hedge overview

Hedge overviewHedge overview

Futures provide additional Futures provide additional marketing alternativesmarketing alternatives

Can transfer price riskCan transfer price riskCan establish approximate price Can establish approximate price

levels in advance of cash market levels in advance of cash market transactionstransactions

HedgingHedging

What are the basics you need to What are the basics you need to know to be a effective hedger in know to be a effective hedger in futures?futures?

Volume cash commodityVolume cash commodityCurrent futures pricesCurrent futures pricesRelevant basisRelevant basisCurrent basis vs. history Current basis vs. history

AssignmentAssignment

Find the current basis for a Find the current basis for a commodity at your local market commodity at your local market outlet this week, and where you outlet this week, and where you could get past basis data for that could get past basis data for that location in the last five years.location in the last five years.

HedgingHedging

In long run, can futures hedge In long run, can futures hedge improve returns? Will it?improve returns? Will it?

In short run, can it reduce risk, or In short run, can it reduce risk, or improve returns?improve returns?

What’s your objective?What’s your objective?

HedgingHedging

What should be your criteria for What should be your criteria for success in hedging?success in hedging?

Achieving approximate Achieving approximate expected cash price = expected cash price = futures futures ++ expected basis expected basis

Making the maximum profit?Making the maximum profit?

HedgingHedging

Initiation of a position in the futures Initiation of a position in the futures market that is intended as a market that is intended as a temporary substitutetemporary substitute for the sale or for the sale or purchase of the actual commodity purchase of the actual commodity at a later date.at a later date.

HedgingHedging

Use of futures markets to lock-in a Use of futures markets to lock-in a purchase or selling price purchase or selling price nownow, even , even though the physical purchase or though the physical purchase or sale won’t occur until sale won’t occur until laterlater..

Usually bushel-bushel or pound-Usually bushel-bushel or pound-pound hedge, though optimum pound hedge, though optimum hedge may be slightly less for grainhedge may be slightly less for grain

Necessary conditionsNecessary conditions

Cash price must move in parallel Cash price must move in parallel 1 : 1 or in fixed ratio e.g. 1.5 : 11 : 1 or in fixed ratio e.g. 1.5 : 1

to futures price when futures are converted to futures price when futures are converted to cash positionsto cash positions

want to have gains in one market offset in want to have gains in one market offset in the other market, so expected cash price will the other market, so expected cash price will be achievedbe achieved

Hedge ratioHedge ratio

Hedge 1 unit cash product in 1 unit Hedge 1 unit cash product in 1 unit futures if prices move 1:1futures if prices move 1:1

Hedge appropriate ratio if cash prices Hedge appropriate ratio if cash prices move more or less than futures (if move more or less than futures (if hams move more 1.2:1 than hogs, buy hams move more 1.2:1 than hogs, buy 20% more pounds in hog contracts to 20% more pounds in hog contracts to hedge hams)hedge hams)

PRICEPRICE

TIMETIME

CASHCASH

FUTURESFUTURES

Futures/Hedging Futures/Hedging TerminologyTerminology

Nearby contract--the contract Nearby contract--the contract expiring soon after the cash market expiring soon after the cash market transaction transaction

Spread--difference in prices in two Spread--difference in prices in two contract monthscontract months

Rollover--shifting futures position Rollover--shifting futures position from one contract month to another from one contract month to another contract month (Feb to April)contract month (Feb to April)

BasisBasis

Cash - Futures Price DifferenceCash - Futures Price Difference

Usually expressed as so much over or Usually expressed as so much over or under futuresunder futures[Cash P - Futures P = Basis][Cash P - Futures P = Basis]

for a specific contract month; for a specific contract month; reflects location and product quality reflects location and product quality differences and time of deliverydifferences and time of delivery

BasisBasis

Cash - Futures Price DifferencesCash - Futures Price Differences

Reflects local S & D versus Reflects local S & D versus delivery point S & Ddelivery point S & D

Reflects transfer costs betweenReflects transfer costs betweenlocal market and delivery or cash local market and delivery or cash settlement points for futuressettlement points for futures

Changes when contract changesChanges when contract changes

BasisBasis

Reflects futures delivery costs/risksReflects futures delivery costs/risksReflects storage costs sometimes -- Reflects storage costs sometimes --

in carrying charge marketsin carrying charge marketsReflects difference in current vs Reflects difference in current vs

expected price over time prior to expected price over time prior to contract expiration (especially contract expiration (especially livestock with seasonal P swings)livestock with seasonal P swings)

BasisBasis

If basis is predictable when If basis is predictable when commodity will be bought or sold, can commodity will be bought or sold, can accurately translate futures you sell accurately translate futures you sell today into net cash price you expect.today into net cash price you expect.

Basis variation is usually a lot less Basis variation is usually a lot less than cash price variation, so hedging than cash price variation, so hedging is less risky.is less risky.

BasisBasis

Gross return to hedged storage =Gross return to hedged storage =change in basischange in basis

Today’s basis versus July futuresToday’s basis versus July futuresminus June basis = payment for minus June basis = payment for storage storage 30 under minus 10 under=30 under minus 10 under=20 cents/bu to cover costs20 cents/bu to cover costs

Useful HintsUseful Hints

Critical in determining cash price Critical in determining cash price expected w/r/t any futures priceexpected w/r/t any futures price

Unusually wide basis -- hold cashUnusually wide basis -- hold cashUnusually narrow basis -- sell cashUnusually narrow basis -- sell cashCompare with forward contract Compare with forward contract

basis to determine whether it’s a basis to determine whether it’s a better deal than hedgingbetter deal than hedging

Basis-how to get itBasis-how to get it

Need cash prices at your market outlet Need cash prices at your market outlet for several years or morefor several years or more

Need nearby futures prices for same Need nearby futures prices for same time period from brokers, exchanges, time period from brokers, exchanges, etc.etc.

Sometimes basis history from Sometimes basis history from university extension can be adjusted university extension can be adjusted to local conditionsto local conditions

Short HedgeShort Hedge(Selling Hedge)(Selling Hedge)

Intends to sell cash (Physical) Intends to sell cash (Physical) commodity in the future.commodity in the future.

Initiates a short futures position as Initiates a short futures position as a temporary substitute for a later a temporary substitute for a later cash market sale.cash market sale.

Price risk = basis change vs. what’s Price risk = basis change vs. what’s expected.expected.

Short Hedging MechanicsShort Hedging Mechanics

Cash MarketCash Market Futures Futures Market Market TransactionsTransactions TransactionsTransactions

NowNow SELLSELL

LaterLater SELLSELL BUYBUY

Short Hedging Example:Short Hedging Example:

Want to lock in a price for Nov. delivery.Want to lock in a price for Nov. delivery.Cash MarketCash Market Futures Market Futures Market Transactions Transactions Transactions Transactions

MayMay Not Not Short Dec. Corn Short Dec. CornHarvested YetHarvested Yet $2.80 (Basis -.20) $2.80 (Basis -.20)

Later Sell Corn locally Buy Dec. CornLater Sell Corn locally Buy Dec. Corn $2.00 $2.20$2.00 $2.20

Expected Hedge PayoffExpected Hedge Payoff

Expected net price =Expected net price =Futures price Futures price plus basis plus basis (equals expected (equals expected

cash price)cash price)minus commission (if sale)minus commission (if sale)plus commission plus commission (if purchase)(if purchase)

Actual Hedge PayoffActual Hedge Payoff

Net price equalsNet price equalsCash priceCash price

plus/minus futures gain/lossplus/minus futures gain/loss

plus/minus commissionplus/minus commission

(determine whether each is going into (determine whether each is going into or out of your pocket to get correct or out of your pocket to get correct signs)signs)

Which contract to use?Which contract to use?

Typically, the contract closest to Typically, the contract closest to and ahead of cash market actionsand ahead of cash market actionse.g. December contract for e.g. December contract for November feeder cattle saleNovember feeder cattle sale

Cash and nearby futures will be Cash and nearby futures will be most closely related, so basis is most closely related, so basis is more predictablemore predictable

Which contract to useWhich contract to use

If nearby contract isn’t used, subject If nearby contract isn’t used, subject to much greater riskto much greater risk

Spread risk may benefit you if prices Spread risk may benefit you if prices are temporarily out of line, and move are temporarily out of line, and move favorablyfavorably

Spread risk can be a killer-- e.g. Spread risk can be a killer-- e.g. hedging new crop(s) in old crop hedging new crop(s) in old crop futures in short crop yearfutures in short crop year


Exceptions-- when spread favors a Exceptions-- when spread favors a different contract, or expected nearby different contract, or expected nearby contract is not trading enough volumecontract is not trading enough volumee.g. October-December difference e.g. October-December difference

unusually favorable for Octoberunusually favorable for OctoberMay temporarily hedge in other May temporarily hedge in other

month, and shift later (involves spread month, and shift later (involves spread and basis risk)and basis risk)

Short HedgeShort Hedge

Determine expected cash priceDetermine expected cash priceFutures price in appropriate Futures price in appropriate

contract plus/minus typical basiscontract plus/minus typical basisIf attractive expected price, take If attractive expected price, take

futures position to establish futures position to establish approximate selling price later in approximate selling price later in cash marketcash market

Short Hedging Example:Short Hedging Example:

Want to lock in a price for Nov. delivery.Want to lock in a price for Nov. delivery.Cash MarketCash Market Futures Market Futures Market Transactions Transactions TransactionsTransactions

MayMay Sell Dec. FC @ Sell Dec. FC @ $80 (Basis=0)$80 (Basis=0)

Nov Sell cattle Nov Sell cattle Buy Dec. FC Buy Dec. FC $75 $75$75 $75

Hedge resulltsHedge resullts

Expected cash price = $80 per 100 Expected cash price = $80 per 100 lbs.__________________________lbs.__________________________Sell cash cattle at Sell cash cattle at $75$75Futures gainFutures gain 5 5CommissionCommission -.02-.02

Net sale priceNet sale price $79.98 $79.98

Basis changeBasis change

If basis narrows vs. expectedIf basis narrows vs. expectedGood for shorts, bad for longsGood for shorts, bad for longs

If basis widens vs. expectedIf basis widens vs. expectedBad for shorts, good for longsBad for shorts, good for longs

Long Hedge ExampleLong Hedge Example

Cash Market Futures MarketCash Market Futures MarketNowNowLaterLater

Cash Price Received:Cash Price Received:Futures Profit/Loss:Futures Profit/Loss:Commission:Commission:Net Price:Net Price:

Grain storage hedgesGrain storage hedges

Establish storage returns using:Establish storage returns using:deferred futures deferred futures - - basis (= expected cash basis (= expected cash price)price)-- current cash pricecurrent cash price-- storage costs (interest, storage costs (interest, shrink, shrink, handling, drying)handling, drying)-- commission commission== net returnnet return

Storage hedge problemStorage hedge problemCalculate storage gain/lossCalculate storage gain/loss

Current May corn futures $2.86Current May corn futures $2.86October cash price $2.54October cash price $2.54Expected basis -.15 [+ or - .03]Expected basis -.15 [+ or - .03]Interest rate 10% annual rateInterest rate 10% annual rateShrink 1%, other extra costs $.04Shrink 1%, other extra costs $.04Commission $.01/bu.Commission $.01/bu.

Storage expected resultStorage expected result

$2.86 $2.86 - .15 basis- .15 basis-.01*2.71 shrink-.01*2.71 shrink- (.10*7/12*2.54) value of early pay- (.10*7/12*2.54) value of early pay-.01 commission-.01 commission-.04 handling cost-.04 handling cost= 2.48 if hedged vs 2.54 today= 2.48 if hedged vs 2.54 today

Storage hedge actual resultStorage hedge actual result

Cash price $2.38Cash price $2.38plus futures gain .33 (2.86 - 2.53)plus futures gain .33 (2.86 - 2.53)minus commission .01minus commission .01minus other costs .04minus other costs .04minus interest .15minus interest .15shrink .03shrink .03= $2.48 October equivalent price= $2.48 October equivalent price

More complicated hedgesMore complicated hedges

Fed cattle margin hedge, using fed Fed cattle margin hedge, using fed cattle, feeder cattle, corn futurescattle, feeder cattle, corn futures

Soybean crush margin hedge, using Soybean crush margin hedge, using soybean, oil, meal futures.soybean, oil, meal futures.

Hedging considerationsHedging considerations

Are there disadvantages to hedging?Are there disadvantages to hedging?margin calls and costsmargin calls and costslost opportunitieslost opportunitiesquantity riskquantity riskbasis riskbasis riskbroker commission, broker commission,

Tax ConsiderationsTax Considerations

HedgeHedgeindividuals - ordinary income, no limitsindividuals - ordinary income, no limitscorporations - no limitscorporations - no limits

SpeculationSpeculationcapital gain or loss capital gain or loss $3,000 loss limit per year for individuals$3,000 loss limit per year for individuals

Hedging examplesHedging examples

What futures position should I take if What futures position should I take if I want to hedge:I want to hedge: to establish a selling price for to establish a selling price for

corn at harvest?corn at harvest?to protect against a price decline on to protect against a price decline on

corn in storage?corn in storage?three years’ crops at today’s high three years’ crops at today’s high

pricesprices


to fix a margin for a cattle feeding to fix a margin for a cattle feeding operation when use own corn?operation when use own corn?

to establish a to establish a merchandising/storage margin for merchandising/storage margin for corn your elevator is buying today?corn your elevator is buying today?

to establish a purchase price for to establish a purchase price for soybean meal for six months in the soybean meal for six months in the future?future?


elevator manager establish a elevator manager establish a purchase price on a price later corn purchase price on a price later corn contract purchase she just sold to contract purchase she just sold to ADMADM

to hedge hams you will buy for to hedge hams you will buy for Christmas sales (fixed, formula P?)Christmas sales (fixed, formula P?)

to hedge Pioneer’s seed corn to hedge Pioneer’s seed corn purchases from contract growerspurchases from contract growers


To set up a forward purchase To set up a forward purchase contract with farmers at the local contract with farmers at the local grain elevatorgrain elevator

To set up a forward contract with To set up a forward contract with hog suppliers to IBPhog suppliers to IBP

To set up a basis contract for To set up a basis contract for farmers at the local grain elevatorfarmers at the local grain elevator


Exceptions-- when spread favors a Exceptions-- when spread favors a different contract, or nearby is not different contract, or nearby is not trading yettrading yete.g. March-July unusually narrow or e.g. March-July unusually narrow or

widewideMay temporarily hedge in another, May temporarily hedge in another,

and shift later (somewhat and shift later (somewhat speculative)speculative)

New innovationsNew innovations

Contract changes--examples:Contract changes--examples:Lean hog, boneless beef, stocker cattle, Lean hog, boneless beef, stocker cattle,

weather, milk, butter, cheese, nonfat weather, milk, butter, cheese, nonfat dry milk, wheydry milk, whey

Some mini-contractsSome mini-contractsElectricity, crude oil, Electricity, crude oil, Delivery changes--soybeans, cornDelivery changes--soybeans, corn


Cash settlement--volume wtd. 3 area Cash settlement--volume wtd. 3 area average of two days USDA price average of two days USDA price reports -- 9th and 10th business reports -- 9th and 10th business days of monthdays of month

Closes after 10 days in delivery Closes after 10 days in delivery monthmonth


New delivery points--CBOT grains New delivery points--CBOT grains and soybeans --not in Chicago!!and soybeans --not in Chicago!!

New contracts--boneless beef, New contracts--boneless beef, butter, cheese, nonfat dry milk, butter, cheese, nonfat dry milk, broilersbroilers


Electronic tradingElectronic tradingnights--CME and CBOTnights--CME and CBOTmany European exchanges with many European exchanges with

electronic trading taking overelectronic trading taking over

Will open outcry system continue?Will open outcry system continue?


Offers more marketing alternativesOffers more marketing alternativesCan transfer risk Can transfer risk Can improve or reduce returnsCan improve or reduce returnsImpacts many forward contracts, Impacts many forward contracts,

since that is how contractor often since that is how contractor often shifts riskshifts risk


Results often considered “bad” by Results often considered “bad” by farmers farmers

5 - 25% of producers use futures, 5 - 25% of producers use futures, and then only sometimesand then only sometimesWHY??WHY??

Factors InfluencingFactors Influencing Forward Positions Forward Positions

Price expectations versus current Price expectations versus current prices available--likelihood of this prices available--likelihood of this position being advantageousposition being advantageous

Ability to withstand possible Ability to withstand possible adversities associated with taking or adversities associated with taking or not taking a market positionnot taking a market positionWhat are the factors which you What are the factors which you

should consider?should consider?

Forward position Forward position influencesinfluences

Diversification;offsetting risks?Diversification;offsetting risks?Crop yield or revenue insuranceCrop yield or revenue insuranceQuantity risk Quantity risk Costs of cash flow shortageCosts of cash flow shortageHow well objectives would be metHow well objectives would be metEvaluate tradeoffs; determine Evaluate tradeoffs; determine NETNET

benefit perceivedbenefit perceived

hedge overview

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