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Studies in Agriculture

Learn about risk management strategies, agricultural futures, hedging, basis, and options in the agriculture sector. Understand key concepts, mitigate risks, and set yourself up for success in agribusiness. Join the class now!

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Studies in Agriculture

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  1. Studies in Agriculture SAB – 103 Wednesday: 7.00 pm – 8.40 pm Fall 2016 Instructor: Sankalp Sharma Email: ssharma3@unl.edu

  2. Who am I?

  3. A word on my teaching philosophy

  4. About this class • In class expectation • Out of class expectation • Homework • Grading

  5. In-class Expectation • Key to learning: interaction • Review previous class’ notes before class (same file will be updated) • Attend all classes (cannot emphasize enough) Ask questions… But don’t be a troll! No cellphones or laptops during the class !!

  6. Out-of-class Expectation • No gains without practice. • Reading not enough, you must practice problems. • Form groups to practice. • Understand concept, memorization won’t help you.

  7. Homework • Frequently assigned. • Usually only one question. • A random student will be asked to solve the HW on the board.

  8. Grading • Exams will be long and difficult. • Everything taught in class is fair game. • But grading will be easy. • 40% midterm, 40% final, 20% HW, (bonus: 20% class interaction)

  9. Questions?

  10. The Road Map Ahead • Understanding the nature of risk • What is risk management • Introduction to agricultural futures and forwards markets • Hedging Risk using Futures Markets • Introduction to Basis • Hedging with Basis • Discussion on Options

  11. Understanding the nature of risk • What is risk? • What is uncertainty? • What is the difference between the two? • Types of risk • What is risk management? - Types of risk management strategies.

  12. What is risk management? • Strategies available to negate risk: • Good on-farm practices • Foward Contracts • Futures Contracts • Options • Hedging

  13. Introduction to agricultural futures and forwards markets • What is a forward contract? • What is a futures contract? • What is the difference between the two? • Brief History of Futures market. • Mechanics • Futures prices • Futures market participation • Price risk

  14. Hedging Risk Using Futures Markets - Understanding the core concept - Margins - Local vs Futures Market - Hedging Local Market Price Risk - Offsetting price risk

  15. Basis • Introduction • What do we mean by “basis” • Basis risk

  16. Options • Types of options • Options positions • Underlying assets • Trading • Margins

  17. But today let’s begin with…

  18. Risk - So what do we mean by “risk” in agriculture?

  19. How is risk different from Uncertainty?

  20. How is risk different from Uncertainty? - You can assign a “probability”, there is prior information - Uncertainty, no prior information.

  21. For our purposes, we will focus only on risk

  22. Types of risk - Poor on-farm practices - Limited market information - Yield risk through weather (drought, hail, excess rainfall) - Price risk (including input price risk)

  23. What can be done to mitigate said “risk”? “Mitigate” risk  Also defined as risk management. - Crop insurance - Market options (hedging, futures and forward market) - Government programs (such as the Conservation Reserve Program)

  24. What causes people to manage risk? - Because people are reluctant to take gambles - People care about “losses” more than they care about “winning”. - This behavior is known as “risk aversion”.

  25. Introduction to Agricultural Futures Markets • Futures markets for commodities have been an important method for agricultural producers to hedge revenue risk, which can be very high. Reasons to hedge: • They may have to face fluctuations in demand for their goods. • Risky events that can substantially affect their output. • Both of the above can affect output prices. • By allowing producers to “lock in” a price far in advance, futures markets can be used to remove the risk of fluctuating and unknown sale prices.

  26. Basic Intuition: Futures markets • You are a commodity producer, which you will harvest in the future. • Long-story-short, you don’t want to lose money on it. • Find somebody with whom you can lock in “contract”. • Somebody with whom you can agree upon a price and quantity.

  27. Brief history of agricultural futures markets A futures market is a designated location used to assist agribusiness and farmers discover prospective prices for a commodity. Agricultural markets appeared in mid 1800s. • Chicago Board of Trade – 1848 • Chicago Mercantile Exchange (1874). Formally, known as the “Chicago Egg and Butter Board”. • First Corn futures contract written in 1851.

  28. Why did markets come about? • Transportation distances increased, causing higher price volatility followed. • No central information source. • No standardized trading rules and methods.

  29. Futures Markets • They are used to create and trade futures contracts between a buyer and seller of a commodity. • Futures contract are a statement signifying a promise between a seller and a buyer (two sides are required to trade).

  30. What does a futures contract look like? • An obligation of the seller to deliver a commodity to a specified point-of-delivery at a future time. • An obligation of the buyer to pay a fixed price and pick up the commodity at the pre-specified point-of-delivery. • An expiration date (time of delivery). • Remember, futures contracts can be traded by a trader who has no position in the actual physical or cash commodity.

  31. Examples: Commodities Examples include: - Corn - Wheat - Cocoa - Live cattle - Feeder Cattle

  32. Examples: General • Natural Gas • US Dollars • US Treasury Bond

  33. Commodity futures markets – contract price info: Chicago Board of Trade http://www.cmegroup.com/trading/commodities/ Minneapolis Grain Exchange (dark northern spring wheat) http://www.mgex.com/ Kansas City Board of Trade (hard red winter wheat) http://www.kcbt.com/ Wall Street Journal - Market Data http://online.wsj.com/mdc/public/page/marketsdata.html

  34. Futures Contracts • Futures contract provide a very structured and standardized method for buyers and sellers to determine the terms of an exchange. • Each futures contract is exactly the same except for the price of exchange established by the buyer and seller.

  35. Futures Contracts: The following describe the standardizations that exist in each futures contract: • Measures: - 5000 bushels: Corn, Wheat, Soybeans, etc. - 40,000 lbs live cattle. - 50,000 lbs feeder cattle.

  36. Futures Contracts 2) Quality: (say for Wheat) #2 Soft Red Winter (SRW) – CBOT #2 Hard Red Winter (HRW) – KCBT (Kansas City Board of Trade) #2 Hard Red Spring (HRS) – MGX (Minnesota Grain Exchange) 3) Delivery Location: For Example: Chicago and Burns Harbor, Indiana

  37. Futures Contracts 4) Contract end date: - 15th day in the contract month. - Last day of the contract month  Live cattle - Last Thursday of the contract month  Feeder cattle 5) Pricing units - Cents per bushel (tick: 0.25 cents) - Cents per pound (tick: 0.0025 cents per pound)

  38. Brief tangent to understand the difference between: Futures and Forward Contract • A futures contract is standardized. • A forward contract works exactly the same way, except it is not standardized. • It is a privately negotiated contract for a transaction that occurs in the future.

  39. Sample Futures Contract: Commodity Commodity: Crop Quantity: 5000 bushels Quality: #2 Yellow at contract price Delivery Location: Lockport-Seneca.

  40. Sample Futures Contract: Cattle Cattle: Live Quantity: 40,000 pounds Quality: 55% choice, 45% select, Yield grade 3 live steers. Delivery Location: - Approved slaughter plant corresponding to the stockyards, the cattle are at. - Approved slaughter plant within 200 miles of the feedlot from which the cattle originate.

  41. But what is a Cash-Market? - Prices offered or received via private negotiations between two parties, may be an elevator, grain merchandiser, etc.

  42. A word on Prices • Prices in the futures markets, unlike cash (spot) markets, are limited as to the daily price movements. • Price movement limits attempt to prevent panicked trading and lessen the likelihood of a market crash • Price movements also include minimum price movements, referred to as a “tick” - A tick is the smallest price change allowed by the exchange that may occur from one price to another - For example, the minimum tick for Chicago corn is ¼ cent per bushel - So, if corn last traded at $2.32 / bushel, the minimum price change that may be traded is 2.32 ¼ or 2.31 ¾

  43. Purchasing a Futures Contract. (Extremely important that you understand this!) Every contract requires two parties: A seller and a buyer

  44. Who is a Seller? • A party that promises to deliver the designated quantity of a commodity. Selling a contract is known as taking a short position. If the delivery date comes and the seller can’t deliver, they are short of the commodity.

  45. Who is a Buyer? • A party that promises to take delivery of a specified quantity of commodity. • In exchange, they will pay a fixed price. Buying a contract is known as taking a long position. If delivery date comes and the buyer has a commodity they may not want (or too much of it), they are long in the commodity.

  46. Offsetting Contracts • Typically, only few contracts have sellers and buyers who can actually deliver or take on a commodity. • Instead of delivering or taking on a commodity, a party can offset a short or long position by purchasing an opposite contract. Short position  offset by buying a contract (long position). Long position  offset by selling a contract (short position).

  47. Offsetting Contracts • Offsetting releases an individual from the responsibility of either buying or selling a contract. • The only obligation that the individual is required to meet is any difference in the price of the two contracts. • For example, if one contract was bought at $5.00/bu and another was sold at $4.50/bu, the individual would be responsible to pay $0.50/bu (more on this later).

  48. Homework 1 - Emperor Palpatine has 3 futures contract for the following commodities. His positions at the beginning of the contract were: 1) He sold 1 Corn Futures contract at $4.00/bu 2) He sold 1 SR Wheat Futures contract at $5.60/bu 3) He bought 1 HR Wheat Futures contract at $4.70/bu

  49. Homework 1: Continued - Tell me, how should he should offset his positions for each of the contracts above, given that the price now of corn and SR wheat futures contract is $5.00/bu and the price of HR Wheat futures is $5.50/bu?

  50. Next class….

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