Hedge

Hedge overview
overview

 Futures provide additional

marketing alternatives
 Can transfer price risk
 Can establish approximate price
levels in advance of cash market
transactions
 Hedging
Hedging

 What are the basics you need to

know to be a effective hedger in
futures?
Volume cash commodity
Current futures prices
Relevant basis
Current basis vs. history
 Assignment
Assignment

Find the current basis for a

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

 In long run, can futures hedge

improve returns? Will it?
 In short run, can it reduce risk, or
improve returns?
 What’s your objective?
 Hedging
Hedging

 What should be your criteria for

success in hedging?
Achieving approximate
expected cash price =
futures + expected basis

Making the maximum profit?

 Hedging
Hedging

 Initiation of a position in the futures

market that is intended as a
temporary substitute for the sale or
purchase of the actual commodity
at a later date.
 Hedging
Hedging

 Use of futures markets to lock-in a

purchase or selling price now, even
though the physical purchase or
sale won’t occur until later.
 Usually bushel-bushel or pound-
pound hedge, though optimum
hedge may be slightly less for grain
 Necessary
Necessary conditions
conditions

 Cash price must move in parallel

1 : 1 or in fixed ratio e.g. 1.5 : 1
to futures price when futures are converted
to cash positions
want to have gains in one market offset in
the other market, so expected cash price will
be achieved
 Hedge
Hedge ratio
ratio

 Hedge 1 unit cash product in 1 unit

futures if prices move 1:1

 Hedge appropriate ratio if cash prices

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

FUTURES

CASH

TIME
 Futures/Hedging
Futures/Hedging
Terminology
Terminology
 Nearby contract--the contract
expiring soon after the cash market
transaction
 Spread--difference in prices in two
contract months
 Rollover--shifting futures position
from one contract month to another
contract month (Feb to April)
 Basis
Basis

 Cash - Futures Price Difference

Usually expressed as so much over or

under futures
[Cash P - Futures P = Basis]
for a specific contract month;
reflects location and product quality
differences and time of delivery
 Basis
Basis

 Cash - Futures Price Differences

Reflects local S & D versus

delivery point S & D
Reflects transfer costs between
local market and delivery or cash
settlement points for futures
Changes when contract changes
 Basis
Basis

 Reflects futures delivery costs/risks

 Reflects storage costs sometimes --

in carrying charge markets
 Reflects difference in current vs
expected price over time prior to
contract expiration (especially
livestock with seasonal P swings)
 Basis
Basis

 If basis is predictable when

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

 Basis variation is usually a lot less

than cash price variation, so hedging
is less risky.
 Basis
Basis
Gross return to hedged storage =
change in basis

Today’s basis versus July futures

minus June basis = payment for
storage
30 under minus 10 under=
20 cents/bu to cover costs
 Useful
Useful Hints
Hints

 Critical in determining cash price

expected w/r/t any futures price
 Unusually wide basis -- hold cash
 Unusually narrow basis -- sell cash
 Compare with forward contract
basis to determine whether it’s a
better deal than hedging
 Basis-how
Basis-how to
to get
get itit

 Need cash prices at your market outlet

for several years or more
 Need nearby futures prices for same
time period from brokers, exchanges,
etc.
 Sometimes basis history from
university extension can be adjusted
to local conditions
 Short
Short Hedge
Hedge
(Selling
(Selling Hedge)
Hedge)
 Intends to sell cash (Physical)
commodity in the future.
 Initiates a short futures position as
a temporary substitute for a later
cash market sale.
 Price risk = basis change vs. what’s
expected.
 Short
Short Hedging
Hedging Mechanics
Mechanics

Cash Market Futures Market

Transactions
Transactions
Now SELL

Later SELL BUY

 Short
Short Hedging
Hedging Example:
Example:

Want to lock in a price for Nov. delivery.

Cash Market Futures Market
Transactions
Transactions
May Not Short Dec. Corn
Harvested Yet $2.80 (Basis -.20)
Later Sell Corn locally Buy Dec. Corn
$2.00 $2.20
 Expected
Expected Hedge
Hedge Payoff
Payoff

 Expected net price =

Futures price
plus basis (equals expected
cash price)
minus commission (if sale)
plus commission (if purchase)
 Actual
Actual Hedge
Hedge Payoff
Payoff

Net price equals

Cash price
plus/minus futures gain/loss
plus/minus commission
(determine whether each is going into
or out of your pocket to get correct
signs)
 Which
Which contract
contract to
to use?
use?

 Typically, the contract closest to

and ahead of cash market actions
e.g. December contract for
November feeder cattle sale
 Cash and nearby futures will be
most closely related, so basis is
more predictable
 Which
Which contract
contract to
to use
use

 If nearby contract isn’t used, subject

to much greater risk
 Spread risk may benefit you if prices
are temporarily out of line, and move
favorably
 Spread risk can be a killer-- e.g.
hedging new crop(s) in old crop
futures in short crop year
 Which
Which contract
contract to
to use?
use?

 Exceptions-- when spread favors a

different contract, or expected nearby
contract is not trading enough volume
e.g. October-December difference
unusually favorable for October
May temporarily hedge in other
month, and shift later (involves spread
and basis risk)
 Short
Short Hedge
Hedge

 Determine expected cash price

Futures price in appropriate
contract plus/minus typical basis
 If attractive expected price, take
futures position to establish
approximate selling price later in
cash market
 Short
Short Hedging
Hedging Example:
Example:

Want to lock in a price for Nov. delivery.

Cash Market Futures Market
Transactions
Transactions
May Sell Dec. FC @
$80 (Basis=0)
Nov Sell cattle Buy Dec. FC
$75 $75
 Hedge
Hedge resullts
resullts

 Expected cash price = $80 per 100

lbs.__________________________
Sell cash cattle at $75
Futures gain 5
Commission -.02
Net sale price
$79.98
 Basis
Basis change
change

 If basis narrows vs. expected

Good for shorts, bad for longs
 If basis widens vs. expected
Bad for shorts, good for longs
 Long
Long Hedge
Hedge Example
Example

Cash Market Futures Market

Now
Later
Cash Price Received:
Futures Profit/Loss:
Commission:
Net Price:
 Grain
Grain storage
storage hedges
hedges

 Establish storage returns using:

deferred futures
- basis (= expected cash price)
- current cash price
- storage costs (interest, shrink,
handling, drying)
- commission
= net return
 Storage
Storage hedge
hedge problem
problem
Calculate
Calculate storage
storage gain/loss
gain/loss
Current May corn futures $2.86
October cash price $2.54
Expected basis -.15 [+ or - .03]
Interest rate 10% annual rate
Shrink 1%, other extra costs $.04
Commission $.01/bu.
 Storage
Storage expected
expected result
result

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

 Cash price $2.38

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

 Fed cattle margin hedge, using fed

cattle, feeder cattle, corn futures
 Soybean crush margin hedge, using
soybean, oil, meal futures.
 Hedging
Hedging considerations
considerations

Are there disadvantages to hedging?

margin calls and costs
lost opportunities
quantity risk
basis risk
broker commission,
 Tax
Tax Considerations
Considerations

 Hedge
individuals - ordinary income, no limits
corporations - no limits

 Speculation
capital gain or loss
$3,000 loss limit per year for individuals
 Hedging
Hedging examples
examples

 What futures position should I take if

I want to hedge:
 to establish a selling price for
corn at harvest?
to protect against a price decline on
corn in storage?
three years’ crops at today’s high
prices
 Hedging
Hedging examples
examples

to fix a margin for a cattle feeding

operation when use own corn?
to establish a
merchandising/storage margin for
corn your elevator is buying today?
to establish a purchase price for
soybean meal for six months in the
future?
 Hedging
Hedging examples
examples

elevator manager establish a

purchase price on a price later corn
contract purchase she just sold to
ADM
to hedge hams you will buy for
Christmas sales (fixed, formula P?)
to hedge Pioneer’s seed corn
purchases from contract growers
 Hedging
Hedging examples
examples

 To set up a forward purchase

contract with farmers at the local
grain elevator
 To set up a forward contract with
hog suppliers to IBP
 To set up a basis contract for
farmers at the local grain elevator
 Which
Which contract
contract to
to use?
use?

 Exceptions-- when spread favors a

different contract, or nearby is not
trading yet
e.g. March-July unusually narrow or
wide
May temporarily hedge in another,
and shift later (somewhat
speculative)
 New
New innovations
innovations

 Contract changes--examples:
 Lean hog, boneless beef, stocker
cattle, weather, milk, butter, cheese,
nonfat dry milk, whey
 Some mini-contracts
 Electricity, crude oil,
 Delivery changes--soybeans, corn
 New
New innovations
innovations

 Cash settlement--volume wtd. 3 area

average of two days USDA price
reports -- 9th and 10th business
days of month
 Closes after 10 days in delivery
month
 New
New innovations
innovations

 New delivery points--CBOT grains

and soybeans --not in Chicago!!
 New contracts--boneless beef,
butter, cheese, nonfat dry milk,
broilers
 New
New innovations
innovations

 Electronic trading
nights--CME and CBOT
many European exchanges with
electronic trading taking over

Will open outcry system continue?

 Hedge
Hedge overview
overview

 Offers more marketing alternatives

 Can transfer risk
 Can improve or reduce returns
 Impacts many forward contracts,
since that is how contractor often
shifts risk
 Hedge
Hedge overview
overview

 Results often considered “bad” by

farmers
 5 - 25% of producers use futures,
and then only sometimes
WHY??
 Factors
Factors Influencing
Influencing
Forward
Forward Positions
Positions
 Price expectations versus current
prices available--likelihood of this
position being advantageous
 Ability to withstand possible
adversities associated with taking or
not taking a market position
What are the factors which you
should consider?
 Forward
Forward position
position
influences
influences
 Diversification;offsetting risks?
 Crop yield or revenue insurance
 Quantity risk
 Costs of cash flow shortage
 How well objectives would be met
 Evaluate tradeoffs; determine NET
benefit perceived