1. Overview u Price risk u Futures markets and hedging u Options on futures –Definitions –Strategies u Livestock price and margin insurance

2. Why worry about price risk? Steer feeding profit variation explained (%) Placement wt<600700-800 Fed price58.0750.46 Feeder price2.3019.31 Corn price5.294.19 Feed/gain7.223.55 ADG1.366.31 Interest rate1.55-.38 Total explained 75.7983.44

3. Average Hog Price Forecast Error,1995-2004 QuartersForecast Source OutISUFuturesIndex 10.07-0.67-0.40 20.000.010.16 30.630.750.23 40.410.630.37

4. Standard Deviation of Hog Price Forecast Error, 1995-2004 QuartersForecast Source OutISUFuturesIndex 14.863.645.36 27.066.367.26 37.968.019.29 4 9.2811.48 Actual price expected at the forecast price +/- the standard deviation 68% of the time.

5. Fed Cattle Price Forecast Error, 1995-2004: Seasonal Index and Basis Adjusted Futures QuartersIndex Futures OutAverageStd DevAverageStd Dev 1-0.265.240.053.86 2-0.376.180.594.97 3-0.116.290.956.33 40.565.890.806.89 http://www.econ.iastate.edu/faculty/lawrence/

6. S D 68% of time 16%

7. Futures markets u Organized and centralized market u Today’s price for products to be delivered in the future. u A mechanism of trading promises of future commodity deliveries among traders.

8. Futures markets u Biological nature of ag production –Excess supply at harvest –Shortage in spring and summer –Producers need price forecast because prices not known when production decision is made –Processors need year around supply u Modern futures market began long ago –1848 Chicago Board of Trade –1919 Chicago Mercantile Exchange

9. Futures Market Exchanges u Trading pits and e-trading u Centralized pricing –Buyers and sellers represented by brokers in the pits –All information represented through bids and offers u Perfectly competitive market –Open out-cry trading –Beginning electronic trading

10. The futures contract u A legally binding contract to make or take delivery of the commodity –Trading the promise to do something in the future –You can “offset” your promise u Standardized contract –Form (wt, grade, specifications) –Time (delivery date) –Place (delivery location)

11. Standardized contract u Certain delivery (contract) months u Fixed size of contract –Grains 5,000 bushels »Corn, Wheat, Soybeans –Livestock in pounds »Lean Hogs 40,000 lbs carcass »Live Cattle 40,000 lbs live »Feeder Cattle 50,000 lbs live u Specified delivery points –Relatively few delivery points

12. The futures contract u No physical exchange takes place when the contract is traded. u Payment is based on the price established when the contract was initially traded. u Deliveries are made when the contract expires (delivery time).

13. Market position u Objective: Buy low, sell high u You can either buy or sell initially to open a position –“Make” a promise u Do the opposite to close the position at a later date –“Offset” the promise u Trader may also hold the position until expiration and make or take physical delivery of the commodity –Exceptions include Lean Hogs and Feeder Cattle

14. Terms and Definitions u Basis –The difference between the spot or cash price and the futures price of the same or a related commodity. u Margin –The amount of money or collateral deposited by a client with his or her broker for the purpose of insuring the broker against loss on open futures contracts.

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

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

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

18. Producer short hedge example u A farmer will have 800 hogs to sell in June u The farmer is long the cash market »Damaged by a price decline

19. Producer short hedge example u To have an equal and opposite hedge the farmer would sell 4 Lean Hog futures contracts that expires near the expected marketing time. –800 x 270 x 74% /40,000 = –The farmer would short the futures »The futures position would benefit from a price decline

20. Producer 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 June hogs is -$2.25/cwt in the meat. Currently June Lean Hogs trading at$70.75 Local basis-2.25 Commission -.10 Expected hedge price$68.40

21. Producer short hedge example u Step 3: Call broker and place order to sell 4 June hog contracts at the market u Step 4: Broker calls to confirm fill u Step 5: Send margin money to broker

22. Producer short hedge example u It is now June 5 and the farmer is ready to sell hogs to the packer. u Prices could have gone up or down u Basis could be wider or narrower than expected

23. Hedging example Higher Prices June hog futures =$74.00 Basis as expected-$2.25 Cash hogs (carcass)$71.75 Futures position loss $70.75 - 74.00 -0.10-$3.35 Net price$68.40

24. Hedging example Lower Prices June hog futures =$65.25 Basis as expected-$2.25 Cash hogs$63.00 Futures position gain $70.75 - 65.25 -0.10+$5.40 Net price$68.40

25. Hedging example Basis Change June hogs futures =$74.00 Basis is wider-$1.80 Cash corn$72.20 Futures position gain $70.75 - 74.00 -0.10-$3.35 Net price$68.85 Expected $68.40 and received $68.85, $.45 more Why????

26. Hedging results u In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis. u Basis estimation is critical to successful hedging

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

28. 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

29. 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 $2.90 - 2.70 -0.01+$0.19 Net price $2.46

30. 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 $2.30 - 2.70 -0.01-$0.41 Net price $2.46

31. Forward Contracts u Contract for delivery –Defines time, place, form u Tied to the futures market –Buyer offering the contract must lay off the market risk elsewhere –The buyer does the hedging for you

32. Futures Summary u Today’s price for delivery in future u Standardized contract/promise to make or take delivery u Contract/promise can be offset u Several participants for different positions u Basis estimation important to hedgers

33. Options on Futures u Separate market u Option on the futures contract u Can be bought or sold u Behave like price insurance –Is different from the new insurance products

34. Options on Futures u Two types of options Four possible positions –Put »Buyer »Seller –Call »Buyer »Seller u Calls and puts are not opposite positions of the same market. They are different markets.

35. Put option u The Buyer pays the premium and has the right, but not the obligation to sell a futures contract at the strike price. u The Seller receives the premium and is obligated to buy a futures contract at the strike price.

36. Call option u The Buyer pays a premium and has the right, but not the obligation to buy a futures contract at the strike price. u The Seller receives the premium but is obligated to sell a futures contract at the strike price.

37. Options as price insurance u Person wanting protection pays a premium u If damage occurs the buyer is reimbursed for damages u Seller keeps the premium but must pay for damages u Option buyer has unlimited upside and limited (premium) downside risk u Option seller has limited upside (premium) and unlimited downside risk

38. Options u May or may not have value at end –The right to sell at $2.20 has no value if the market is above $2.20 u Buyer can chose to offset, exercise, or let it expire u Seller can only buy back or wait for buyer to choose

39. Strike price u Level of price insurance u Set by the exchange (CME, CBOT) u A range of strike prices available for each contract

40. Premium u Is traded in the option market u Different premium –For puts and calls –For each contract month –For each strike price u Depends on five variables –Strike price –Price of underlying futures contract –Volatility of underlying futures –Time to maturity –Interest rate

41. In-the-money u If expired today it has value u Put: futures price below strike price u Call: futures price above strike price

42. At-the-money u If expired today it would breakeven u Strike price nearest the futures price

43. Out-of-the-money u If expired today it does not have value u Put: futures price above strike price u Call: futures price below strike price

44. Option decisions u Buyer can choose –Let option expire –Exercise right –Re-sell option rights to another u Seller has less flexibility –Obligated to honor option contract –Can buy back option to offset position

45. Buyer decision depends upon u Remaining value and costs of alternative u Time mis-match –Most options contracts expire 2-3 weeks prior to futures expiration –Cash settlement expire with futures –Improve basis predictability

46. Setting a Floor Price u Short hedger u Buy put option u Floor price = SP – Prem + Basis – Com u At maturity –Futures < SP the Net price = Floor Price –Futures > SP the Net price = Cash – Prem - Com

47. Futures Net Price SP 1 Long Cash Adjust for basis Hedge Adjust for basis Buy Put Short Hedger Position SP 2 NP 1 NP 2 HP

48. Setting a Ceiling Price u Long hedger u Buy call option u Ceiling price = SP + Prem + Basis + Com u At maturity –Futures > SP the Net price = Ceiling Price –Futures < SP the Net price = Cash + Prem + Com

49. Futures Net Price Long Cash Adjust for basis Hedge Adjust for basis Buy Call Long Hedger Position SP 1 SP 2 SP 1 SP 2

50. Combination strategies u Option fence –Buy put and sell call –Higher floor but now have ceiling u Put spread –Buy ATM put and sell OTM put –Higher middle and higher prices, but also no floor below OTM strike

51. Net Price with Options u Buy Put –Minimum price –Cash price - premium - comm u Buy Call –Maximum price –Cash price + premium + comm

52. Summary on Options u Options on futures contract u Buyer –Pays premium, has limited risk and unlimited potential u Seller –Receives premium, has limited potential and unlimited risk

53. Analyzing Livestock Risk Protection William M. Edwards, Iowa State University Insuring Iowa’s Agriculture

54. Livestock Risk Protection (LRP) u Coverage for hogs, fed cattle and feeder cattle u 70% to 95% guarantees available, based on CME futures prices. u Coverage is available for up to 26 weeks out for hogs and 52 for cattle.

55. Livestock Risk Protection u Guarantees available are posted at: www.rma.usda.gov/tools/ www.rma.usda.gov/tools/ u Posted after the CME closes each day until 9:00 am central time the next working day. u Assures that guarantees reflect the most recent market movements.

56. Size of Coverage Futures and options have fixed contract sizes –Hogs: 400 cwt. or about 150 head –Fed cattle: 400 cwt. or about 32 head –Feeder cattle: 500 cwt., 60-100 head u LRP can be purchased for any number of head or weight

57. Some Risks Remain u LRP, LGM do not insure against production risks u Futures prices and cash index prices may differ from local cash prices (basis risk) u Selling weights and dates may differ from the guarantees

58. Expiration Date of Coverage u LRP ending date is fixed. Price may change after date of sale. u Hedge or options can be lifted at any time before the contract expires.

59. Who can benefit from LGM/LRP? u Producers who depend on the daily cash market or a formula related to it. u Producers with low cash reserves. u Smaller producers who do not have the volume to use futures contracts or put options. u Producers who prefer insurance to the futures market. No margin account.

60. LRP Analyzer u Covers swine, fed cattle, feeders u Compares net revenue distribution –No risk protection –LRP –Hedge –Put options

61. Case Example u Small cow herd producer will have 62 head of 650 pound steer calves to sell in 4 months. u What price will LRP lock in? u How much will it cost? u How does LRP compare to futures?

64. Livestock Gross Margin u Cattle –Calves –Yearlings u Hogs –Farrow to finish –Finishing feeder pig –Finishing SEW pig

65. Livestock Gross Margin Insures a “margin” between revenue and cost of major inputs Hogs Value of hog – corn and SBM costs Cattle Value of cattle – feeder cattle and corn Protects against decreases in cattle/hog prices increases in input costs

66. LGM Hogs u Farrow to Finish option u Gross margin per hog t = –2.5*0.74*LeanHog Price t –- 13.22 bu. * Corn Price t -3 –- (188.52 lb./2000 lb.) * SoyMeal Price t -3 u Finish Only option u Gross margin per hog t = –2.5*0.74*Lean Hog Price t –- 10.19 bu. * Corn Price t -2 –- (147.31 lb./2000 lb.) * SoyMeal Price t -2

67. LGM-Cattle u Uses futures markets to lock in the average expected gross margin for fed cattle to be sold in each of the next ten months u Protects against decreases in live cattle prices increases in feeder cattle prices and increases in feed costs

68. LGM-Cattle Yearling GM = 12.5 x Basis adjusted LC futures - 7.5 x Basis adjusted FC futures - 57.5 x Basis adjusted Corn futures Calf GM = 11.5 x Basis adjusted LC futures - 5.5 x Basis adjusted FC futures - 55.5 x Basis adjusted Corn futures

69. Learn More About Risk Tools u Livestock Revenue Protection u Livestock Gross Margin u http://www.rma.usda.gov/livestock/ http://www.rma.usda.gov/livestock/ –Factsheets –Premium calculator u Livestock Futures and Options u Historic basis patterns

70. For more information visit: ISU Ag Decision Maker website www.extension.iastate.edu/agdm Decision file B1-50