Managing Agricultural Price Risk

1. Managing Agricultural Price Risk

2. Types of Price Risk • Year-to-year price cycles • Within year price patterns • Basis risk (local cash price vs. futures)

3. Iowa Yearly Average Cash Prices

4. Daily Soybean Prices

5. Daily Corn Prices

6. Commodity Prices • Cash or spot price: Price received when a commodity is sold locally. • Forward contract price: Price received for selling a commodity locally at a future date. • Futures price: Price at which a contract for a specific commodity and delivery date is sold, on a futures market exchange. • Example: Dec. corn or March soybeans @ CBOT • Basis = difference between cash & futures

7. Basis Risk for Corn--2005

8. Pricing Tools • Sell cash • Forward contract • Hedge by selling a futures contract • Buy PUT options

9. Sell on the Cash Market • Try to guess when the highest price will occur • Sell when you need the cash • Sell a little bit throughout the year • Sell when price reaches a target, or by a certain date

10. Forward Contracts • Fixed price contract for a set delivery location, date, quantity and quality • Example: sell 3100 bu. yellow soybeans at $6.20 for delivery to Roland Co-op by November 1 • Contracts can be: • Preharvest (production unknown) • Post-harvest (production known) • Local elevator resells on the futures mkt.

11. Forward Contract Advantages • Lock in a sure price (but give up a gain if the prices increases later) • No broker or fees • Can contract any number of bushels

12. Sell with a Futures Contract(Hedge) 1. Sell with a futures contract through a commodity exchange 2. When you are ready to sell the commodity, buy back the contract 3. Sell on the local cash mkt. 4. Change in the cash market is offset by the change in the futures market

13. Example (price declines) * Sell corn futures contract in June @ $3.60 per bushel • 4 months later, market has declined • Buy back futures contract at $3.30 for a gain of $.25 • Sell for cash price of $3.00 • Net price is $3.00 + .25 = $3.25

14. Example (price increases) * Sell futures contract for $3.60 • 4 months later, market has risen • Buy back futures contract at $4.00 for a loss of $.40 • Sell for cash price of $3.70 • Net price is $3.70 - .45 = $3.25

15. Hedging Advantages • Give up a gain if the market rises in order to avoid a loss if the market declines • Hedges can be lifted early (unlike a forward contract) • Grain can be sold anywhere on any date • However, futures contracts are for a fixed quantity (5000 bu. on CBOT)

16. Basis Risk • Basis is the difference between the futures price and the cash price • Futures and cash trend together, but not exactly • Gain or loss on futures contract may not exactly offset the fall or rise of the cash price • Basis will vary (basis risk) less than the cash price varies, though

17. Hedging vs. Speculation • Hedging is owning both the actual commodity and a futures contract • Speculation is owning only a futures contract • Storing unpriced grain is also speculation

18. PUT Options • Right to sell a futures contract at a set price (strike price) • Cost of buying a PUT is the premium • If the futures market moves up or down, the PUT premium will move in the opposite directly • Premium cannot go below zero

19. Futures Price and PUTs

20. Using a PUT Option to set a minimum price • Buy a PUT option • Later-sell the cash commodity, sell the PUT • If the market moves down, the value of the PUT moves up by about the same value • If the market moves up, the value of the PUT moves down, but can’t go below $.00 • Losses are limited, gains are not.

21. Example: Buy a PUT • Cash price is at $2.80 (corn) • Futures market is at $3.20 • Buy a PUT for a $3.50 for a premium of $.30

22. Futures declines $.60 to $2.60, cash to $2.20 PUT value goes up by $.60 to $.90. Net price is: Cash price $2.20 +PUT value .90 orig.premium .30 =net price $2.80 Futures increases $.50 to $3.70and cash to $3.30 PUT value goes down, but only to $.00 Net price is: Cash price $3.30 +PUT value .00 orig.premium .30 = net price $3.00 Example: PUT Options

23. PUT Options • Establish a minimum price (except for basis variation) • Can still benefit from higher prices • May lose the original premium (at most)

24. CALL Options • Right to buy a futures contract • Premiums for CALLS move in the same direction as the futures price • Protects the buyer of a commodity against a price increase

25. Remember! • PUTs move opposite the market. • CALLs move with the market.

26. USDA Commodity Programs • All major farm crops (and milk) • Administered by the Farm Service Agency (FSA) • Combination of subsidy and price risk protection

27. Direct Payments • Based on historical acres and yields, not current production. • Paid twice a year. • About $15 - 30 per acre in Iowa

28. Loan Deficiency Payments (LDPs) • Each county has a Loan Rate, which is fixed by the USDA, for each grain • Each county has a Posted County Price (PCP), which varies daily. It is roughly equal to the local cash price • When the PCP is below the loan rate, the LDP is equal to the difference • Paid on bushels actually produced

29. LDP Example • A farmer in Adair Co. raises 15,000 bu. of soybeans • The Loan Rate is $5.13 • The PCP on Nov. 1 is $4.80 • Farmer can receive a payment of $.33/bu ($5.13 - $4.80) x 15,000 = $12,450 • Can request payment anytime after harvest, until grain is sold (or May 31)

30. USDA Marketing Loan • Farmer can take out a marketing loan instead of applying for an LDP • Loan = county loan rate x bushels stored • If the market price is lower than the loan rate, repay market price x bushels stored • Farmer keeps the difference between the loan rate and the market price

31. Counter Cyclical Payment--CCP • If the national average selling price for a crop for 12 months after harvest is below the trigger price, a CCP is paid. • Trigger prices: corn $2.35 soybeans $5.36 wheat $3.40 • Paid on 85% of historical production, not current bushels. • No decisions to make.

32. Dairy LDP • If monthly milk price is below the target price ($16 in Boston), farmer is paid 40% of the difference.

33. Revenue Insurance for Livestock(Livestock Risk Protection—LRP) • Available for hogs, feeder cattle and fed cattle • Based on futures prices on the Chicago Mercantile Exchange (CME) • Can buy guarantees of 70% to 95% of the futures price each day • Specify no. to sell, weight and date

34. LRP • “Actual” revenue is based on quantity insured and closing futures price on projected date of sale. • If actual revenue is below the guarantee a payment is made for the difference. • Another product called LGM also includes feed prices (corn and soybean meal)

35. LRP • Advantages vs. PUT options: • Can insure any quantity • No broker’s fees • Disadvantages • May not sell on the specified date • Local price may not match futures price • No. and weight sold may not match plan • Do not insure production risks