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Marketing Tactics in Volatile Times. Matthew Diersen, Ph.D. Department of Economics South Dakota State University May 6 & 8, 2008. Outline. General observations Volatility discussion Wheat strategies Synthetic puts Cattle strategies Timing price & risk. What Has Changed.
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Marketing Tactics in Volatile Times Matthew Diersen, Ph.D. Department of Economics South Dakota State University May 6 & 8, 2008
Outline • General observations • Volatility discussion • Wheat strategies • Synthetic puts • Cattle strategies • Timing price & risk
What Has Changed • Disruptions have occurred • Question rural legends about marketing • Ability to price like never before • Fundamental drivers • Speculative forces • Need to deal with credible partners
Marketing Plans • One plan per enterprise • Get a handle on the big picture • High stakes mean: • more to keep track of • more room for error • Evaluation more important than ever • Understand what did not work • Contingency plans important
Pricing • Know what you are trying to “beat” • Lock in “high enough” up-front profit • Pull trigger after prices move favorably • Reduce transaction costs • Done with: • Handshakes to forward contracts • Futures contracts
Protection • Already realize profits • Want to get higher returns • Want to guard against wrecks • Cover yourself prudently • Done with: • Options contracts • Insurance contracts
Buying Options • A put option is the right, but not the obligation, to sell a futures contract • Cost is paid up front • $/cwt quoted times the cwt of the contract • Premium made up of following parts • Intrinsic value (strike-futures) • Time value (interest) • Volatility in futures price (biggest driver today) • A call option is the right, but not the obligation, to buy a futures contract
Money Talk • In-the-money put • Strike price is above the futures price • Implies a positive intrinsic value • Will cost the most • At-the-money put • Strike price is near the futures price • May be closest-to the futures price • Out-of-the-money put • Strike price is below the futures price
Wheat Tactics for Today • Winter wheat • Know your insurance • Cover sales by buying calls • Buy put options • Spring wheat • Forward contract prudent % • Buy put options • Sell futures & buy OTM calls
Crop Insurance • Often buy Crop Revenue Coverage (CRC) • Futures have exceeded upper limit • Hedge losses could greatly exceed indemnity • Can be managed with call options • Risk Calculator • Available at http://econ.sdstate.edu/ • What level can be prudently hedged?
Pricing and Protecting Wheat • Rely heavily on KC, MPLS markets • Better hedging performance • Work with lender on margin account • Margin costs are higher • Worst-case returns likely low given: • Low loan rate • Increased production costs • Inadequate insurance • Prices have some support from corn (feed)
Basis Risk & Storage • Highlights local conditions • Transportation concerns • Price convergence still probable • Crop insurance of no help • Weigh basis improvement against carry • Tough to store with inverted markets • Monitor interest opportunity cost • Some research supports some “speculative” storage behavior
Before: forward contracted winter wheat for $9.00 Now: buy KC Sep $9.00 call for $0.75 Contract 9.00 - Premium - 0.75 +/- Basis n/a = Floor 8.25 * No ceiling * Now: sell MPLS wheat futures for $9.00 Now: buy MPLS Sep $11.00 call for $0.40 Futures 9.00 - Premium - 0.40 +/- Basis - 0.80 = Floor 7.80 * No ceiling * Cover by Buying Calls
CHANGE IN BEEF COW NUMBERSJANUARY 1, 2007 TO JANUARY 1, 2008(1000 Head) Alaska Hawaii US Total Livestock Marketing Information Center Data Source: USDA/NASS
Feeder Cattle Tactics for Today • Sell futures or forward contract • Know the relevant basis • Buy put options • Buy Livestock Risk Protection • Build wide fences
Feeder Cattle Contracts • Contract is for 50,000 pounds of steers • Contract months: January, March, April, May, August, September, October, and November • Futures settle on the last Thursday of the contract month (except November) • Cash settled to the CME Feeder Cattle Index • 650-849 lbs Medium and Large #1, #1-2
High Corn Volatility Seasonal Price Increase Livestock Marketing Information Center
Buy a Put Oct Feeder Cattle trade at $110: Out At In Strike 104 110 114 - Premium - 3 - 5 - 9 +/- Basis + 8+ 10+12 = Floor 109 115 117
LRP vs. Other Tools • LRP has Price Adjustment Factors • Fixed percent up front and at settlement • For Steer calves: 110% • Forward contracts likely give the best basis • Synthetic put strategies need broker’s help • LPR designed for spot sales in final 30 days of coverage (transferable on earlier sales)
Typical Marketing Plan Cow-calf producer with 140 steers & 100 heifers to sell on October 15, 2008 • Buy 2 Oct puts (200 head), 108 strike, for $3.00 per cwt. or better • Buy LRP on 40 steers if floor exceeds $115 and cost is $4.00 per cwt. or better • Sell 1 Oct futures (100 head) if $115 or better (assume $10 cwt. basis)
For More Information • Commodity Exchanges • CME, MGEX, KCBOT • USDA’s Risk Management Agency • http://www.rma.usda.gov/ • SDSU Department of Economics • http://econ.sdstate.edu/ • Extension / Current Market Analysis • FS 929 – Writing a Commodity Marketing Plan • ExEx 5055 – How to Capture High Calf Prices
Some Thoughts • “Put all your eggs in one basket, then watch that basket.” – Mark Twain • Active risk management means doing things 1) when prices are high, 2) when volatility is low, and 3) before its too late