ECON 337: Agricultural Marketing

1. ECON 337: Agricultural Marketing Chad Hart Associate Professor chart@iastate.edu 515-294-9911

2. CME Group • http://www.cmegroup.com/ • Products • Agricultural commodities • Corn, soy, cattle, hogs, etc. • Energy • Currency • Metals • Weather • Others

3. Futures Contracts • A legally binding contract to make or take delivery of the commodity • Trading the promise to do something in the future • You can “offset” your promise • Standardized contract • Form (weight, grade, specifications) • Time (delivery date) • Place (delivery location)

4. Soybean Futures • Form • 5,000 bushels • No. 2 Yellow Soybeans (at price), No. 1 Yellow soybeans (at 6 cents over price), and No. 3 Yellow Soybeans (at 6 cents under price) • Time • Contract months: Sept, Nov, Jan, Mar, May, July, and August Source: CME Group

5. Delivery Points Corn Soybeans Wheat Source: Irwin, Garcia, Good, and Kunda, 2009 Marketing and Outlook Research Report 2009-02

6. Futures Contracts • No physical exchange takes place when the contract is traded (no actual commodity moves) • Payment is based on the price established when the contract was initially traded (prices can and will change before delivery is taken) • Deliveries can be made when the contract expires or the offsetting futures position must be taken to settle up • Deliveries occur on less than 5 percent of the traded contracts

7. Market Positions • You can either buy or sellinitially to open a position in the futures market • “Make” a promise to make or take delivery • Do the opposite to close the position at a later date • “Offset” the promise (and no commodity changes hands) • Trader may also hold the position until expiration and make or take physical delivery of the commodity

8. Trading Futures Contracts • All trades through a licensed broker • Brokerage house has a “seat” at the exchange and is allowed to trade • Represented “on the floor” to exercise trade • Local broker to initiate transaction and manage account with client • Full service and discount brokers

9. CME Group • http://www.cmegroup.com/ • Open, High, Low, Last Price • Settlement Price • Volume • Open Interest • Daily Limits

10. Cash vs. Futures Prices Iowa Corn in 2016 The gap between the lines is the basis.

11. Market Participants • Hedgers are willing to make or take physical delivery because they are producers or users of the commodity • Use futures to protect against a price movement • Cash and futures prices are highly correlated • Hold counterbalancing positions in the two markets to manage the risk of price movement

12. Hedgers • Farmers, livestock producers • Merchandisers, elevators • Food processors, feed manufacturers • Exporters • Importers What happens if the futures market is restricted to only hedgers?

13. Market Participants • Speculators have no use for the physical commodity • They buy or sell in an attempt to profit from price movements • Add liquidity to the market • May be part of the general public, professional traders or investment managers • Short-term – “day traders” • Long-term – buy or sell and hold

14. Market Participants • Brokers exercise trade for traders and are paid a flat fee called a commission • Futures are a “zero sum game” • Losers pay winners • Brokers always get paid commission

15. Hedging • Holding equal and opposite positions in the cash and futures markets • The substitution of a futures contract for a later cash-market transaction • Who can hedge? • Farmers, merchandisers, elevators, processors, exporter/importers

16. Cash vs. Futures Prices Iowa Corn in 2016

17. Short Hedgers • Producers with a commodity to sell at some point in the future • Are hurt by a price decline • Sell the futures contract initially • Buy the futures contract (offset) when they sell the physical commodity

18. Short Hedge Example • A soybean producer will have 25,000 bushels to sell in November • The short hedge is to protect the producer from falling prices between now and November • Since the farmer is producing the soybeans, they are considered long in soybeans

19. Short Hedge Example • To create an equal and opposite position, the producer would sell 5 November soybean futures contracts • Each contract is for 5,000 bushels • The farmer would short the futures, opposite their long from production • As prices increase (decline), the futures position loses (gains) value

20. Short Hedge Expected Price • Expected price = Futures prices when I place the hedge + Expected basis at delivery – Broker commission

21. Short Hedge Example • As of Jan. 20, ($ per bushel) Nov. 2017 soybean futures $10.29 Historical basis for Nov. $-0.30 Rough commission on trade $-0.01 Expected price $ 9.98 • Come November, the producer is ready to sell soybeans • Prices could be higher or lower • Basis could be narrower or wider than the historical average

22. Prices Went Up, Hist. Basis • In November, buy back futures at $11.50 per bushel ($ per bushel) Nov. 2017 soybean futures $11.50 Actual basis for Nov. $-0.30 Local cash price $11.20 Net value from futures $-1.22 ($10.29 - $11.50 - $0.01) Net price $ 9.98

23. Prices Went Down, Hist. Basis • In November, buy back futures at $7.00 per bushel ($ per bushel) Nov. 2017 soybean futures $ 7.00 Actual basis for Nov. $-0.30 Local cash price $ 6.70 Net value from futures $ 3.28 ($10.29 - $7.00 - $0.01) Net price $ 9.98

24. Short Hedge Graph Hedging Nov. 2017 Soybeans @ $10.29

25. Prices Went Down, Basis Change • In November, buy back futures at $7.00 per bushel ($ per bushel) Nov. 2017 soybean futures $ 7.00 Actual basis for Nov. $-0.10 Local cash price $ 6.90 Net value from futures $ 3.28 ($10.29 - $7.00 - $0.01) Net price $10.18 • Basis narrowed, net price improved

26. Hedging Results • In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis. • So basis estimation is critical to successful hedging. • Narrowing basis, good for short hedgers, bad for long hedgers • Widening basis, bad for short hedgers, good for long hedgers

27. Basis Basis = Cash – Futures Futures reflect global supply and demand Basis reflects local supply and demand Cash = Futures + Basis

28. Basis Basics Specific to time and place Typically use nearby futures Convergence Less variable than cash prices Relatively predictable

29. Basis Factors Relative storage capacity Transportation availability and cost Time to expiration Quality issues

30. Average Iowa Corn Basis, 2010-14 Source: http://www.extension.iastate.edu/agdm/crops/pdf/a2-41.pdf

31. Basis Information ISU Extension and Outreach, Ag Decision Maker Corn http://www.extension.iastate.edu/agdm/crops/html/a2-41.html Soy http://www.extension.iastate.edu/agdm/crops/html/a2-42.html Cattle http://www.extension.iastate.edu/agdm/livestock/html/b2-42.html Hogs http://www.extension.iastate.edu/agdm/livestock/html/b2-41.html USDA-Ag. Marketing Service http://www.ams.usda.gov/mnreports/lsddgr.pdf http://www.ams.usda.gov/mnreports/nw_gr110.txt Local elevators, ethanol plants, processing plants, etc.

32. Cash Contracts • When we talk about a cash contract, it is an agreement between a seller and a buyer covering a quantity and quality of a product to be delivered at a specified location and time for a specific price • If the time is now, we call it a “cash” contract • If the time is sometime in the future, then it’s a “forward cash” contract

33. The Highest Cash Price Is … … Not always the highest return Need to think about transportation and storage costs Compare the cash prices we’ve seen today: • If storage is costing me 3 cents/bushel/month, do the May bids look better than the current cash price? • If transportation is costing me 0.5 cents/bushel/mile, which is the better price? Boone (16 miles) Gilbert (8 miles) Nevada (10 miles) Alleman (16 miles) Eddyville (100 miles)

34. Cash vs. Futures Hedge • Cash Sales • Locks in full price and delivery terms • No margin requirements • Futures Hedge • Locks in futures price, but leaves basis open • Could see price improvement/loss • Can be easily offset if problems arise

35. Options • What are options? • An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period. • Options on futures are the right to buy or sell a specific futures contract. • Option buyers pay a price (premium) for the rights contained in the option.

36. Option Types • Two types of options: Puts and Calls • A put option contains the right to sell a futures contract. • A call option contains the right to buy a futures contract. • Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets.

37. Put Option • The Buyer pays the premium and has the right,but not theobligation,to sell a futures contract at the strike price. • The Seller receives the premium and isobligatedtobuy a futures contract at the strike price if the Buyer uses their right.

38. Call Option • The Buyer pays a premium and has the right, but not theobligation,to buy a futures contract at the strike price. • The Seller receives the premium butis obligatedtosell a futures contract at the strike price if the Buyer uses their right.

39. Options as Price Insurance • The person wanting price protection (the buyer) pays the option premium. • If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages. • The seller keeps the premium, but must pay for damages.

40. Options as Price Insurance • The option buyer has unlimited upside and limited downside risk. • If prices moves in their favor, the option buyer can take full advantage. • If prices moves against them, the option seller compensates them. • The option seller has limited upside and unlimited downside risk. • The seller gets the option premium.

41. Option Issues and Choices • The option may or may not have value at the end • The right to buy corn futures at $6.00 per bushel has no value if the market is below $6.00. • The buyer can choose to offset, exercise, or let the option expire. • The seller can only offset the option or wait for the buyer to choose.

42. Strike Prices • The predetermined prices for the trade of the futures in the options • They set the level of price insurance • Range of strike prices determined by the futures exchange

43. Options Premiums • Determined by trading in the marketplace • Different premiums • For puts and calls • For each contract month • For each strike price • Depends on five variables • Strike price • Price of underlying futures contract • Volatility of underlying futures • Time to maturity • Interest rate

44. Option References • In-the-money • If the option expired today, it would have value • Put: futures price below strike price • Call: futures price above strike price • At-the-money • Options with strike prices nearest the futures price • Out-of-the-money • If the option expired today, it would have no value • Put: futures price above strike price • Call: futures price below strike price

45. Options Premiums Dec. 2017 Corn Futures $3.93 per bu. In-the-money Out-of-the-money Out-of-the-money In-the-money

46. Setting a Floor Price • Short hedger • Buy put option • Floor Price = Strike Price + Basis – Premium – Commission • At maturity • If futures < strike, then Net Price = Floor Price • If futures > strike, then Net Price = Cash – Premium – Commission

47. Put Option Graph Dec. 2017 Corn Futures @ $3.9325 Strike Price @ $4.00 Put Option Return = Max(0, Strike Price – Futures Price) – Premium – Commission Premium = $0.3425 Commission = $0.01

48. Put Option Graph Dec. 2017 Corn Futures @ $3.9325 Strike Price @ $4.00 Premium = $0.3425 Net = Cash Price + Put Option Return

49. Short Hedge Graph Sold Dec. 2017 Corn Futures @ $3.9325 Net = Cash Price + Futures Return

50. Comparison