Basics of Futures Hedging

1
Basics of Futures Hedging

• Jim Sartwelle, III
• Extension Economist
• Texas AM University
• ANSC 437, March 6, 2003

2
What do you worry about when you own cattle?

• That the price might go down before you can get
  them sold
• You know your breakeven, but you dont really
  know if you can meet it
• How can you manage that risk?
• Forward contract
• Hedging with futures

REVIEW OF 10-17
3
What are futures?

• A futures contract is a binding agreement between
  a seller and a buyer to make (seller) and to take
  (buyer) delivery of the underlying commodity at a
  specified future date with agreed upon payment
  terms.

REVIEW OF 10-17
4
Contract specifications for cattleEach trades at
the Chicago Mercantile Exchange from 905 am to
100 pm CST

• FEEDER CATTLE
• Months Jan, Mar, Apr, May, Aug, Sep, Oct, Nov
• 50,000 pounds of 700-849 USDA Medium Frame 1
  and Medium and Large Frame 1 steers

• FED CATTLE
• Months Feb, Apr, Jun, Aug, Oct, Dec
• 40,000 pounds of 55 Choice/45 Select live
  steers

REVIEW OF 10-17
5
Impact of a change in value

• The impact depends if you bought the futures
  contract or sold the futures contract
• Futures jargon
• Short position means you sold the futures
• Long position means you bought the futures

REVIEW OF 10-17
6
Impact of a change in value, contd

• If you are in a short position (you sold)
• You benefit from a decrease in value
• If you are in a long position (you bought)
• You benefit from an increase in value
• This is not rocket science. Do not become
  intimidated by futures.

REVIEW OF 10-17
7
Back to the breakeven example

• Remember that the East Texas rancher has an
  estimated breakeven of 0.7521/lb for 710 pound
  steers
• What was Johnnys question?
• What can that rancher do to get a sales price
  above the breakeven price?
• Look to the futures to HEDGE in a price

8
Selling Hedge

• Taking a futures market position that is equal
  and opposite to the position that will ultimately
  be taken in the cash market
• Why do you use a selling hedge?
• When a commodity price is acceptable prior to
  when the product is sold in the cash market, a
  selling hedge can reduce the risk of declining
  prices.

9
How does the selling hedge work?

• Futures and cash prices generally move together
• If futures and cash prices decrease while a hedge
  is in place, gains in the futures market offset
  lower cash prices
• If futures and cash prices increase while a hedge
  is in place, losses in the futures market offset
  higher cash prices

10
What is basis?

• Simply put, it is cash price minus futures price
• What is it?
• Since futures price is a national price and cash
  price is basically local, the difference between
  the two is due to local supply and demand factors
• Basis is important because it can really screw up
  your hedge if youre wrong

11
Steps in implementing a hedge

• Determine your breakeven
• Determine the quantity to hedge
• Use the proper futures contract and contract
  month
• Estimate your expected basis
• Be disciplined
• Maintain the hedge till you sell in the cash

12
Example Selling hedge for corn

• Bill is a corn farmer who harvests in October.
  His 10-year average corn production is 24,000 bu.
  During the past 5 years, his lowest production
  was 15,000 bu.
• At planting in March, Bills expected breakeven
  is 2.35/bu
• He looks at the futures for a hedge opportunity

13
Selling hedge for corn March

• In March
• December CBOT Corn futures is 2.65/bu
• Historical harvesttime basis is -0.05/bu
• Bill expects a harvesttime cash price of 2.60/bu
  (futures price less expected basis)
• He decides to hedge 15,000 bu (3 contracts at
  5,000 bu each)

14
Selling hedge for corn October

• At harvest
• Cash market at harvest is 2.40/bu
• December CBOT Corn futures is 2.45/bu
• Actual basis is -0.05/bu, as predicted

15
Summary of corn selling hedge
16
How and why did it work?

• How?
• Because the futures and cash prices each went
  down, gains in the futures offset the diminished
  cash price
• Why?
• Bill forecast basis accurately. Basis moves can
  increase or decrease the net sales price.

17
Lets go to the paper exercise
18
So what do we have?

• We have a seamless link between production
  efficiency, cost of production, market outlook,
  and marketing strategies.
• YOU CANT HAVE ONE WITHOUT HAVING THEM ALL

19
Closing up

• I will provide an Excel spreadsheet with much of
  the historical market information we discussed
  last Tuesday
• E-mail me at j-sartwelle_at_tamu.edu
• Put Market Spreadsheet in subject line
• Best of luckits been fun