnreports/lsddgr.pdf http://www.card.iastate.edu/ag_risk_tools/basis_maps/ www.BeefBasis.com http://www.econ.iastate.edu/faculty/lawrence/Acrobat/Curre ntLiveCattleBasis.pdf http://www.econ.iastate.edu/faculty/lawrence/Acrobat/Curre ntHogBasis.pdf

14. 14 Grain Basis vs. Livestock Basis Grain is a storable commodity and the same grain can be used to satisfy several futures contract delivery months. So grain futures prices tend to be tied to one another. Livestock is not storable so livestock futures prices for alternative delivery months tend to move independently. Because grain is a storable commodity, the grain basis is tied closely to grain storage costs and interest costs. Livestock are not storable so there are no storage costs built into the basis.

15. 15 Grain Basis vs. Livestock Basis An inverse basis in grain futures (cash above futures) is unusual and indicates there is something amiss in the grain industry (lack of transportation, for example). An inverse basis in grains will usually last only for a short period. An inverse basis in livestock futures is not unusual for distant delivery contracts and can exist for extended periods of time. Only during the nearby futures contract delivery periods do we expect livestock futures to be above cash price.

16. 16 Basis Summary Difference between cash and futures Reflects local conditions More predictable than futures Essential to effective hedging

17. 17 Introduction to Hedging Definition Types Mechanics

18. 18 Hedging definition Hedging is buying or selling futures contracts as protection against the risk of loss due to changing prices in the cash markets. Holding equal and opposite positions in the cash and futures markets The substitution of a futures contract for a later cash-market transaction

19. 19 Market participants Hedgers are willing to make or take physical delivery because they are producers or users of 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

20. 20 Short Hedgers Producers with a commodity to sell in the cash market 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

21. 21 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

22. 22 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

23. 23 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

24. 24 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$3.50 Local basis-.25 Commission -.01 Expected hedge price$3.24

25. 25 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

26. 26 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

27. 27 Hedging example Higher Prices Dec Corn futures =$4.00 Basis as expected-$0.25 Cash corn$3.75 Futures position loss $3.50 - 4.00 -0.01-$0.51 Net price$3.24

28. 28 Hedging example Lower Prices Dec Corn futures =$3.20 Basis as expected-$0.25 Cash corn$2.95 Futures position gain $3.50 - 3.20 -0.01+$0.29 Net price$3.24

29. 29 Hedging example Basis Change Dec Corn futures =$3.20 Basis is wider-$0.30 Cash corn$2.90 Futures position gain $3.50 - 3.20 -0.01+$0.29 Net price$3.19 Expected $3.24 and received $3.19 Difference is due to basis change

30. 30 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

31. 31 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

32. 32 Long Hedge Example Currently July corn trading at$3.70 Local basis-.25 Commission +.01 Expected hedge price$3.46 Call Broker and buy July corn at $3.70

33. 33 Long Hedge Example It is now July and prices went up. Call broker and sell July corn to offset: Currently July corn trading at$3.90 Local basis-.25 Cash price$3.65 Futures position gain $3.90 - 3.70 -0.01+$0.19 Net price $3.46

34. 34 Long Hedge Example It is now July and prices went down. Call broker and sell July corn to offset: Currently July corn trading at$3.30 Local basis-.25 Cash price$3.05 Futures position loss $3.30 - 3.70 -0.01-$0.41 Net price $3.46

35. 35 The Storage Hedge Store grain at harvest for sale a later date Protect against adverse price change Help earn a carrying charge Storage, interest

36. 36 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

37. 37 The Storage Hedge TimeCash July FutBasis Nov 1$3.40$3.85$0.45 Actionstoresell July 1$3.70$3.00$0.30 Actionsell buy Gain/loss+$0.30-$0.15+$0.15 Net gain from storage hedge is +$0.15 and is equal to the change in basis

38. 38 Short hedge for middleman It is March. A grain elevator has storage available and is thinking about buying corn to store until July. Estimated storage cost is $0.10/bu Current spot (cash) price is $3.40/bu July corn futures are at $3.70 Expected July basis is -$.15/bu

39. 39 Short hedge for middleman Compare expected price to current price Expected July hedge price $3.70-.15-.01=$3.54 Less storage cost-.10 Net price in July$3.44 Current spot price $3.40 Profit potential per bushel$.04 What is the risk?

40. 40 Short hedge for middleman What if prices rise by July? $4.20-.15-.01=$4.04 Less storage cost-.10 Net price in July$3.94 Current spot price $3.40 Cash profit per bushel$.54 Futures G/L (3.70-4.20) -.50 Net profit $.04

41. 41 Short hedge for middleman What if prices fall by July? $3.20-.15-.01=$3.04 Less storage cost-.10 Net price in July$2.94 Current spot price $3.40 Cash profit per bushel-$.46 Futures G/L (3.70-3.20) +.50 Net profit $.04

42. 42 Short hedge for middleman What if the basis changes from expected? $3.20-.25-.01=$2.94 Less storage cost-.10 Net price in July$2.84 Current spot price $3.40 Cash profit per bushel-$.56 Futures G/L (3.70-3.20) +.50 Net profit -$.06 Basis changed $.10 and net profit changed $.10

43. 43 Hedging Summary “Counterbalancing investment” “equal and opposite” position in cash and futures Used to manage price risk Basis estimation is essential Allows for forward contracting