Crop Marketing Tools Workbook: Basics of Futures Hedging

1. Chad Hart Assoc. Professor of Economics, Iowa State University Steve Johnson ISU Extension Farm Management Specialist Ed Kordick Commodity Services Manager, Iowa Farm Bureau

2. Presentation Objectives: • Education on basic marketing tools • Introduction to the Marketing Tools Workbook • Invitation to continue learning by experience with Iowa Commodity Challenge after this session.

3. Marketing Tools Workbook

4. Crop Marketing • Unpredictable events, emotions, volatility • Back to the basics: know the tools, have revenue perspective, realistic goals • Price is not an adequate measure of success • How do you define success? hitting revenue goals, reducing risk, . . . . . . Decide what success means to you

5. Futures and Basis Movement

6. Futures Hedging • Hedging: taking an equal and opposite position in the futures market than you have in the cash market. • When a farmer hedges they take an action now in the futures market that they will take later in the cash market. • If the farmer will sell bushels later in the cash market, the bushels can be sold now in the futures market to protect downside price risk.

7. Why Hedging Works: 5

8. Sell now Start date End date

9. In this presentation, T diagrams are used in examples to track three market components: Cash Futures Basis over the time period that the hedge is in place.

10. Basis • The difference between the cash price and futures price. Many factors influence basis: local supply/demand, etc. • The calculation for basis is: Cash Price – Futures Price = Basis $4.80 – $5.10 = - $0.30 $14.20 – $14.70 = - $0.50

11. Example futures hedge story • It’s November: the goal is to sell 5000 bushels of cash corn in late Feb. at $4.30. • Estimated basis for late February is -30¢ (cash under March futures). • March corn futures are sold at $4.60 • Let’s see what happens if the market goes either way !

12. Hedging Example (market lower) 6 Goal: $4.30 Cash Corn Sell 1 March Corn @ $4.60 Estimated: - 30¢ November Buy 1 March Corn @ $4.15 Late February Sell Cash Corn @ $3.85 Actual: - 30¢ 0.00 Results + 45¢ - 45¢

13. Hedging Example (market lower) • Net Hedge (without commissions and interest cost) • Original futures less actual basis = net hedge • $4.60 – 0.30 = $4.30 • 2. Cash sale to buyer +/– futures gain/loss = net hedge • $3.85 + 0.45 = $4.30

14. Hedging Example (market higher) 7 Goal: $4.30 Cash Corn Sell 1 March Corn @ $4.60 Estimated: - 30¢ November Buy 1 March Corn @ $5.00 Late February Sell Cash Corn @ $4.70 Actual: - 30¢ 0.00 Results - 40¢ + 40¢

15. Hedging Example (market higher) • Net Hedge (without commissions and interest cost) • Original futures less actual basis = net hedge • $4.60 – 0.30 = $4.30 • 2. Cash sale to buyer +/– futures gain/loss = net hedge • $4.70 – 0.40 = $4.30

16. Example futures hedge story • Story begins the same: November, the goal is to sell 5000 bu. cash corn at $4.30. • Estimated basis for late February is -30¢, March corn futures are sold at $4.60 • Let’s see what happens if basis is different than expected !

17. Hedging Example (market lower) 9 Sell 1 March Corn @ $4.60 Goal: $4.30 Cash Corn Estimated: - 30¢ November Buy 1 March Corn @ $4.10 Late February Sell Cash Corn @ $4.00 Actual: - 10¢ + 20¢ Results + 50¢ - 30¢

18. Hedging Example (market lower) • Net Hedge (without commissions and interest cost) • Original futures less actual basis = net hedge • $4.60 – 0.10 = $4.50 • 2. Cash sale to buyer +/– futures gain/loss = net hedge • $4.00 + 0.50 = $4.50

19. Hedging Example (market higher) 10 Sell 1 March Corn @ $4.60 Goal: $4.30 Cash Corn Estimated: - 30¢ November Buy 1 March Corn @ $5.20 Late February Sell Cash Corn @ $4.80 Actual: - 40¢ - 10¢ Results - 60¢ + 50¢

20. Hedging Example (market higher) • Net Hedge (without commissions and interest cost) • Original futures less actual basis = net hedge • $4.60 – 0.40 = $4.20 • 2. Cash sale to buyer +/– futures gain/loss = net hedge • $4.80 – 0.60 = $4.20

21. Key points: • Price does not define marketing success, hitting revenue goals, reducing risk, . . . . . . • The cash market, futures market and basis can be tracked in futures hedges • A futures hedge works in up & down markets • Basis is key to result of futures hedge: Stronger basis than expected = Higher price Weaker basis than expected = Lower price

22. Carry and Cost of Ownership

23. Carry Market Defined: The difference in price between the nearby contact and the more distant delivery months (deferred). Compare the carry offered by the market to the costs of storing grain for the various delivery months.

24. Inverted Market In a year like 2012, the limited supply has reduced demand. There is little to no carry in the futures markets. The nearby futures contract is actually higher than the deferred futures. The market provides little incentive for storing the crop. Soybean Futures Inverse Corn Futures Inverse

25. Example Corn Futures Date: Oct. 16th, 2013 $4.71 July May $4.63 Mar. $4.55 $4.43 Dec. Source: www.cmegroup.com

26. Example Soybean Futures Date: Oct. 16th, 2013 $12.75 Jan. Mar. $12.63 May $12.49 July $12.47 Source: www.cmegroup.com

27. Cost of Ownership • Corn • On-Farm: Monthly Charge = 3¢/bushel • Commercial: Monthly Charge = 6¢/bushel • Soybeans • On-Farm: Monthly Charge = 4¢/bushel • Commercial: Monthly Charge = 6¢/bushel

28. Key points: Compare the carry offered by the market to the costs of storing grain for the various delivery months The Cost of Ownership will accrue Commercially for both corn and soybeans at 6¢/bushel/month.

29. Forward Cash Contracts

30. Forward Cash Contract 14 Defined: An agreement between a buyer and seller covering a quantity and quality of grain to be delivered at a specified location and time in exchange for a specific price. • Example: • 5,000 bushel of #2 yellow corn delivered to Local Co-op the last half of February • The cash price at delivery will be -$.40 under the March corn futures contract that closed at $4.60/bu.

31. Forward Cash Contract A Forward Cash Contract is a binding transaction between the seller and buyer for a later delivery date. Conditions are set including the quantity of bushels, the quality, delivery time and cash price.

32. Forward Cash Contract • Forward Cash Contracts are widely used and: • Set the cash price and delivery terms • Are available both before and after harvest • Don’t require margin deposits or premiums.

33. Forward Cash Contract • Advantages • No margin deposit required • Lock in price and delivery terms • Disadvantages • Penalties if cannot deliver the contracted amount • Locked in price (can’t go higher) • Often receive a wider basis.

34. Hedge-to-Arrive Contract • Hedge-to-Arrive (HTA) Contracts are similar to Forward Cash Contracts. The binding transaction sets the: • Delivery Date and Location • Amount of Bushels to Deliver • Quality of those Bushels • The Basis is typically not set when the transaction is initiated, however the Futures Price is established. The Seller sets the Basis prior to Delivery.

35. Hedge-to-Arrive Contract Similar to a Forward Cash Contract, an HTA Contract is a binding transaction between the seller and buyer for a later delivery date. Conditions are set including the quantity of bushels, the quality, delivery time but the cash price is not known until the Basis is set.

36. Margin Flows

37. Futures Contracts • Advantages • Flexibility, ease of entry and exit • Reduces price risk • Can improve basis • Disadvantage • Must understand margin calls • Commissions • Basis risk

38. Margin Account • Margin money is “good faith” money that is deposited into the futures account. • Performance bond • Money that covers changes in the value of the contract position • Minimum margins are set by the exchange • Additional margin can be collected if the futures contract is losing value for the user

39. Key Margin Levels • There are two key margin levels: • Initial margin • Maintenance margin The initial margin is the amount you have to deposit to participate in the futures market. The maintenance margin is the amount you have to keep as a minimum balance.

40. Key Margin Levels $ per contract Let’s go through an example

41. Margin Example 17 Sold 1 corn futures contract at $5.00 per bushel

42. Basic Options, Intrinsic and Time Value

43. Options Contracts An option is the right, but not the obligation, to buy or sell a futures contract. • Farmers can buy and sell options. • When you buy an option, you get the right. • When you sell an option, you face the obligation. Options are tied to specific futures contracts. The strike price is the price in the option at which you may buy (or sell) futures contracts.

44. Types of Options • There are two types of options: • Puts • Calls A put option gives you the right to sell futures. Put options are often used to set price floors. A call option gives you the right to buy futures. Call options are often used to replace cash bushels.

45. Examples Let’s say you buy a $4.50 put on July corn futures. That put gives you the right to sell July corn futures for $4.50 per bushel. If you had bought a $4.50 call, that would give you the right to buy July corn futures for $4.50 per bushel.

46. Example Put Put options pay out when futures prices fall. Here’s the payout schedule for a $4.50 put on July 2014 corn.

47. Example Call Call options pay out when futures prices rise. Here’s the payout schedule for a $4.50 call on July 2014 corn.

48. Premium vs. Margin 22

49. Options Premiums • Can be divided into two sections: • Intrinsic value • What is the option worth today? • Time value • How much time is left on the option? Intrinsic value depends on the futures price and the strike price of the option. Time value depends on the length of time in the option and the price volatility in the market.

50. Example 29 Start with an soy put option @ $12.00 per bushel