Hedging

1
GRAIN MARKETING
Chapter 3
2
Grain Marketing Alternatives
3
Marketing Alternatives Extend Time to Price Grain
Time Periods to Price Grain
Pre-harvest Pricing
Planting Growing Season
Harvest Post Harvest
About 24 months
About 6 months
About 12 months
4
Pricing Decision Chart
UP
ALTERNATIVES
ALTERNATIVES
1. BASIS CONTRACT 2. SELL CASH AND BUY
FUTURES OR CALL OPTION 3. MINIMUM PRICE
CONTRACT
1. STORE WAIT TO PRICE 2. DELAYED PRICE
CONTRACT
FUTURES PRICE
BASIS
BASIS
STRENGTHEN
WEAKEN
ALTERNATIVES
ALTERNATIVES
1. CASH SALES 2. FORWARD CONTRACT
1. HEDGE 2. NO BASIS ESTABLISHED 3. PUT
OPTION
FUTURES PRICE
DOWN
5
Cash Market Sell at Harvest Advantages 1. Easy,
well understood 2. No storage required 3.
Money available at harvest 4. Limits risk to
production season 5. Price known
immediately 6. Shrink to 15.5 vs 14 for
storage Disadvantages 1. No pricing
flexibility 2. Prices usually lower 3. Basis
usually weak 4. Congestion at elevator
6
Cash Market Commercial Storage, Sell
Later Advantages 1. Adds pricing
flexibility 2. No risk in maintaining
quality 3. Market by delivering warehouse
receipt 4. May get loan using warehouse receipt
as collateral 5. Can gain from price
increase Disadvantages 1. Speculation
continues after harvest 2. Storage costs may
exceed price gain 3. No income until sale of
grain or loan 4. Reduces flexibility on where
to sell 5. Pay commercial storage rates
7
Cash Market On-Farm Storage, Sell
Later Advantages 1. Gives pricing
flexibility 2. Adds flexibility over where to
deliver 3. Can gain from price increase 4.
Utilizes on-farm storage Disadvantages 1.
Speculation continues after harvest 2. Grain
quality may deteriorate 3. May miss marketing
opportunities due to seasonal workload 4.
Storage costs may exceed price gain 5. No
income until sale of grain
8
Cash Forward Contracts Advantages 1. Price
known immediately 2. Most popular of forward
pricing alternatives 3. No initial margin, or
margin calls 4. Easy, binding on buyer and
seller 5. Eliminates basis and price risk 6.
Can sell any amount 7. Extends marketing
season Disadvantages 1. Must deliver
regardless of production 2. Basis gain, if any,
goes to elevator 3. Cannot get out of contract
without a charge
9
Hedging in Futures Advantages 1. Takes
advantage of basis gain, reduces price risk 2.
Flexible can sell contracts, then buy back
if market conditions change (speculator) 3.
Up to 24 months to market the crop Disadvantages
1. Requires margin money to open account and
initiate position 2. Must pay broker fees 3
Subject to margin calls 4. Accept basis
risk 5. Must sell in 1,000 or 5,000 bushel
increments 6. Must deliver grain or buy back
contract
10
Basis Contract Advantages 1. Bypass weak
harvest basis and low prices 2. May receive up
to 80 of the value at delivery 3. Eliminates
basis risk 4. Shrink is to 15.5 rather than
14 for storage Disadvantages 1. Open to price
risk 2. No basis appreciation 3. Buyer and
seller must understand historical basis 4.
Elevator can recall a portion of advance if
market declines before grain is priced 5.
Limited application
11
Options Advantages 1. Price insurance 2.
Limited financial obligation 3. Marketing
flexibility 4. Profit potential
retained Disadvantages 1. Limited choice 2.
Fluctuating premium 3. Investment in knowledge
required a. options b. futures
12
Delayed Pricing Advantages 1. Can deliver at
harvest price later 2. Lengthens marketing
year to capture any price gain 3.
No storage needed 4. No storage-related
problems 5. May receive part of value of crop
at delivery Disadvantages 1. Does not lock in
price 2. Elevator takes title to grain at
delivery 3. Elevator given unsecured loan in
case of elevator bankruptcy, may not get
money 4. Frequently must pay a service charge
13
Hedging Defined

• Initiation of a position in the futures market
  that is intended as a temporary substitute for
  the sale/purchase of the actual commodity at a
  later date.
• or
• Processing of making simultaneous but opposite
  transactions in the cash and futures markets.

14
Hedging Mechanics A Short Hedge
15
Hedging Mechanics A Long Hedge
16
Ways to Use Hedging Profitably

• Reduce price risk
• Secure bank loans
• Establish profit margins production costs
• Freeze inventory value
• Evaluate profit alternatives
• Evaluate local cash quotes
• Lock in a return to storage
• Reduce inventory needs
• Extend selling season
• Lock in basis

17
Pre-Hedging Considerations

• Establish Pricing Objectives
• Select proper futures delivery month
• Collect local basis information
• Calculate production costs

18
Farm Pre-Harvest Hedge A. If market price
increases, what is net farm price and profit
? Cash Market Futures Market Basis Dec.
1 Will grow wheat Sell July Futures -.50
Expected Cash _at_ 4.50 Price 4.00 July
1 Sell cash wheat Buy July futures -.50 Harvest
time _at_ 4.50 _at_ 5.00 - .50 Farm Cash
Price 4.50 Futures market loss -
.50 ---------- Net farm price
4.00 Less production costs - 3.50
--------- Net farm profit 0.50
19
Farm Pre-Harvest Hedge B. If market price
decreases, what is net farm price and profit
? Cash Market Futures Market Basis Dec.
1 Will grow wheat Sell July Futures -.50 Expe
cted Cash _at_ 4.50 Price 4.00 July 1 Sell
cash wheat Buy July futures -.50 Harvest time _at_
3.50 _at_ 4.00 .50 Farm Cash Price
3.50/bu. Futures Market gain
.50 ---------- Net Farm Price
4.00 Less production costs - 3.50
--------- Net farm profit 0.50
20
Farm Pre-harvest Hedge C. If Basis strengthens
to -.20, what is net farm price and
profit? Cash Market Futures Market Basis Dec.
1 Will grow wheat Sell July Futures -.50
Expected Cash _at_ 4.50 Price 4.00 July
1 Sell cash wheat Buy July futures -.20 _at_
4.00 _at_ 4.20 .30 Farm cash
price 4.00 Basis Gain .30
---------- Net farm price
4.30 Less production costs - 3.50
--------- Net farm profit 0.80
21
Farm Pre-harvest Hedge D. If Basis Weakens to
-.70, what is net farm price and profit? Cash
Market Futures Market Basis Dec. 1 Will grow
wheat Sell July Futures -.50 Expected Cash _at_
4.50 Price 4.00 July 1 Sell cash wheat Buy
July futures -.70 _at_ 4.00 _at_ 4.70 -
.20 Farm cash price 4.00 Basis
loss - .20 ---------- Net farm
price 3.80 Less production costs
- 3.50 --------- Net farm price
0.30
22
Buying Hedge A. If Basis Strengthens, what is
net price paid ? Cash Market Futures
Market Basis Jan 15 Need Corn in Buy May
futures Expect April _at_
2.50 -.35 Expected April Cash Price
2.15 April 1 Buy cash _at_2.45 Sell May
futures Actual _at_ 2.65 -.20
.15 Net Buying Price
2.45 Less profit from futures -
.15 ---------- Net price
paid for corn 2.30
23
Buying Hedge B. If Basis weakens, what is net
price paid? Cash Market Futures
Market Basis Jan 15 Need Corn Buy May
futures Expect in April _at_
2.50 -.35 Expect to pay 2.15
April 1 Buy cash _at_2.45 Sell May
futures Actual _at_ 2.95 -.50
.45 Cash Buying Price
2.45 Less profit from futures -
.45 ---------- Net price
paid for corn 2.00
24
Producer or Elevator Storage Hedge Cash
Market Futures Market Basis Oct 1 Store
2.00/Bu. Sell Dec _at_2.25 -.25 Dec 1 Sell cash
2.00/Bu. Buy Dec _at_2.05 -.05 Cash
Price 2.00 Profit from futures
.20 Minus .01 Comm. - .01 --------
Net Selling Price 2.19 Carrying Costs
Interest 2.00 x .10 x 60/365 .03
Storage .03/Bu/mo. x 2.0 mo. .06 -----
----- Total carrying cost
.09 Profit from storage .10
25
Farm Pre-harvest Hedge Rolled to a Storage
Hedge Cash Market Futures Market Basis Feb.
1 Plan to grow corn Sell Dec. Futures -.80 Exp
ected Cash _at_ 2.80 Price 2.00 Nov.
15 Harvest and Buy Dec. futures -.50 store on
farm _at_ 2.50 cash price 2.00
.30 Sell July futures _at_
2.69 July-Dec spread (2.69 2.50) is
.19 Full carry is .18 so storage is
profitable
26
Continued June 15 Sell cash corn Buy July
futures _at_2.35 _at_ 2.55 -.20
.14 Cash corn price in June 2.35 Profit
from futures .44
---------- Net farm price 2.79
June price is 2.79 compared to Dec cash price
of 2.00
27
Basis Contract On October 15 you have 50,000 Bu.
Stored. March Corn Futures at 2.90 Cash Corn
2.70 Need money to pay off bank note before
January Prices expected to increase due to strong
export demand Basis also increases according to
historical charts Decide to sign basis contract
to lock in basis only Call elevator today for Feb
1 delivery quote. They quote a basis of 15 under
March futures contract In January call elevator
to set price when March futures reach 3.05
28
A) What cash price will you receive?
2.90 March futures at 3.05 -.15 basis
2.90 B) What is your basis improvement? .05 -
.20 -.15 -.05 C) What is your speculative
price gain? .15 3.05 - 2.90 .15 D) What is
your total gain? .20 March cash price -Dec
cash price 2.90 2.70 .20
29
Delayed price option On Nov. 10 farmer chooses a
delayed price sale. On Nov. 10 farmer delivers
5000 bu. of corn to elevator. On Nov. 10 cash
corn at elevator is 2.00. On Nov. 10 July corn
futures closed at 2.55. On Nov. 10 elevators
delayed price rate is .15/bu plus
.03/bu/month Interest is 12 on a loan the
farmer has outstanding. On May 10 the July corn
futures are trading at 2.60 and the basis at
the elevator is .15 under July. Farmer sets
the price.
30
A) What is the farmers total marketing cost per
bushel if he sets price on May 10? DP Charge
.15 (3 x 6 ) .33 Interest Charge 6/12
x .12 x 2.00 .12 Total Market Costs
.45 B) How much gross profit per
bushel does the farmer realize by using the
delayed price option? July Futures 2.60 May 10
price 2.45 Basis - .15 Harvest
price - 2.00
--------
-------- May 10 price 2.45 Gross profit
.45 C) How much was the basis gain? -.55
-.15 -.40 basis gain
31
D) How much was the speculative price
gain? 2.60 - 2.55 .05 speculative price
gain E) What is the outcome if July corn
futures are only 2.45 when price is
set? 2.45 - .15 ------- 2.30 Farm
price received on May 10 - 2.00 Farm price at
harvest ------- .30 Gross profit - .45
Marketing costs
------- - .15 Loss
32
Comparison of Expected and Actual Outcomes of
Hedge to Arrive Contracts (HTA) Expected
Result Actual Result March 15 Sell July contract
_at_3.36 3.36 Sell cash forward contract to
buyer Late June Buy July Contract _at_3.20
4.81 Net Futures Gain (Loss) .16
(1.45) Deliver cash contract corn to buyer on
December 15 3.29 3.29 Total Price
Received 3.45 1.84 Less brokerage
fee .04 .04 Less basis
.40 .40 Net Selling Price 3.01
1.40