Hedge overview

1. Hedge overview • Futures provide additional marketing alternatives • Can transfer price risk • Can establish approximate price levels in advance of cash market transactions

2. 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

3. 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.

4. 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?

5. Hedging • What should be your criteria for success in hedging? • Achieving approximate expected cash price = futures + expected basis • Making the maximum profit?

6. 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.

7. 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

8. Necessary 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

9. Hedge 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)

10. PRICE FUTURES CASH TIME

11. Futures/Hedging 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)

12. 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

13. 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

14. 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)

15. 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.

16. 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

17. Useful 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

18. Basis-how to get it • 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

19. Short Hedge(Selling 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.

20. Short Hedging Mechanics Cash Market Futures Market Transactions Transactions Now SELL Later SELL BUY

21. Short Hedging 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

22. Expected Hedge Payoff • Expected net price = Futures price plus basis (equals expected cash price) minus commission (if sale) plus commission (if purchase)

23. Actual Hedge 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)

24. Which contract to 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

25. Which contract to 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

26. Which contract to 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)

27. Short 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

28. Short Hedging 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

29. Hedge resullts • Expected cash price = $80 per 100 lbs.__________________________ • Sell cash cattle at $75 • Futures gain 5 • Commission -.02 • Net sale price $79.98

30. Basis change • If basis narrows vs. expected • Good for shorts, bad for longs • If basis widens vs. expected • Bad for shorts, good for longs

31. Long Hedge Example Cash Market Futures Market Now Later Cash Price Received: Futures Profit/Loss: Commission: Net Price:

32. Grain storage hedges • Establish storage returns using: • deferred futures • - basis (= expected cash price) • - current cash price • - storage costs (interest, shrink, handling, drying) • - commission • =net return

33. Storage hedge problemCalculate storage 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.

34. Storage expected 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

35. Storage hedge actual 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

36. More complicated hedges • Fed cattle margin hedge, using fed cattle, feeder cattle, corn futures • Soybean crush margin hedge, using soybean, oil, meal futures.

37. Hedging considerations Are there disadvantages to hedging? margin calls and costs lost opportunities quantity risk basis risk broker commission,

38. Tax Considerations • Hedge individuals - ordinary income, no limits corporations - no limits • Speculation capital gain or loss $3,000 loss limit per year for individuals

39. Hedging 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

40. Hedging 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?

41. Hedging 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

42. Hedging 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

43. Which contract to 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)

44. New 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

45. New 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

46. New innovations • New delivery points--CBOT grains and soybeans --not in Chicago!! • New contracts--boneless beef, butter, cheese, nonfat dry milk, broilers

47. New innovations • Electronic trading • nights--CME and CBOT • many European exchanges with electronic trading taking over • Will open outcry system continue?

48. Hedge 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

49. Hedge overview • Results often considered “bad” by farmers • 5 - 25% of producers use futures, and then only sometimes • WHY??

50. Factors Influencing Forward 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?