ECON 338C: Topics in Grain Marketing

1. ECON 338C: Topics in Grain Marketing Chad Hart Assistant Professor/Grain Markets Specialist chart@iastate.edu 515-294-9911

2. Risk Management Tools Price Risk Futures, Options, Revenue Insurance Yield Risk Yield Insurance Today’s Topic

3. Iowa Corn Revenues Source: USDA, NASS

4. Iowa Corn Yields Source: USDA, NASS

5. Iowa Corn Prices Source: USDA, NASS

6. Nearby Corn Futures Prices Corn users are worried about this Corn suppliers are worried about this Source: CBOT

7. Crop Price Variability Price distributions for corn based on March prices for the following July futures

8. Market tools to help manage (share) price risks Mechanisms to establish commodity trades among participants at a future time Available from commodity exchanges / futures markets Futures and Options

9. Futures Markets A market where contracts for physical commodities are traded, the contracts set the terms of quantity, quality, and delivery • Chicago: Corn, soybeans, wheat (soft red), oats, rice • Along with the livestock complex • Kansas City: Wheat (hard red winter) • Minneapolis: Wheat (hard red spring) • Tokyo: Corn, soybeans, coffee, sugar • Has a market for Non-GMO soybeans • Other markets in Argentina, Brazil, China, and Europe

10. Agricultural Futures Markets • Has some unique features due to the nature of the grain business • Supply comes online once (or twice) a year • So at harvest, supply spikes, then diminishes until the next harvest • Production decisions are based price forecasts • Planting decisions can be made a full year (or more) before the crop price is realized • Users provide year-round demand • Livestock feeding, biofuel production, food demand

11. Futures Market Exchanges • Competitive markets • Open out-cry and electronic trading • Centralized pricing • Buyers and sellers are both in the market • Relevant information is conveyed through the bids and offers for the trades • Bid = the price at which a trader would buy the commodity • Offer = the price at which a trader would sell the commodity

12. The View from the Corn Pit Source: M. Spencer Green, AP Photo

13. 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) Futures Contracts

14. 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 Soybean Futures on CBOT Source: CBOT

15. Soybean Futures on CBOT Partial listing of delivery points Source: CBOT Rulebook

16. No physical exchange takes place when the contract is traded (no actual corn 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 Futures Contracts

17. 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 Market Positions

18. Basis The difference between the spot or cash price and the futures price of the same or a related commodity. Margin The amount of money or collateral deposited by a client with his or her broker for the purpose of insuring the broker against loss on open futures contracts. Terms and Definitions

19. Historical Basis for Iowa Basis = Cash price – Futures price Factors that affect basis: Transportation costs Storage and interest costs Local supply and demand

20. Margin Accounts A margin account is an account that traders maintain in the market to ensure contract performance. There are minimum limits on the size of the account. Crop Trader Type Initial Maintenance Corn Hedger $1,500 $1,500 Corn Speculator $2,025 $1,500 Soybeans Hedger $3,500 $3,500 Soybeans Speculator $4,725 $3,500 To trade, you must create a margin account with at least the “Initial” amount and maintain at least the “Maintenance” amount in the account at the end of each trading day.

21. Margin Calls • Margin accounts are rebalanced each day • Depending on the value of futures • If your futures are losing value, money is taken out of the margin account to cover the loss • If the account value falls below the “Maintenance” level, you receive a margin call (a call to put additional money in your margin account) • If your futures position is gaining value, money is put into your margin account

22. 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 Hedging

23. 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 Short Hedgers

24. Short Hedge Graph Hedging Nov. 2009 Soybeans @ $8.93

25. 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 Short Hedge Example

26. 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 Short Hedge Example

27. As of Friday, ($ per bushel) Nov. 2009 soybean futures 8.93 Historical basis for Nov. -0.25 Rough commission on trade -0.01 Expected local hedged price 8.67 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 Short Hedge Example

28. In November, buy back futures at $9.75 per bushel ($ per bushel) Nov. 2009 soybean futures 9.75 Actual basis for Nov. -0.25 Local cash price 9.50 Net value from futures -0.83 ($8.93 - $9.75 - $0.01) Net price 8.67 Prices Went Up, Hist. Basis

29. In November, buy back futures at $7.75 per bushel ($ per bushel) Nov. 2009 soybean futures 7.75 Actual basis for Nov. -0.25 Local cash price 7.50 Net value from futures +1.17 ($8.93 - $7.75 - $0.01) Net price 8.67 Prices Went Down, Hist. Basis

30. In November, buy back futures at $7.75 per bushel ($ per bushel) Nov. 2009 soybean futures 7.75 Actual basis for Nov. -0.10 Local cash price 7.65 Net value from futures +1.17 ($8.93 - $7.75 - $0.01) Net price 8.82 Basis narrowed, net price improved Prices Went Down, Basis Change

31. Processors or feeders that plan to buy a commodity in the future Are hurt by a price increase Buy the futures initially Sellthe futures contract (offset) when they buy the physical commodity Long Hedgers

32. Long Hedge Graph Hedging Dec. 2009 Corn @ $4.28

33. An ethanol plant will buy 50,000 bushels of corn in December The long hedge is to protect the ethanol plant from rising corn prices between now and December Since the plant is using the corn, they are considered short in corn Long Hedge Example

34. To create an equal and opposite position, the plant manager would buy 10 December corn futures contracts Each contract is for 5,000 bushels The plant manager would long the futures, opposite their short from usage As prices increase (decline), the futures position gains (loses) value Long Hedge Example

35. As of Friday, ($ per bushel) Dec. 2009 corn futures 4.28 Historical basis for Dec. -0.25 Rough commission on trade +0.01 Expected local net price 4.04 Come December, the plant manager is ready to buy corn to process into ethanol Prices could be higher or lower Basis could be narrower or wider than the historical average Long Hedge Example

36. In December, sell back futures at $5.00 per bushel ($ per bushel) Dec. 2009 corn futures 5.00 Actual basis for Nov. -0.25 Local cash price 4.75 Less net value from futures -0.71 -($5.00 - $4.28 - $0.01) Net cost of corn 4.04 Futures gained in value, reducing net cost of corn to the plant Prices Went Up, Hist. Basis

37. In December, sell back futures at $3.75 per bushel ($ per bushel) Dec. 2009 corn futures 3.75 Actual basis for Nov. -0.25 Local cash price 3.50 Less net value from futures +0.54 -($3.75 - $4.28 - $0.01) Net cost of corn 4.04 Futures lost value, increasing net cost of corn Prices Went Down, Hist. Basis

38. In December, sell back futures at $3.75 per bushel ($ per bushel) Dec. 2009 corn futures 3.75 Actual basis for Dec. -0.10 Local cash price 3.65 Less net value from futures +0.54 -($3.75 - $4.28 - $0.01) Net cost of corn 4.19 Basis narrowed, net cost of corn increased Prices Went Down, Basis Change

39. 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 Hedging Results

40. Contract for delivery Defines time, place, form Tied to the futures market Buyer offering the contract must lay off the market risk elsewhere The buyer does the hedging for you Forward Contracts

41. Today’s price for delivery of commodity in the future Standardized contract for commodity delivery Positions in the market can be offset before delivery Several participants use the market in different ways Basis estimation important to hedgers of all types Futures Summary

42. 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. Options

43. 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. Option Types

44. 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. Put Option

45. 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. Call Option

46. 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. Options as Price Insurance

47. 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. Options as Price Insurance

48. The option may or may not have value at the end The right to buy at $4.00 has no value if the market is below $4.00. 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. Option Issues and Choices

49. 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 Strike Prices

50. 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 Options Premiums