Hedging Against Falling Rapeseed Prices using Rapeseed Futures

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Contents

Hedging Against Falling Rapeseed Prices using Rapeseed Futures

Rapeseed producers can hedge against falling rapeseed price by taking up a position in the rapeseed futures market.

Rapeseed producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of rapeseed that is only ready for sale sometime in the future.

To implement the short hedge, rapeseed producers sell (short) enough rapeseed futures contracts in the futures market to cover the quantity of rapeseed to be produced.

Rapeseed Futures Short Hedge Example

A rapeseed farmer has just entered into a contract to sell 5,000 tonnes of rapeseed, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of rapeseed on the day of delivery. At the time of signing the agreement, spot price for rapeseed is EUR 292.50/ton while the price of rapeseed futures for delivery in 3 months’ time is EUR 290.00/ton.

To lock in the selling price at EUR 290.00/ton, the rapeseed farmer can enter a short position in an appropriate number of Euronext Rapeseed futures contracts. With each Euronext Rapeseed futures contract covering 50 tonnes of rapeseed, the rapeseed farmer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the rapeseed farmer will be able to sell the 5,000 tonnes of rapeseed at EUR 290.00/ton for a total amount of EUR 1,450,000. Let’s see how this is achieved by looking at scenarios in which the price of rapeseed makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rapeseed Spot Price Fell by 10% to EUR 263.25/ton on Delivery Date

As per the sales contract, the rapeseed farmer will have to sell the rapeseed at only EUR 263.25/ton, resulting in a net sales proceeds of EUR 1,316,250.

By delivery date, the rapeseed futures price will have converged with the rapeseed spot price and will be equal to EUR 263.25/ton. As the short futures position was entered at EUR 290.00/ton, it will have gained EUR 290.00 – EUR 263.25 = EUR 26.75 per tonne. With 100 contracts covering a total of 5000 tonnes, the total gain from the short futures position is EUR 133,750

Together, the gain in the rapeseed futures market and the amount realised from the sales contract will total EUR 133,750 + EUR 1,316,250 = EUR 1,450,000. This amount is equivalent to selling 5,000 tonnes of rapeseed at EUR 290.00/ton.

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Scenario #2: Rapeseed Spot Price Rose by 10% to EUR 321.75/ton on Delivery Date

With the increase in rapeseed price to EUR 321.75/ton, the rapeseed producer will be able to sell the 5,000 tonnes of rapeseed for a higher net sales proceeds of EUR 1,608,750.

However, as the short futures position was entered at a lower price of EUR 290.00/ton, it will have lost EUR 321.75 – EUR 290.00 = EUR 31.75 per tonne. With 100 contracts covering a total of 5,000 tonnes of rapeseed, the total loss from the short futures position is EUR 158,750.

In the end, the higher sales proceeds is offset by the loss in the rapeseed futures market, resulting in a net proceeds of EUR 1,608,750 – EUR 158,750 = EUR 1,450,000. Again, this is the same amount that would be received by selling 5,000 tonnes of rapeseed at EUR 290.00/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the rapeseed seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling rapeseed prices while still be able to benefit from a rise in rapeseed price is to buy rapeseed put options.

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Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Rapeseed Prices using Rapeseed Futures

Businesses that need to buy significant quantities of rapeseed can hedge against rising rapeseed price by taking up a position in the rapeseed futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of rapeseed that they will require sometime in the future.

To implement the long hedge, enough rapeseed futures are to be purchased to cover the quantity of rapeseed required by the business operator.

Rapeseed Futures Long Hedge Example

A biodiesel maker will need to procure 5,000 tonnes of rapeseed in 3 months’ time. The prevailing spot price for rapeseed is EUR 292.50/ton while the price of rapeseed futures for delivery in 3 months’ time is EUR 290.00/ton. To hedge against a rise in rapeseed price, the biodiesel maker decided to lock in a future purchase price of EUR 290.00/ton by taking a long position in an appropriate number of Euronext Rapeseed futures contracts. With each Euronext Rapeseed futures contract covering 50 tonnes of rapeseed, the biodiesel maker will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the biodiesel maker will be able to purchase the 5,000 tonnes of rapeseed at EUR 290.00/ton for a total amount of EUR 1,450,000. Let’s see how this is achieved by looking at scenarios in which the price of rapeseed makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rapeseed Spot Price Rose by 10% to EUR 321.75/ton on Delivery Date

With the increase in rapeseed price to EUR 321.75/ton, the biodiesel maker will now have to pay EUR 1,608,750 for the 5,000 tonnes of rapeseed. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the rapeseed futures price will have converged with the rapeseed spot price and will be equal to EUR 321.75/ton. As the long futures position was entered at a lower price of EUR 290.00/ton, it will have gained EUR 321.75 – EUR 290.00 = EUR 31.75 per tonne. With 100 contracts covering a total of 5,000 tonnes of rapeseed, the total gain from the long futures position is EUR 158,750.

In the end, the higher purchase price is offset by the gain in the rapeseed futures market, resulting in a net payment amount of EUR 1,608,750 – EUR 158,750 = EUR 1,450,000. This amount is equivalent to the amount payable when buying the 5,000 tonnes of rapeseed at EUR 290.00/ton.

Scenario #2: Rapeseed Spot Price Fell by 10% to EUR 263.25/ton on Delivery Date

With the spot price having fallen to EUR 263.25/ton, the biodiesel maker will only need to pay EUR 1,316,250 for the rapeseed. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the rapeseed futures price will have converged with the rapeseed spot price and will be equal to EUR 263.25/ton. As the long futures position was entered at EUR 290.00/ton, it will have lost EUR 290.00 – EUR 263.25 = EUR 26.75 per tonne. With 100 contracts covering a total of 5,000 tonnes, the total loss from the long futures position is EUR 133,750

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rapeseed futures market and the net amount payable will be EUR 1,316,250 + EUR 133,750 = EUR 1,450,000. Once again, this amount is equivalent to buying 5,000 tonnes of rapeseed at EUR 290.00/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the rapeseed buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising rapeseed prices while still be able to benefit from a fall in rapeseed price is to buy rapeseed call options.

Learn More About Rapeseed Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Chapter 5 Fundamentals of futures hedging.

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net hedged selling price

net hedged buying price

reverse crush hedge

Futures contracts have long been the standard for price risk management. This chapter outlines the important concepts and provides examples in the grain, livestock, interest rate, and foreign exchanges markets of how agribusinesses can manage price risks.

Most people don’t have a problem understanding a simple contract. Two people decide to trade something. One agrees to sell an item and the other agrees to buy it. They agree on when the product will exchange or service will take place, where, and at what price. It really is quite simple. Yet when the term futures contract is mentioned, most people’s eyes glaze over and they mutter that they don’t understand or that the futures market is just a gambling den in Chicago or New York. But the essence of a futures contract is the same as that for the simple contract. Futures contracts are no more difficult to understand than any other concept in finance or economics.

Once a few simple terms and concepts are understood, anyone can either speculate or hedge with futures contracts. As with all things, people have added (often unnecessarily) complexity and finesse to futures contracts so that a novice immediately thinks that it will take a lot of work to understand how they operate. But the truth is that knowledge of a few basic concepts will open up a powerful risk management tool. The trick is to know the basics really well and ignore all the add-ons–just like with a vehicle. A simple car or truck gets the job of transportation done just as completely as a fully-loaded model of the same make. A fully-loaded model may make a statement about your wealth and may impress others, but getting from point A to point B is done just as well by a basic pickup with a heater and air conditioner as the fully loaded special edition.

A futures contract is nothing more than a forward contract that is traded on an organized futures exchange. Special provisions apply, but a futures contract is a strong forward contract that has the bidding for its price open to everyone. A simple forward contract is privately negotiated between two parties, but a futures contract bearing the same terms would be open to all buyers and sellers. A futures contract is an agreement between the buyer to accept delivery of a product from the seller with prespecified (standardized) terms. Buyers and sellers place their bids (the price the buyer hopes to pay) or ask (the price the seller hopes to receive) on the trading floor of the exchange. They must negotiate or find another party with whom to trade. Once a price is agreed upon between buyer and seller, the contract is complete. Since futures contracts are strong, the buyer and seller are free to immediately retrade the contract. The buyer could sell the contract to someone else and be totally out of the obligation. Likewise the seller can buy a contract back from anyone else willing to sell and be out of the promise. This retrading is what attracts risk managers.

Figure 5-1 shows the major agricultural commodities that have futures contracts and the specifications for each. Buyers and sellers know exactly what they are getting with a futures contract. Because the contracts don’t vary by terms and conditions, the ability to trade out of the contract (retrade) is easy. A buyer can sell or a seller can buy and be in the market and out again without ever going through the delivery process or settlement. The difference between the beginning and ending price determines if a profit or loss was incurred by the trader. Since the contracts are standardized and can be retraded, the futures markets are generally very liquid–traders can get in and out quickly. Futures markets are said to have high liquidity.

The full value of a contract does not generally have to be advanced to get control of the contract. Usually only a portion of the value, called margin, has to be posted to gain control. Margins are set by each exchange and then each brokerage house can add to the minimums if they so choose. The initial margin required to enter a contract is roughly 10 percent of the contract value. For a December corn contract that has a price of $2 per bushel, the contract value would be 5,000 x $2, or $10,000, but the margin to get control of the contract would be approximately $1,000. However, if the contract’s value changes, the holder of the contract must pay in any additional losses. Payment for additional losses is called getting a margin call.

Leverage attracts speculators. A cash market speculator would have to pay $10,000 to get control of 5,000 bushels of corn valued at $2 per bushel. However, with futures contracts that same trader could get control of 10 times the volume, or 50,000 bushels, because the amount of margin required is only $1,000 for one contract of 5,000 bushels. Consequently, the futures market speculator could gain 10 times the profit for the same price movements as the cash market speculator (or 10 times the loss).

Those Nasty Margin Calls

To buy a December delivery futures contract for a price of $2 per bushel, the trader must post a margin of approximately $1,000. The margin will have a prespecified level called a maintenance margin. Usually the maintenance margin level is approximately 75 percent of the value of the initial margin. A $1,000 margin might have a maintenance margin of $750. The difference between the margin and the maintenance margin level is the amount of money that is allowed to be lost before additional money will be requested–a margin call. The corn contract is for 5,000 bushels and the difference between the margin and the maintenance margin is $250. If the difference between the two margins is divided by the size of the contract, then the trader will know how much can be lost on a per-unit basis. Dividing $250 by 5,000 equals 5 cents per bushel. The trader is allowed to lose up to 5 cents per bushel before a margin call will occur. Table 5-1 shows the effects on margin as price moves.

Notice that as the price moves down the trader is losing money on paper. The trader was allowed to lose up to $250 without a margin call. No margin call occurred until the price had fallen 6 cents per bushel and margin had deteriorated to $700. The margin call is for an amount ($300) to bring the margin account back to full value–$1,000 ($700 + $300).

Traders hate to get margin calls because they signify that trades are losing money. The idea behind a margin call is that because the trade was allowed with only a fraction of the contract value posted, losses need to be paid in as they occur to assure financial performance from the trader. The purpose of the maintenance margin level is to allow a certain amount of price movement that will naturally occur in markets so that a margin call is not made for every price movement.

If a trade is generating paper profits then the trader can withdraw the extra revenue. The converse of a maintenance margin for profits is not in widespread use, but each brokerage house will set an amount of paper profit that has to be made before they will allow for it to be withdrawn. Table 5-2 indicates how a paper profit is handled.

At this point the trader could withdraw $200 in paper profits. If the trader in the example in Table 5-2 withdraws the $200 in paper profits, the margin account balance falls back to the $1,000 initial requirement level.

Margin is important to understand because it is a cash flow financial consideration for businesses. To hold a futures position either as a speculator or hedger is to be subject to margin calls. For paper losses, businesses will have to inject cash to hold the position and for paper gains, cash can and should be withdrawn and managed from a time value of money standpoint.

Concept of Counterbalance

Hedging is the process of counterbalance–one action is offset by another action. A single action is simply speculation, complete with all the risks associated with the action. Hedging is an attempt to cover some aspect of the risk of the speculative action with another action. For hedging to work, the results of the two or more actions must be opposite, otherwise risk has actually increased rather than decreased.

Futures contract hedging entails having opposite cash and futures positions. If a grain elevator buys corn and stores grain for a certain period of time they have the risk that prices will fall during the holding period. What they need is a financial product that gains in value when cash corn prices fall to offset the loss of value in the cash market. When they buy corn initially, they could simultaneously sell a corn futures contract. If corn prices fall, their cash corn loses value, but the sell position in the futures gains in value because it can be repurchased at a lower price, thus, the hedge. What is lost in one market is gained in another. The hope is that the losses exactly cover the gains.

What if the elevator had simultaneously bought a futures contract when they purchased the cash corn? Now they would have two simultaneous positions in different markets, but they are not counterbalanced. The two markets will move together, not oppositely. Hedging must involve counterbalance. If it does not, then it is not a price risk management tool, but rather another form of speculation. Table 5-3 reveals the effects of counterbalance in a hedge and a parallel speculative position with both a price increase and decrease.

The counterbalanced position always has the opposite results of the cash position while the parallel position always has the same effect. Counterbalancing is hedging while parallel positions are always a doubling of the risk of the cash position. Parallel positions will yield twice the gain and also twice the loss as the example in Table 5-3 shows; they double your pleasure when they work in your favor but double your sadness when they don’t.

This trade-off is critical to understanding and using hedging. If the hedge is not properly placed, then price risk is not managed, but in fact may, as parallel positions show, double the exposure to price risk. Speculation is not a bad or wrong thing to do; it becomes a problem when a business wants and needs to hedge, but in fact is entering into a higher level of risk, not a lower level.

Only Two Types of Hedges

There really are only two ways to hedge. An initial sell position in the futures is called a short hedge, as shown in the example in Table 5-3. A short hedge is used to protect against declining spot market values. The other type of hedge is an initial buy position in the futures market called a long hedge. Long hedges are used to protect against increasing values in the cash market. That’s it. Almost all hedges for price risk management will be a simple short or long hedge. More complex futures hedging exists, but the structure is just a combination of various types of short and long hedges.

The example in Table 5-3 of a perfect short hedge reveals the purpose: to protect against the spot price going down, which it did. When the cash corn price decreased, the short futures position gained in value. Short hedges are widely used in agriculture by producers who have growing crops or livestock and agribusinesses such as elevators (as in Table 5-3) that need to protect an asset (owned corn) against a declining value.

Some agricultural businesses need protection against rising prices. A food company that uses wheat to manufacture a food product will price the finished food product (bread or pancake mix, for example) to wholesalers in advance but will then have to go into the spot market regularly, maybe even each week, to buy wheat for the factory. Once it fixes its final price to the wholesaler, the food company has the risk that the raw ingredients it purchases will increase in price and thus squeeze profit margins. Table 5-4 shows how they could long hedge that risk.

The food company suffered a loss of 20 cents per bushel on the cash wheat, but the hedge offset the loss with an exact gain. The company, in effect, bought the wheat at the original $3.40 per bushel.

A hedge is called long or short based on the initial position in the futures market. Short hedges are also called bear hedges or sell hedges and long hedges are called bull hedges or buy hedges. The most generally used terms in the industry, however, are short and long. Short and long are also used in reference to the cash position. If a business has forward sold a product in the spot market, they are said to be short the cash. Conversely, if they have purchased a product in the spot market they are said to be long the cash. Short and long, for both futures and cash positions, refer to initial positions only. If a business is long the cash (i.e., an initial buy in the spot market) when they sell the product, the action of getting out of the long cash position is not called being short, it is referred to as a sell.

The Role of Futures Contracts in Hedging

Futures contracts derive their value from the underlying cash market. The same factors that cause the cash market price to change will result in a change in the futures contract price. The two prices will move in tandem, or as the trade says, the two prices “tend to trend together.” This derivative aspect of the two prices is the reason that futures contracts can be used as a counterbalance for cash positions.

Absolute Price Movements

When the price of an item changes in the cash market, that price activity is called an absolute price movement. Figure 5-2 demonstrates the movement for the largest grain market product–corn. Figure 5-2 shows the prices of corn in one of the United States’ largest corn producing states, Iowa. The motion of the prices is quite pronounced in terms of highs and lows for the year, i.e., the absolute price movement. The high for the year was $1.90 per bushel and the low was $1.70. The $.20 difference represents a price movement from the highest to the lowest point of the year. These absolute price movements are the source of the price risk that producers and agribusinesses face in dealing with the products. If a business is not going to hedge with futures contracts, then knowledge of the absolute price movement for the cash commodity needs to be studied so that other risk management tools can be used, such as timing of sales or processing or insurance.

[FIGURE 5-2 OMITTED]

Historical price information can be used to calculate certain statistical values such as means, medians, and variances. These values can be helpful in analyzing how risky the movements are to the business. Certain commodities exhibit patterns that are seasonal (within a calendar or growing period) or cyclical (over several calendar years or growing periods). It is important to know the likely tendencies of price movements as a way to help manage the risk of the price movement. Later in this book specific characteristics of price patterns will be incorporated in risk management hedging strategies for grains and livestock.

Just as cash prices have their own absolute price movements, futures contract prices have their own absolute price movements. Even though the futures price is derived from the cash price, futures contracts are standardized and relate to future prices rather than current-day prices and thus don’t exactly match the spot mandate for the cash commodity. Because futures contracts are traded on exchanges and price is determined by open outcry auction, prices exist for each day the commodity is traded and for each moment within the day. In fact, futures prices are more readily available than most cash market prices merely because they are centralized. Figure 5-3 illustrates the futures price movement for corn for the year 2001. Futures prices exhibit price patterns and can be analyzed historically for statistical properties such as means and variances.

Relative Price Movements

Hedging necessitates counterbalance, thus both cash and futures absolute price movements will exist side by side. The importance of price movements with a hedge is not the absolute price movement of either the cash or futures but how the two prices relate to each other during the hedging period, that is, the relative movement. The two price series will move in tandem, but because each price movement has unique characteristics, they will not move exactly the same. When a hedge is placed, only the relative differences between the two absolute price movements has importance. The two price movements counterbalance, but not perfectly. Hedging removes the risk of absolute price movements and replaces it with the risk of relative price movement. Figure 5-4 shows the relative price movement of cash corn prices and corn futures prices. The two markets tend to trend together, but not perfectly. Hedging can manage the risk of an absolute cash price movement only by substituting that risk with the risk that the cash and futures markets will not move perfectly together. The difference between the cash market price and the futures market price is called basis. Basis is the risk of relative price movements. The general statement is now modified to read: Hedging removes the risk of absolute price movements and replaces it with basis risk.

[FIGURE 5-3 OMITTED]

[FIGURE 5-4 OMITTED]

A basis value exists for every cash market. Futures prices are centralized but cash prices exist wherever individuals or businesses want to trade. Corn in Iowa is not the same as corn in Nebraska, even though they border each other, nor is it the same as in Texas. Not only do they differ by location, but the corn will be used differently at each location and will exhibit different price levels and patterns as shown in Figure 5-5. Nebraska and Iowa prices were almost identical from January to May 2000, but started to change during the summer and fall. The Texas price followed the same general price pattern as in Iowa and Nebraska but differed radically most of the year. When the futures price for corn is added, the basis for each market emerges and would be different because the cash prices are different, as Figure 5-5 clearly shows. Basis values for one cash market cannot generally be substituted for basis values for another. The importance of basis values will be more easily understood when hedging is more fully explained. Basis patterns are important and are discussed in more detail later in this chapter. Suffice to say at this point, basis is the most important aspect of hedging to understand.

[FIGURE 5-5 OMITTED]

Basis is defined as the difference between the futures price and the cash price, or basis = futures price (Fp) at time t less the cash price (Cp) at time t,

B = [Fp.sub.t] – [Cp.sub.t]

Markets that have futures prices that are higher than the cash price are said to be in contango, while markets that have the cash or spot price higher than futures prices are in backwardation. Using the above formula, markets in contango will produce a basis that is positive and markets that are in backwardation will have a negative basis.

General Rules and Effects of Hedging with Futures

Perfect hedges are like perfect humans–they don’t exist nor will they ever exist, but they can serve as a benchmark. A perfect hedge eliminates the cash market risk and has no basis risk effects.

A grain elevator buys 5,000 bushels of cash corn for a price of $2.00 per bushel. The elevator simultaneously sells a March delivery corn futures contract for $2.20 per bushel. Two days later the elevator sells the cash corn for a price of $1.95 per bushel and lifts the hedge by buying a corn futures contract for $2.15 per bushel. Table 5-5 reveals the effects of the hedge. The cash price risk to the elevator was that the price of corn would decrease and the corn would have to be sold for a lower price than the purchase price. The sell position in the futures provided the counterbalance. When the cash price decreased the futures price did likewise by the same amount, thus a perfect trade-off. The elevator did not make any money on the deal, but didn’t lose any either. Had they not hedged, the loss would have been 5 cents per bushel in the cash market.

If prices had increased instead, then a gain in the cash market would have been offset by a loss on the futures position as shown in Table 5-6. No matter whether prices go up or down, the elevator ultimately gets the same selling price for the corn because the gain or loss in either market exactly matches the other. The elevator sells the corn for $2.00 per bushel net regardless of whether or not prices went up or down. The elevator paid $2.00 per bushel for the corn, so the deal yielded no net gain or loss.

Without hedging, the elevator would have lost 5 cents per bushel if prices moved down, but would have made 5 cents per bushel if prices had moved up. The risk for the elevator is not that prices will increase, but rather that they will decrease. If the elevator gets in the market and places the hedge and if beginning basis remains the same as when the elevator gets out of the market and lifts the hedge ending basis the hedge will be perfect–neither a gain nor a loss will occur. Beginning basis (basis when the first trade occurred) will equal ending basis (basis when the offsetting trade occurred).

If the elevator has a perfect hedge then the effect is no gain or loss on the transaction. The elevator would have been just as well off by not entering the deal at all. In fact, when brokerage fees and the time value of money for the margin are considered, the elevator actually lost money by hedging with a perfect hedge versus not doing the cash deal at all. Therein lies the paradox–a perfect hedge is not desirable. What hedgers really want and need are imperfect hedges.

Imperfect hedges have a beginning basis and an ending basis that are different. A change in the basis will result either in a net loss or gain for the hedger. Table 5-7 shows a basis change that results in a net gain for the hedger, regardless of whether prices increase or decrease. Price direction is unimportant, only the relative movements between the cash and futures markets–basis–matters.

When a net gain from basis movements occurs the basis is said to have improved. A deterioration in the basis will result in a net loss for the hedger. Table 5-8 is an example of a basis that deteriorates. The elevator lost 2 cents per bushel regardless of whether price increases or decreases.

Imperfect hedges have gains and losses in the cash and futures markets when the prices go up or down. The only thing that matters is the net effect of both markets together. It is important to notice that the net gain or loss exactly matches the change in the basis. In both examples in Tables 5-7 and 5-8 the net gain and loss is 2 cents per bushel which is exactly the change in the basis between the beginning basis and the ending basis.

For long hedges the results are just the opposite. Table 5-9 shows an example of a feed company that forward sells mixed feed for delivery in two weeks with corn prices set at $2 per bushel. The feed company does not have the corn in storage and must buy the corn in the spot market a day before delivery and manufacture the feed. The feed company has the risk that corn prices will increase and squeeze or eliminate its profit margin in the feed.

The example in Table 5-9 shows the feed manufacturer losing 20 cents in the cash market, but the futures hedge made 22 cents because the basis improved 2 cents. The feed manufacturer made its profit margin plus an extra 2 cents per bushel on the corn because they had an improving basis on its hedge.

General rules of thumb about basis movements can be established. Short hedgers want the basis to narrow, that is, they want the ending basis to be less than the beginning basis. However, long hedgers want the basis to widen, as the example in Table 5-9 shows.

Net Hedged Prices

In the previous examples of Tables 5-7 and 5-8, a grain elevator buys spot corn and then hedges. A grain elevator is buying spot corn and later selling, hopefully at a profit. When the elevator buys the spot corn, the buying price is set ($2.00 per bushel in the previous examples). The elevator later sells the corn in the spot market, but the cash selling price is not the final net selling price because the effects of the futures market transactions have to be calculated as well. The net effect of both cash and futures market transactions yields the net selling price for the hedge.

Table 5-8 shows a net loss when price decreases 2 cents per bushel. The elevator paid $2.00/bushel for the corn and had a net loss of 2 cents per bushel on the sale, so the actual net selling price is $1.98 per bushel considering the effects of both cash and futures transactions. The elevator sold the corn in the cash market for $1.95 per bushel, but made 3 cents per bushel from the futures transactions. In effect then, the elevator had a net hedged selling price of $1.98 per bushel.

NHSP = net hedged selling price

FCSP = final cash selling price

NF = net futures gain/loss

Using the formula for the results in Table 5-8, Price decrease

NHSP = $1.95 + $0.03 = $1.98

NHSP = $2.05 + (-$0.07) = $1.98

The elevator paid $2 per bushel for the spot corn and ended up selling it for a net price of $1.98 per bushel which resulted in a 2-cents per bushel loss (exactly the change in the basis).

The long hedge example in Table 5-9 illustrates that the feed manufacturer has forward sold feed for delivery in two weeks with the price of corn fixed at $2 per bushel. When it actually buys the corn in 2 weeks it has to pay $2.20 per bushel in the spot market. Yet the futures transactions made 22 cents, thus the feed company had a gain of 2 cents. When the feed company forward sold the feed for delivery in two weeks it assumed a buying price of corn at $2 per bushel. It paid $2.20 in the spot market, but 22 cents in the futures, thus it really bought the corn for a net hedged buying price of $1.98 per bushel.

NHBP = net hedged buying price

FCBP = final cash buying price

NF = net futures gain/loss

Using the formula for the results in Table 5-9,

NHB = $2.20 – $0.22 = $1.98 per bushel

Using Futures in the Grains and Oilseed Markets

The oldest futures-type contracts in the United States originated in the grain markets. Needless to say, much has been written and observed about grain futures contracts. The range of traders in grains is perhaps the widest of all commodities. The list begins with simple short hedges for wheat farmers and continues up in complexity to large trading giants like Cargill that use complex basis trades to move grain around the world.

Wheat, corn, oats, barley, soybeans, canola (rapeseed), and flaxseed are crops that provide food for humans and animals. More and more, though, industrial uses are being made of these crops, such as ethanol, biodiesel, and plastics. Pharmaceuticals are becoming more mainstream in crop agriculture as ethnobotanists and biotech scientists discover products within plants that have medicinal properties. Higher value uses for major crops will necessitate a better understanding of how to manage the risk of price changes.

Grains and oilseeds are produced and harvested on a fairly regular schedule. Different varieties mature earlier and later and widen the harvest season, but with the exception of winter wheat and barley crops, all major grain and oilseed crops are planted in the spring and harvested in the fall. Grains and oilseeds are storable for extended periods of time. The combination of the biological process of planting and harvesting on a fairly fixed time schedule and the storable characteristics of the product provide a theoretical underpinning to develop a pattern for seasonal price movement. The price at harvest should be the lowest during the year as all of the year’s product is available to the market. As the product is placed in storage and pulled out during the year for use, the cost of storage will be reflected in the price–that is, after harvest the price should gradually increase to reflect the cost of carry. At the beginning of this chapter, Figure 5-2 illustrated this principle with the seasonal average cash price for corn in Iowa. The price is lowest at harvest in the early fall and gradually increases throughout the spring and then begins to fall as harvest approaches again. The model is not perfect, of course, but it does provide insight into the seasonal movement for grain and oilseed prices.

Cost of Carry Model

Storable products should have the cost of carry reflected in the price at various points in time. The cost of carry is the term used to reflect not only the physical cost of storage but the financial costs as well. Financial costs include the cost of insurance and should also contain the opportunity cost of money. Storage also has a deterioration cost because there is a risk that the product will change during storage and lose value or be totally lost. The cost of carry model is

[P.sub.t+1] = [P.sub.t] + [COC.sub.t]

[P.sub.t] = price in time period t

[P.sub.t+1] = price in next time period

[COC.sub.t] = cost of carry from one time period, t, to the next time period, t+1

For a grain like corn, this model works fairly well, as Figure 5-6 illustrates, from mid fall to early summer. As the new crop is harvested, [P.sub.t] reflects the new supply and demand conditions and restarts the seasonal pricing. If the model is started in September (Pt), then the price in October ([Pt.sub.t+1]) should be the price in September plus the cost of carry for one month. The price in November should be the October price plus the cost of carry for another month and so on and so forth until the new crop starts being harvested in summer and then there is a new [P.sub.t] as reflected by supply and demand for that particular crop year.

[FIGURE 5-6 OMITTED]

Basis and Cost of Carry

Basis is the numerical difference between a futures price and a cash price. If the cash price in Chicago for corn on November 1 is $2.00 per bushel, what price should a futures contract for December delivery trade for relative to the November 1 price? A rational value would be the cost of carrying the corn from the time period November 1 to December 1. The expected value of the futures contract would be the cash price in Chicago plus the amount of one month’s cost of carry. As December approaches the cost of carry lessens, and in December the cash price and the December futures price should be approximately the same. Figure 5-7 shows the cash price and futures price moving together as the futures contract nears maturity, reflecting the conceptual nature of the cost of carry model. The Iowa cash price for corn and the July delivery futures contract price differed by 60 cents per bushel in October 2001, but by May 2002, the difference had fallen to only 20 cents per bushel. As time eroded, so did the value of the cost of storage. The cash and futures prices for storable commodities should gradually come together (a lessening of the basis) as the futures contract nears maturity.

[FIGURE 5-7 OMITTED]

Basis and the Cost of Transportation

In Figure 5-7 the cash price of corn in Iowa and the futures price are moving closer together as the contract matures. But Iowa corn and corn futures are not the same because the futures contract is standardized for delivery to Chicago, St. Louis, or Toledo at a future date. As the Iowa cash price and futures price difference gets less due to the eroding nature of cost of carry, the prices should not be the same in July when the futures contract matures. The price of Iowa cash corn in July and the July futures contract for delivery elsewhere should differ by the cost of transportation from Iowa to one of the three delivery points. Transportation costs are fairly stable and thus the cost of transportation can be treated like a constant value throughout the holding period for the futures contract. The grain trade treats the transportation cost as a constant value to either be added or subtracted, depending on whether they are buying or selling the product, to the cash price relative to the futures price. For example, Tulsa, Oklahoma, can be reached by grain barges via rivers and canals from the Mississippi River. This added cost of transportation is called the “Tulsa basis,” implying the cost of transportation by river grain barge from the Mississippi River to the grain port in Tulsa.

Grain and Oilseed Basis Model

The basis for grain crops and oilseed crops can be expressed now as

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

[B.sup.t+n.sub.t] basis at time t for delivery in time t + n

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

(t + n) = futures delivery month

The estimated basis is

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

[??].sup.t+n.sub.t] = estimated basis at time t for delivery at time t + n

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

[COC.sub.t] = monthly cost of carry

T = transportation cost

The estimated basis model can be useful to determine how the real basis is conforming to the basis model of cost of carry and transportation. Estimates of basis values are very important to hedgers.

Farmers are involved in a complex process of combining inputs, managing those inputs in a crop-growing process, and harvesting the results. Once they commit to a growing a crop, farmers do not know with certainty what price they will get several months later at harvest.

As the production process proceeds and the price of the product decreases (remember that price tends to decline as harvest approaches), a hedge would need to increase in value to offer the proper counterbalance. Thus production hedges need a futures position that is short initially so that if price decreases, a gain will occur with the futures position. Regardless of the type of product or time period involved, a production price risk will always be hedged short.

Wheat Producer Example

A Kansas wheat farmer plants winter wheat in late summer or early fall and harvests the next calendar year in late spring or early summer. The farmer normally plants 1,000 acres and her average yield over the last five years has been 30 bushels per acre. She estimates this year’s crop at 30,000 bushels. She plants the crop in late August. The local cash price for hard red winter wheat is $4.00 per bushel. She harvests her crop in June and has a total crop of 32,000 bushels. She received a price from her local cash market of $3.20 per bushel. When she planted the crop she also hedged by selling six Kansas City July futures contracts at a price of $4.40 per bushel. When she sold her cash crop in June she bought back her futures contracts at a price of $3.40 per bushel. Table 5-10 summarizes the results and shows the net hedged selling price. Notice the net hedged price had to be adjusted because the cash and futures quantities were not a perfect match. A quantity adjustment factor must be applied to the futures portion to use the formula for net hedged prices. The quantity adjustment would be the futures quantity divided by the cash quantity. In the example, that would be 30,000/32,000 = 0.9375. This quantity multiplier would then be applied to the amount per bushel that the futures positions made ($1.00), or $0.9375 per bushel. The futures position made 93.75 cents per bushel for the cash position of 32,000 bushels. Using the formula for a net hedge selling price (NHSP),

NHSP = $3.20 + $0.9375 =$4.1375

This example has the farmer in an under-hedged situation by 2,000 bushels. The farmer estimated the crop to be 30,000 bushels and hedged accordingly. However, the actual crop turned out to be 32,000 bushels. The futures contracts are standardized and thus inflexible; therefore, this situation is very real. The futures and cash quantity positions will almost never be equal and a quantity adjustment multiplier must be used.

This example also shows a narrowing of the basis from the beginning of 40 cents per bushel to 20 cents at the end for a net gain of 20 cents. The local cash price when the crop was planted was $4.00 per bushel. The farmer did not have the product to sell at that time so she could not take advantage of that price. When the farmer sold her grain several months later, the price had fallen to $3.20 per bushel, a price decline in the spot market of $0.80 per bushel. However, the futures position gained $1.00 per bushel during the same time because the futures price declined by $1.00 per bushel, thus the 20-cent improvement in the basis ($1.00 – $0.80). The farmer didn’t get the net effect of the 20 cents because the cash and futures quantities were mismatched. The farmer’s net futures gain adjusted for the quantity difference was $0.9375 per bushel. So the farmer wanted protection against the 80 cents the cash price moved, but instead got the gain in the basis such that she received $0.9375. Therefore, the farmer was shooting for the $4.00 per bushel original cash price, but got instead $4.1375. The $0.1375 difference is also (and always is) the difference between the cash price movement ($0.80) and the quantity adjusted futures price movement ($0.9375).

A production hedge is the same regardless of whether the product is cotton, canola, or soybeans. The core concept of a production hedge is that the risk of a declining price during the production process needs to be counterbalanced with a financial asset that gains in value. The financial asset in the example in Table 5-10 is a short futures position. The wheat farmer in the example not only received price risk protection, but actually got a bonus of almost $0.14 per bushel because of a favorable basis change.

What about a price increase? The wheat farmer would have had a gain in the cash price but would have a loss in the futures side. Table 5-11 exhibits that effect.

Using the net hedged price formula,

NHSP = $4.50 + ($0.30 x 0.9375)

NHSP = $4.50 + ($0.28125) = $4.21875

The Decision to Over- or Under-Hedge

The farmer was under hedged by 2,000 bushels. When cash prices moved lower (against the farmer) under hedging lowered the net hedge price (the futures gain was $1 per futures bushel, but was lowered to $0.9375 per actual cash bushel). However, when prices moved up (in favor of the farmer) under hedging increased the net hedge price (the futures loss was 30 cents per futures bushel, but was lowered to $0.28125 per actual cash bushel).

This production hedge can serve to develop the rules of thumb for over and under hedging. A hedger should under hedge if he believes there is a stronger probability of cash prices moving in his favor than against him. He should over hedge if the chance that cash prices will move against him is greater than in his favor.

Grain and oilseed crops can be stored for long periods of time if proper conditions are maintained. A large segment of the grain and oilseed industry is composed of merchants that perform the task of storing grains and/or oilseeds. Often these market participants are also performing other functions such as assembly, grading, and transporting. The classic example is a merchant called a grain elevator. Elevators buy and sell grains and oilseeds from producers. They will commingle the grains and oilseeds to form larger lots or for a change in grades. Elevators range from simple operations in farming areas that just gather the crops and put them in larger lots for train or truck shipment to terminal centers on major rivers, rail lines, or road junctions that buy and sell from farmers and from other country elevators. Regardless of the size or location of the elevator, they all have a storage function to perform. Grain and oilseed crops are purchased and stored for later sale.

Elevators that hold crops for later sale run the risk that prices will decline after they purchase the grain or oilseed. Storage hedges are short hedges.

Grain Merchant Storage Hedge

A grain merchant buys 5,000 bushels of corn on March 15 for a price of $2.10 per bushel. They hedge it by selling one May corn futures contracts at a price of $2.25 per bushel. On April 15 the merchant sells the cash corn for $2.00 per bushel and lifts the hedge at $2.10 per bushel. Table 5-12 summarizes the results.

The merchant purchased the grain for $2.10 per bushel and ended up selling it for a net price of $2.15 per bushel for a net difference of 5 cents per bushel. What does the net difference of 5 cents per bushel represent? Using the cost of carry concept, the difference should represent approximately the cost of storage for the month that the merchant held the corn. To the extent that the actual costs of storage were less than 5 cents, the merchant had a net gain. If the storage costs were more than 5 cents the merchant had a net loss.

Since grains and oilseeds are storable, the estimated change in the basis values should narrow (decrease) over time. This allows for an opportunity for merchants when they hedge the grain and oilseed to be able to cover the cost of storage if the basis does in fact narrow.

Forward Pricing Hedging

Grain merchants, food processors, and feed processors have the opportunity to forward price grain and oilseeds. A food processor that is using wheat to make a breakfast cereal product generally has to forward sell the final food product to wholesalers before it is manufactured. To properly arrive at a price for the final product, an assumption about what the ingredient prices will be has to be made. The food manufacturer will have to forward price the final product and, consequently, in effect forward price the ingredients such as wheat at the same time. The food processor’s risk is that the ingredient price will increase before they can purchase the item and get the final product produced.

Food Manufacturer Hedge

A cereal manufacturer forward prices the product to a large wholesaler at $3.00 per item. The breakfast cereal product will be delivered to the wholesaler in two weeks. The food manufacturer will buy the ingredients two days prior to delivery, manufacture the product, and then deliver so that the product is fresh. When the food manufacturer sets the $3.00 per item price, they assumed the wheat could be purchased for $3.50 per bushel. The food processor has, in effect, forward sold the wheat at a price of $3.50 per bushel. The risk is that from the pricing time until the actual wheat is produced, the price of wheat will increase and eliminate the processor’s profit margin or severely squeeze the margin. The processor needs a counterbalance of a financial asset that would gain in value when wheat prices in the cash market increase. The processor needs to be a long hedger. Table 5-13 illustrates the hedge.

The processor sells the wheat for $3.50 per bushel and ends up buying it for a net price of $3.53 per bushel. The manufacturer had his profit margin reduced by 3 cents per bushel.

The hedge protected the processor, but not perfectly because the basis moved against the manufacturer by 3 cents per bushel. Yet if the processor had not hedged at all, the loss would have been the full 10-cent difference between the forward selling price and the buying price.

Basis Traders and Basis Contracts

The examples for production, storage, and forward pricing hedges show the effects that basis movements have on the net hedged prices. Once a hedge is properly placed, all that really matters is the movement in the basis–that is, the relative price movements between the cash price and the futures price. As hedgers become more familiar with the process and outcomes from hedging, basis develops into a more important factor to understand and use. The grain and oilseed markets use basis as a shorthand for trading. Sophisticated grain traders will offer cash corn for sale at “three off,” meaning 3 cents under the nearby futures contract. Cash grain and oilseeds are thus usually bought and sold at prices that are relative to the futures price by some amount. The words “off” or “under” mean the cash price is below the futures price and “on” or “over” mean above the futures price. A trader that sold “two on” actually got a price for her grain that was 2 cents above the nearby futures price.

As the cash market is related to the futures via a negotiated price differential, the opportunity to hedge and manage the basis increases. Table 5-14 illustrates an example of a basis trade with a grain merchant. The merchant has spot wheat purchased at $3.50 per bushel and hedged at a price of $3.70 per bushel. The beginning basis (often called the buying basis) is 20 cents. Any trade to sell the wheat for less than 20 cents will result in a net gain for the merchant. If he negotiates to sell the wheat for “15 off ” he will have a 5-cent net gain.

The merchant purchased the grain for $3.50 per bushel and had a net selling price of $3.55 per bushel, for a net gain of 5 cents per bushel–the change in the basis. The merchant assured himself a net gain by negotiating an ending or selling basis that was favorable relative to the beginning or buying basis.

The merchant in the example could have purchased the grain to begin with via a basis contract. The merchant could have offered to a wheat producer a basis contract with the following terms: transfer the title to the wheat now and keep the pricing rights to the wheat until November 30; up to November 30, any day’s December futures price can be used and the wheat priced at 20 cents under the futures. In other words, the wheat producer can select any day’s December futures price and receive 20 cents less than that price for the wheat. If the merchant negotiated this basis contract with the wheat producer in October, then he has set the beginning basis and now knows what ending basis will be.

A basis contact must have as a minimum the following:

1. The futures contract, i.e., which delivery month, such as December

2. A negotiated differential relative to the futures price for the cash commodity to be priced, i.e., what is the basis (“three on,” “two over,” etc.)

3. An ending point date, i.e., up to 5 P.M. on November 30

4. Knowledge of when title to the commodity passes and how storage costs are handled

Basis contracts offer hedgers the opportunity to have better control over beginning and ending basis values and thus the net margins on trades. They are in widespread use in the grain and oilseed markets and reach sophisticated levels using provisions called call contracts.

A call provision that is added to a basis contract specifies that the contract holder must call the broker of the contract provider to stipulate the day that the basis contract will be exercised. Otherwise, a call contract is just a simple basis contract. Proper use of call contracts allows certain hedgers to fix both sides of a trade.

A grain merchant enters into a call contract with a corn producer on September 1. The merchant will give the producer until November 30 to call and price the grain. The negotiated deal is this: the merchant will pay the producer the December corn futures price less 10 cents per bushel. The producer in turn releases the corn to the merchant on September 1, but has until November 30 to call the merchant’s broker. The merchant’s broker is informed of the deal and understands that when the producer calls, the broker will place a short futures position with December corn futures. The merchant then enters into another call with a feed processor to provide corn on September 1. The processor gets the corn now but has until November 30 to price the corn.

The deal the merchant makes with the processor is that the processor will pay the merchant the December corn futures price less 5 cents per bushel. The processor can call the merchant’s broker any time up to November 30. The merchant’s broker is informed of the deal and instructed to buy a December corn futures when the processor calls.

Both sides of the deal are struck and the merchant has made 5 cents per bushel on the deal. How? The merchant has fixed the basis on both sides of his deal–one at 10 cents and the other at 5 cents, thus the change is set for 5 cents and becomes the merchant’s margin. Table 5-15 shows the deal with the processor starting the process and Table 5-16 indicates the same deal with the producer calling first. It doesn’t matter which party calls first, nor does it matter what the futures price is. The merchant will still make the same 5-cent margin because the basis has been fixed for both the beginning and ending deals.

The call contract with the producer is called a seller’s call because the action that the broker is instructed to take is a short futures position. The deal with the processor is called a buyer’s call because the broker’s action will be a buy in the futures market.

Most soybeans go through a crush process that separates the raw beans into meal and oil. The old manufacturing process was an actual crushing machine that squeezed the oil out of the beans. Modern crush plants still crush the raw beans somewhat, but rely on solvents to extract the oil. The solvent is extracted and reused. Soybean processors buy raw soybeans, crush them, and sell the resulting meal and oil. The amount of meal and oil that a bushel of soybeans produces is called the crush yield. Crush yields are reported on a regular basis, but a general rule of thumb is that a 60 pound bushel of soybeans will produce 48 pounds of meal, 11 pounds of oil, and 1 pound of waste. The difference between the value of the meal and oil and the price of the soybeans is called the crush margin. When the crush margin is greater than the cost of crushing, processors will enter into a hedge called putting on crush. When the margin is less than the cost, the hedge is called a reverse crush.

The theory behind the processor crush hedge is that the difference between the value of a raw product and the value of the finished products obtained from the raw product should be equal to the cost of processing. If the margin is higher than the cost of processing, then the profits will bid up the price of the raw product as more processors try to buy the product to produce. As they produce more the final products will be worth less as more of the products reach the market place. This action will reduce the profit margins back down to the cost of processing. On the other hand, if the cost of processing is greater than the margin between the value of the raw product and the finished products, processors will stop producing as much. This will result in the price of the raw product falling as few processors bid in the market place and the value of finished products will increase as they become scarcer. This action will drive the margin back up to the cost of processing.

Soybeans are unique among futures contracts in that the raw product and both of the major items produced from the raw product–meal and oil–have futures contracts. Canola now has a meal futures contract, but not an oil contract, so a complete crush hedge is impossible. Table 5-17 is an example of a soybean crush hedge.

A soybean processor can buy November soybeans for $5.50 per bushel. The November soybean oil contract is trading at $0.10 per pound and the November meal contract is at $0.11 per pound. Using the crush yield of 48/11/1 the value of the meal is 48 x $0.11 = $5.28 in a bushel of soybeans. The oil value is 11 x $0.10 = $1.10 per bushel. The total value of the meal and oil in a bushel of soybeans is $6.38 per bushel. The beans are trading at $5.50 per bushel for a crush margin of $0.88 per bushel. Current crush costs are $0.50 per bushel. There is a net margin of $0.38 per bushel for the November futures. The processor will put on a crush hedge by buying soybeans and at the same time selling meal and oil futures.

By November 1 the processor lifted the hedge and made the net margin as the prices moved as the theory suggested. If the prices did not change by November 1, the processor could stand for delivery of the soybeans, process them and deliver against the futures and make the net margin. Processors that use crush hedges can effectively set their net crush margins in advance.

Reverse crushes are used when the net crush margin is less than the cost of crush. The hedge is a simultaneous selling of the soybeans and buying of meal and oil futures as illustrated in Table 5-18. The crush margin is zero and the net margin is a loss of the cost of crush. The reverse crush allows the processor to make back the cost of crush. This hedge will not yield a positive net crush margin, but does allow the processor to recover the cost of crush. Soybean processing plants cannot easily be shut down and started up just because of a temporary loss. Without the reverse crush hedge the processor would have lost 50 cents per bushel, but with the hedge they broke even.

Using Futures in the Livestock Industry

Livestock products have a rich history in the futures industry. The forerunner to the Chicago Mercantile Exchange (CME) was the Chicago Butter and Egg Board in the late 1800s. Over the last 125 years, almost every type of livestock product from eggs to frozen beef has had a futures contract. No other futures contract enjoys such popularity (good and bad) as bacon–the infamous pork belly futures contract of television and movie lore as a way to speculate in the futures market.

When the CME first proposed live animal futures contracts in the early 1960s, they were greeted with a great deal of skepticism. Critics did not understand how a futures contract could exist on something that was not storable. Livestock products such as eggs, butter, and cheese can be stored and fit the cost of carry model for price differences between two futures months. Live animals cannot be stored for longer than a few days before the growth and aging process changes their form. Critics asked, “What would be the theoretical model for the price differences between two futures months?” The correct answer, one that critics didn’t like, was “We don’t know.” In retrospect, the decision to offer live animal futures contracts became the watershed for other futures such as currencies, financial instruments, and indexes that followed a decade or more later. Futures had to be viewed with a wider angle lens than just storable commodities.

Live animal futures–hogs, feeder cattle, and live cattle–have a basis that does not follow the cost of carry model for price differences. To be sure, a few days of storage exists as both hogs and cattle can be held on a maintenance ration for a brief period of time, but not for any extended period. What should be the difference between today’s local cash price and the next futures delivery contract? A small amount of storage (a few days at most), transportation (if not near a delivery point), and expectations of future supply and demand are the basis components of live animal futures. The storage component is small and almost nonexistent. If a transportation differential exists, it is a constant just like that for storable commodities. The major difference between a cash price and a futures price is the expectations of differing supply and demand conditions in the future versus today. Unfortunately, a useful model to predict the different expectations in supply and demand does not exist. In other words, we don’t know–just as we didn’t know in the 1960s when livestock futures were first proposed.

[FIGURE 5-8 OMITTED]

Hogs and cattle have seasonal and cyclic trends that can be useful to estimate price differences between time periods, but can serve only as a guide. Basis values generally narrow as the futures contract delivery month approaches the calendar date as expectations and reality get closer. However, basis is not as predictable for live animals as it is for storable commodities, and no satisfactory model exists that is a useful guide for estimating expected basis values. Traders resort to empirical data to get trends and patterns. Figure 5-8 shows that Iowa cash hog and futures prices do tend to trend together, thus the futures market can be useful as a price risk management tool.

Livestock products such as milk, butter, nonfat dry milk, and pork bellies (both fresh and frozen) more closely follow the cost of carry model because they can be stored for some period of time (fluid milk is the exception, but fluid milk can be held for 2 weeks so it does have a storage cost).

Live animals such as hogs, feeder cattle, and live cattle go through a growing process that subjects them to the risk that prices will decline and they will be worth less than the cost of production when they are ready for market. The lean hog futures contract is for a slaughter-ready animal and likewise for the live cattle futures contract. The feeder cattle contract is for an animal that is ready to be put into a feeding operation to become a slaughter-ready animal (live cattle). The hog industry is composed of several stages; one stage includes producers who have a farrowing operation that produces only weaning piglets. Others have a finishing operation that buys the weaned animals and finishes them into slaughter-ready animals. Still others are farrow-to-finish operations. Regardless of the type of hog producer, since only one type of futures contract exists, only slaughter-ready animals can be hedged. Cattle production operations are conceptually similar. Ranches run the gamut from cowcalf operations that produce weaned calves to those that carry the weaned animals into a final finishing operation that sells slaughter-ready animals. However, cattle futures exist on feeder animals and live animals and therefore provide more risk management opportunities than hog futures contracts do for swine operators.

Hog Production Hedge

A hog operation that buys weaned pigs will put those animals on an intense feeding plan to get slaughter-ready animals. The feeder pigs are generally purchased near a weight of 60 pounds on average and will be fed for about 80 days on average. Table 5-19 shows a production hedge with a basis improvement. The producer estimates that the death loss will be two feeder pigs and that the slaughter-ready hogs will weigh approximately 230 pounds each at market time. When market time arrives, the producer will have had a death loss of three animals and the average weight was 238 pounds each. The producer received a net price for the hogs of $41.70 per hundredweight for 177 animals despite having a higher death loss than anticipated and selling somewhat heavier hogs. The producer was under-hedged from the beginning because the estimated pounds to be sold later were 178 (estimated death loss of two pigs) at 230 pounds each for a total weight at market estimate of 40,940 pounds. A hog futures contract is for 40,000 pounds. The producer actually sold 42,126 pounds, which made the hedge under-hedged by 2,126 pounds. Put another way, 2,126 pounds received the market price of $36 per hundredweight ($765.36) and 40,000 pounds received the benefit of the hedged price of $42 per hundredweight ($36 + $6), or $16,800 for a total of $17,565.36. Because the hog futures contracts, like the grain and oilseed contracts, are standardized, it is impossible for any producer to ever be perfectly hedged.

A typical cow-calf operation involves a brood herd of cows that are artificially inseminated or bred with bulls. Calves are weaned normally in the fall and weigh between 350 and 600 pounds depending upon breed, feeding conditions, management, health, and weather. Many ranchers will either sell the animals at weaning or hold them to heavier weights. Ranchers will hold the animals to heavier weights if they have ample grazing available or want to sell them to feedlots. The feeder cattle futures contract calls for 50,000 pounds of heavy (greater than 800 pounds) feeder steers. Cow-calf producers will almost always have to place a cross hedge. A cross hedge is a hedge whereby the cash and futures specifications do not match exactly. Almost all futures hedges are cross hedges, but the differences are much greater with feeder cattle. First and foremost, the futures contract calls for steers (males castrated before sexual maturity) while all cow-calf operations will have an approximately 50-50 split between steers and heifers (nonimpregnated females). Steers almost always carry a cash price premium. The second major difference is that feeder cattle futures are for heavy feeder steers (greater than 800 pounds) while most ranchers will sell their animals at weaning weights of 500 pounds on average, thus there is often a major mismatch of weights. Lighter weights carry a higher spot price premium per hundredweight. Despite these two major differences, light weaned mixed-sex feeder animals can be cross-hedged fairly well with the heavier feeder cattle contract because price trends will be similar.

Assume a rancher has 150 cows and estimates a calf crop of 145 animals (a 97 percent calving rate). The rancher estimates a death loss of three animals during the growing season and a net of 142 weaned animals to sell at an approximate weight of 600 pounds each. The total estimated weight of animals at market time will be 85,200 pounds (142 x 600). The futures contract calls for 50,000 pounds. The rancher will have to be under-hedged by 35,200 pounds with one futures contract, or over-hedged 14,800 pounds with two futures contracts.

The rancher opts to be over-hedged, as Table 5-20 reveals. The rancher had 87,120 pounds of animals to sell and was hedged with 100,000 pounds of futures for an over-hedged position of 12,880 pounds. The rancher got a net hedged price of $83.03 per hundredweight. The overall price of feeder cattle fell during the growing season for the rancher and the hedge earned an extra $7,000 in income for the rancher, pushing the net price up from the spot price of $75 per hundredweight to $83.03 per hundredweight.

Feedlots are manufacturing operations that process concentrated rations of grains and oilseeds and other nutrients through feeder cattle into beef that is sold to consumers ultimately as steaks, roasts, and other retail beef products. Feedlots (also called feed yards) put feeder cattle ranging in weight from approximately 600 pounds to 900 pounds on rations that will cause them to gain weight and change product form so that they are appealing to customers as retail beef products. Two major types of feedlots exist: custom feeders and retained owners. Custom feedlots solicit customers to put their own cattle in the feedlot and pay a fixed fee for the feed, care, and management of the animals. The customer then sells the cattle to a packer. A retained-owner feedlot owns its own cattle, pays for the feed, care, and management of the operation, and sells its own cattle. Some feedlots do both. They put as many of their own cattle on feed as they want to and then solicit other custom feeding as a way to fill the yard to capacity.

A retained-owner feedlot has the price risk that while the animals are being fed, the price of live (fed) cattle will decrease. It will need a typical production hedge. Also, it will have to periodically buy grains and proteins to make the rations. It will be worried that grain and protein prices will increase. It will need to long hedge the inputs.

Table 5-21 illustrates a feedlot hedge for the live cattle (output) and the major feed ingredient, corn (input). The example shows no differences between the cash and futures quantities or any basis changes (that is, they are perfectly hedged) for both the output and input. This allows for a better view of the reason to hedge both output and inputs when possible. The feedlot could have sold live cattle in January for $80 per hundredweight but the cattle needed to be fed out until July. During that feeding period, live cattle prices fell to $68 per hundredweight; however, the hedge protected the feedlot and the end result was a net hedged selling price for the live cattle at $80 per hundredweight. A similar opportunity exists for one of the major feed inputs, corn. The feedlot could have purchased all of the corn needed in January, but had storage for only half the amount needed. The hedge protected the feedlot against the price of corn increasing, which it did by April 1 from $2.10 per bushel in January to $3.00. Yet the hedge lowered the net hedged buying price back to $2.10 per bushel. The process by which a manufacturer, such as a feedlot, hedges all available outputs and inputs is called total hedging.

A milk processing plant buys milk from dairies. It pasteurizes and homogenizes the milk, packages it, and ships it out to wholesalers or retailers. A milk processor runs the price risk that between the time it buys the milk from dairies and sells it to a retailer the price will drop. It also forward sells to retailers for delivery at a later date and then has to buy the milk from dairies, and thus faces the risk that prices will increase. This type of a food processing company can be both a short and long hedger, depending upon which cash action it has performed first.

Assume a milk processing company gets a chance to forward sell fluid milk to a retail supermarket chain at a price of $2.10 per gallon ($16.17 per hundredweight equivalent at 7.7 gallons per hundredweight; processing costs are $5 per hundredweight, leaving a profit margin of $1 per hundredweight, assuming a cost of milk from dairies at $10.17 per hundredweight). The processor will deliver the milk in five days. The processor buys fluid milk futures at $12.50 per hundredweight. On day four they buy fluid milk from dairies at an average price of $11 per hundredweight and lift the hedge at $14.83 per hundredweight. Table 5-22 summarizes the transactions. No basis change or quantity differences are used so that the pure effect of price protection can be observed.

This example shows how a processor can forward sell product in advance and still protect profit margins. The processor still made a $1 per hundredweight profit even though the price they had to pay for the product went up $0.83 per hundredweight. Without hedging, the profit margin would have been reduced to only $0.17 per hundredweight. It is important to note that if prices had gone down, the cash purchase price would have been lower and the profit margin wider, but the futures transactions would have taken that away and the profit margin would still be $1 per hundredweight.

Processors and other businesses can fix the profit margin in advance and will receive close to that margin, plus or minus the basis change. Without hedging, the processor’s margins will rise and fall with the spot market. This form of hedging is called margin-based hedging and is a tremendous risk management tool.

Despite not having a good theoretical model to predict basis in live animal futures, livestock futures can perform as a price risk management tool of considerable value. Most traders who regularly use livestock futures use historical basis charts that reveal the empirical values over time. The past is not the future, but the empirical basis does give traders a sense of basis levels during certain periods and what past trends show.

Using Nonagricultural Futures in Agriculture

The most successful futures contract in terms of volume of trades for the last several years has been the Treasury Bond futures contract traded on the Chicago Board of Trade. Prior to the early 1970s only agricultural contracts or other commodities such as metals were traded on futures exchanges. Livestock contracts in the late 1960s exposed traders to dealing with nonstorable commodities, and as they learned to deal with more uncertainty, other ideas emerged. In the early 1970s foreign currencies and then later financial futures contracts were added to the trading pool. Figure 5-9 shows the major interest rate and foreign currency.

Most nonagricultural futures contracts involve large sums of money such as the T-Bond futures contract at $100,000 so they are not very useful to very small agribusinesses, but they can be very important to medium to larger operations. Agribusinesses use large amounts of credit and therefore have credit risks pertaining to changes in interest rates. Additionally, any agribusiness that deals overseas will potentially have a foreign exchange risk as financial payments get converted to and from dollars and other currencies. Interest rate risk and currency risk will be discussed in this section and basic hedging with futures will be outlined. More complex risk management strategies will be developed in other chapters using nonagricultural futures as they relate to overall operational risks in agriculture.

Interest Rate Risk

Futures contracts exist on several interest rate instruments as shown in Figure 5-9. These contracts cover short-term (T-Bills), intermediate (T-Notes), and long-term (T-Bonds) interest rates as well as numerous others such as LIBOR and municipal bonds. Most of these contracts do not directly relate to any agribusiness or producer, yet they can be used to mitigate certain risks with interest rates via cross hedging. T-Bills are 90-day short-term riskless interest rates. U.S. Treasuries–bills, notes, and bonds–carry zero risk of default and thus are called riskless. If the U.S. Treasury fails, so the theory goes, all is lost anyway. Conversely, a bond issued by a private company will have a higher interest rate than a T-Bond because it will carry some risk of default because companies can fail (Enron and Montgomery Ward are recent examples). From a private investment standpoint, the difference between private debt instruments and U.S. Treasury interest rates is important, but from a hedging standpoint all that matters is that the prices of U.S. Treasuries move as the general market for debt instruments moves. Since the U.S. Treasuries represent a riskless rate, they form the base for all interest rates. As the base value moves, so do all other rates. This is the reason that the U.S. Treasuries have become so popular as a way to protect against all interest rate movements.

Two other futures contracts are important: the Eurodollar and one month LIBOR. The Eurodollar futures represents U.S. dollars that are deposited in banks outside the U.S. and represent short-term interest rates on corporate accounts. The London Interbank Offer Rate (LIBOR) is a very short-term rate that is a benchmark for corporate financing and is tied to a variable rate.

Interest Rate Hedging

Agricultural firms that use debt financing can either get a fixed rate loan or a variable rate loan. Fixed rate loans do not have any risk that the interest rate will change during the loan period. Variable rate loans are subject to change based on a fixed schedule, often quarterly or annually. Variable rate loans have the risk that rates will move against the borrower, i.e., go up.

Variable rate loans usually carry a lower initial rate relative to a fixed rate loan. The lower initial rate reflects a lower risk to the loan originator. A variable rate loan will be adjusted as interest rates move up or down, thus the financial institution that made the loan does not bear the risk of the interest rate change–the borrower does. A fixed rate loan has to have a high enough rate to compensate for the risk of an adverse interest rate movement for the financial institution. The financial institution bears the risk of rate changes with a fixed rate loan, not the borrower.

Assume an agribusiness firm borrows $1,000,000 for six months to meet some unusual cash flow needs. The rate is tied to the T-Bill rate and can be adjusted every quarter. The formula for the interest rate on the loan is the current T-Bill rate plus 5 percent. The current rate on the day the loan was completed was the T-Bill rate (3.5 percent plus 5 percent – 8.5 percent). In three months the rate will adjust once again by the formula. The firm has the loan rate fixed at 8.5 percent for the first three months but has interest rate risk for the last three months. If T-Bill rates go up, the loan’s rate will also go up and the borrower will have to pay more. For the firm to protect themselves, they need something that will increase in value when interest rates increase. As interest rates increase, the price of interest rate instruments falls, so the borrower needs to hedge short with T-Bill futures as illustrated in Table 5-23. The firm had to pay 1 percent more on the loan for the last three months of the maturity, for an extra out-of-pocket expense of $2,500. The hedge protected against interest rates going up and brought in an additional $3,000 to more than offset the extra cost of the loan. The loan’s effective interest rate was lower.

Interest rate hedging is trickier than commodity futures hedging because time has to be considered in valuing interest rate instruments and because of the inverse nature between the price of the instrument and the movement in interest rates. Later chapters will provide more detailed risk management examples with hedging and interest rates and the importance of measuring dollar equivalency between the cash exposure and the hedge.

Foreign Currency Risk

The dollar changes in value relative to many other currencies on a continuous basis, just like any other commodity changes in value depending on supply and demand factors. For the last 30 years, most of the world’s currencies have been openly traded instead of being quasi-fixed as was the case while the old Bretton Woods Agreement was in effect from the late 1940s until the early 1970s. The U.S. dollar is said to be strong when it takes fewer dollars to buy a foreign currency and is weak when it takes more. If it currently takes 65 cents U.S. to buy $1 Canadian and later in the week it takes 68 cents U.S. to buy a $1 Canadian, the U.S. dollar is said to be weaker relative to the Canadian dollar.

This is counterintuitive in a way. The higher the price of the U.S. dollar relative to buying Canadian dollars, the weaker the U.S. dollar, and vice versa. When other commodities such as corn increase in price, the commodity has also increased in value. Not so with currencies. Currencies are always priced relative to another currency, so as one increases in value, the other must decrease in value. Because they are priced relative to each other, an increase in the price of one must imply that fewer units of the other currency can be exchanged.

Exchange rates reflect the price of one unit of currency necessary to buy one unit of another currency. In the United States, if a person wanted to buy Canadian dollars, the exchange rate would be quoted as the price of one unit ($1 U.S.) to purchase one unit of Canadian currency ($1 Canadian), or as 0.65, meaning it takes 0.65 x $1 U.S. to buy $1 Canadian, or 65 cents U.S. In Canada, they will use the reciprocal (1 divided by .65 = 1.54). A Canadian would have to put up $1.54 Canadian to buy $1 U.S. Therefore, it is important to know how the currencies are stated relative to each other. Usually, within a country the exchange rate is expressed as how much of that country’s currency is needed to purchase another country’s currency. In Canada the U.S./Canadian exchange rate would be listed as 1.54, while in the U.S. it would be listed as 0.65–the same concept, just the reciprocal. This means there are two exchange rate numbers for each pair of currencies, as the example with Canada and the U.S. shows. When using foreign currency it is important to know and understand how the currencies are priced relative to each other so that proper adjustments and exchanges can be made.

The price risk with foreign currencies necessitates a flow and exchange between two or more currencies. Domestic agribusinesses that deal only in U.S. dollars need not worry about foreign exchange risk. Foreign exchange risk is added to the already-existing bundle of risks that firms must face when international financial dealings occur. Some companies avoid the risk of foreign exchange by demanding payment in U.S. dollars. Everything is priced f.o.b. U.S. dollars. Almost all U.S. cotton that moves to Mexico is priced by cotton merchants in “U.S. dollars f.o.b. border,” meaning the Mexican merchant will pick up the cotton at a point on the U.S./Mexico border and the transaction will be in U.S. dollars. The U.S. merchants have shifted the risk of foreign exchange to the Mexican merchants. The Mexican merchants have all the risk of foreign exchange.

Foreign Exchange Hedging

If a U.S. cotton merchant wanted to win some new customers among Mexican cotton mills, one way to do it would be to shift the risk of foreign exchange from the Mexican business to the U.S. business. What if the U.S. cotton dealer priced the cotton to a Mexican cotton mill as “Pesos f.o.b. border”? The Mexican merchant does not have any foreign exchange risk–they will pay in their own currency at the border and take the cotton. The U.S. cotton dealer will now have pesos, and he will have to convert them to U.S. dollars. All of the risk of foreign exchange is now in the hands of the U.S. cotton dealer. If the U.S. cotton dealer can handle the risk of foreign exchange, then he will have a competitive advantage over other U.S. merchants that force the foreign exchange risk on Mexican merchants.

Table 5-24 presents an example of a U.S. cotton merchant’s deal with a Mexican cotton mill. The U.S. cotton dealer forward sells cotton to a Mexican cotton mill for delivery in two weeks “Pesos f.o.b. border.” The U.S. merchant would have lost 5.5 cents per pound on the exchange rate risk had they not hedged. The hedge protected the merchant almost completely because the net hedged selling price was $0.595 per pound versus $0.60 per pound when the deal was struck. The advantage to the U.S. merchant is that they need not fear foreign exchange risk because proper hedging can counterbalance the risk. International markets are available to businesses that know how to handle the risk of foreign exchange.

Futures contracts allow agricultural businesses and producers to manage the risk of price change. The contracts are simple to use–hedges are either long to protect against increasing prices or short to protect against decreasing prices. A combination of simultaneous buys and sells are used by soybean processors when they protect crush margins. Farmers and ranches do not have to be at the mercy of major market price swings if they hedge with futures. The downside, of course, is if prices move in favor of the hedger, then the hedge will take that gain away. Price risk management with futures has a major cost–it protects against adverse price movements at the expense of taking away gains when favorable moves occur. To compensate for this major drawback, futures hedgers use basis trades and speculate on when is the best time to place the hedge, called selective hedging. Selective hedging and basis trading are important concepts in price risk management and will be dealt with in more detail in later chapters as sophisticated risk management strategies are developed. Nonetheless it is critical to understand the fundamentals of futures hedging extremely well. The basic futures hedge is 90 percent of all price risk management. To know futures hedging is to have the most importance piece of price risk management mastered.

1. A cotton farmer plants in the spring when local cotton prices are at $0.60 per pound. The farmer properly hedges. Assume that the amount the farmer sells in the cash market at harvest and the size of the futures position exactly match. The cotton farmer sells in the fall after harvest at a local price of $0.50 per pound. The farmer had a basis improvement of 2 cents per pound. What would be the farmer’s net hedged selling price?

2. Soybean crush hedges are more certain to protect crush margins than reverse crushes. Why?

3. A rancher estimates that he will have 75,000 pounds of feeder cattle to sell at a later date. He must decide to over-hedge with two futures contracts (50,000 pounds each), or under-hedge with only one. Either way they are over- or under-hedged by the same amount (25,000 pounds). Which way should they hedge? Why?

4. A grain merchant buys cash corn for a price of $2.00 per bushel and properly hedges at $2.20 per bushel with a December corn futures contract. The merchant later sells the cash corn for $2.30 per bushel and lifts the hedge at $2.40 per bushel. What is the merchant’s net hedged selling price? Assume quantities in the cash and futures are identical.

5. A grain merchant buys 9,000 bushels of cash wheat for a price of $3.50 per bushel and properly hedges at $3.70 per bushel with two July wheat futures contracts (5,000 bushels each). The merchant later sells the wheat in the cash market for $3.70 per bushel and lifts the hedge at $3.80 per bushel. What is the merchant’s net hedged selling price?

6. A candy manufacturer forward sells candy to a retailer for delivery in two weeks. The candy uses a great deal of whole milk. The manufacturer prices the candy to the retailer assuming a fluid milk price of $10 per hundredweight. The manufacturer will buy the milk from a local dairy two days before delivery and manufacture the candy and then deliver it by the two-week deadline. What kind of hedge will the manufacturer place? Why?

7. A large agribusiness firm has a commitment from a bank for a loan of $10 million in two months. The bank will give the firm a fixed rate loan, but will not commit to what the rate will be until the actual day the loan is processed in two months. Does the agribusiness firm have an interest rate risk? If so, how would they handle the risk? If not, why?

8. A cattle trader buys feeder cattle from a rancher for $80 per hundredweight and properly hedges them at $82 per hundredweight. The trader can sell the cattle the next day to a feedlot at a basis of $2.30 per hundredweight. Should the trader take the feedlot deal? Why?

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