ECON 337: Agricultural Marketing

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

2. 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/Speculator $2,363 $1,750 Soybeans Hedger/Speculator $3,375 $2,500 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.

3. Margin Calls • Margin accounts are rebalanced each day • Depending on the value of futures • Settlement price • 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) and the balance is brought back up to the Initial amount

4. Margin Example • Let’s say I went short on May 2012 corn • $6.5825/bushel on Jan. 11 • Along with selling a corn futures contract, I have to establish a margin account and deposit $2,363 in it • On Jan. 12, the May 2012 corn futures price moved to $6.1825/bushel • Since I’ll be selling the futures contract later, this price move is in my favor

5. Margin Example • I gained 40 cents per bushel and since the contract is for 5,000 bushels, that’s a gain of $2,000 • At the end of the day (Jan. 12), $2000 is deposited into my margin account, raising the account balance to $4,363 • Since $4,363 is greater than the “Maintenance” level, I will not receive a margin call

6. Margin Example #2 • Let’s say, instead of going short, I went long on May 2012 corn • $6.5825/bushel on Jan. 11 • Along with buying a corn futures contract, I have to establish a margin account and deposit $2,363 in it • On Jan. 12, the May 2012 corn futures price moved to $6.1825/bushel • Since I’ll be selling back the futures contract later, this price move is not in my favor

7. Margin Example #2 • I lost 40 cents per bushel and since the contract is for 5,000 bushels, that’s a loss of $2,000 • At the end of the day (Jan. 12), $2,000 is to be taken from my margin account, lowering the account balance to $363 • Since $363 is less than the “Maintenance” level, I will receive a margin call and be asked to deposit $2,000 more into the account or to close out the futures position • The $2,000 brings the account balance back up to the initial requirement

8. Margin Example – Going Short

9. Margin Example – Going Long

10. 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 Market Participants

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

12. 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 Market Participants

13. 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 Market Participants

14. 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

15. Cash vs. Futures Prices Iowa Corn in 2011

16. 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

17. 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

18. 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

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

20. As of Jan. 13, ($ per bushel) Nov. 2012 soybean futures 11.70 Historical basis for Nov. -0.30 Rough commission on trade -0.01 Expected price 11.39 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

21. In November, buy back futures at $14.00 per bushel ($ per bushel) Nov. 2012 soybean futures 14.00 Actual basis for Nov. -0.30 Local cash price 13.70 Net value from futures -2.31 ($11.70 - $14.00 - $0.01) Net price 11.39 Prices Went Up, Hist. Basis

22. In November, buy back futures at $10.00 per bushel ($ per bushel) Nov. 2012 soybean futures 10.00 Actual basis for Nov. -0.30 Local cash price 9.70 Net value from futures +1.69 ($11.70 - $10.00 - $0.01) Net price 11.39 Prices Went Down, Hist. Basis

23. Short Hedge Graph Hedging Nov. 2012 Soybeans @ $11.70

24. In November, buy back futures at $10.00 per bushel ($ per bushel) Nov. 2012 soybean futures 10.00 Actual basis for Nov. -0.10 Local cash price 9.90 Net value from futures +1.69 ($11.70 - $10.00 - $0.01) Net price 11.59 Basis narrowed, net price improved Prices Went Down, Basis Change

25. 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

26. 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

27. 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

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

29. As of Jan. 13, ($ per bushel) Dec. 2012 corn futures 5.55 Historical basis for Dec. -0.25 Rough commission on trade +0.01 Expected local net price 5.31 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

30. In December, sell back futures at $6.00 per bushel ($ per bushel) Dec. 2012 corn futures 6.00 Actual basis for Nov. -0.25 Local cash price 5.75 Less net value from futures -0.44 -($6.00 - $5.55 - $0.01) Net cost of corn 5.31 Futures gained in value, reducing net cost of corn to the plant Prices Went Up, Hist. Basis

31. In December, sell back futures at $4.00 per bushel ($ per bushel) Dec. 2012 corn futures 4.00 Actual basis for Nov. -0.25 Local cash price 3.75 Less net value from futures +1.56 -($4.00 - $5.55 - $0.01) Net cost of corn 5.31 Futures lost value, increasing net cost of corn Prices Went Down, Hist. Basis

32. Long Hedge Graph Hedging Dec. 2012 Corn @ $5.55

33. In December, sell back futures at $4.00 per bushel ($ per bushel) Dec. 2012 corn futures 4.00 Actual basis for Dec. -0.10 Local cash price 3.90 Less net value from futures +1.56 -($4.00 - $5.55 - $0.01) Net cost of corn 5.46 Basis narrowed, net cost of corn increased Prices Went Down, Basis Change

34. 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

35. Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/Spring2012/