Hedge overview

1
Hedge overview

• Futures provide additional marketing alternatives
• Can transfer price risk
• Can establish approximate price levels in advance
  of cash market transactions

2
Hedging

• What are the basics you need to know to be a
  effective hedger in futures?
• Volume cash commodity
• Current futures prices
• Relevant basis
• Current basis vs. history

3
Assignment

• Find the current basis for a commodity at your
  local market outlet this week, and where you
  could get past basis data for that location in
  the last five years.

4
Hedging

• In long run, can futures hedge improve returns?
  Will it?
• In short run, can it reduce risk, or improve
  returns?
• Whats your objective?

5
Hedging

• What should be your criteria for success in
  hedging?
• Achieving approximate expected cash
  price futures expected basis
• Making the maximum profit?

6
Hedging

• Initiation of a position in the futures market
  that is intended as a temporary substitute for
  the sale or purchase of the actual commodity at a
  later date.

7
Hedging

• Use of futures markets to lock-in a purchase or
  selling price now, even though the physical
  purchase or sale wont occur until later.
• Usually bushel-bushel or pound-pound hedge,
  though optimum hedge may be slightly less for
  grain

8
Necessary conditions

• Cash price must move in parallel
• 1 1 or in fixed ratio e.g. 1.5 1
• to futures price when futures are converted to
  cash positions
• want to have gains in one market offset in the
  other market, so expected cash price will be
  achieved

9
Hedge ratio

• Hedge 1 unit cash product in 1 unit futures if
  prices move 11
• Hedge appropriate ratio if cash prices move more
  or less than futures (if hams move more 1.21
  than hogs, buy 20 more pounds in hog contracts
  to hedge hams)

10
PRICE
FUTURES
CASH
TIME
11
Futures/Hedging Terminology

• Nearby contract--the contract expiring soon after
  the cash market transaction
• Spread--difference in prices in two contract
  months
• Rollover--shifting futures position from one
  contract month to another contract month (Feb to
  April)

12
Basis

• Cash - Futures Price Difference
• Usually expressed as so much over or under
  futures
• Cash P - Futures P Basis
• for a specific contract month reflects
  location and product quality differences and time
  of delivery

13
Basis

• Cash - Futures Price Differences
• Reflects local S D versus
• delivery point S D
• Reflects transfer costs between
• local market and delivery or cash settlement
  points for futures
• Changes when contract changes

14
Basis

• Reflects futures delivery costs/risks
• Reflects storage costs sometimes -- in carrying
  charge markets
• Reflects difference in current vs expected price
  over time prior to contract expiration
  (especially livestock with seasonal P swings)

15
Basis

• If basis is predictable when commodity will be
  bought or sold, can accurately translate futures
  you sell today into net cash price you expect.
• Basis variation is usually a lot less than cash
  price variation, so hedging is less risky.

16
Basis

• Gross return to hedged storage
• change in basis
• Todays basis versus July futures
• minus June basis payment for storage
• 30 under minus 10 under
• 20 cents/bu to cover costs

17
Useful Hints

• Critical in determining cash price expected w/r/t
  any futures price
• Unusually wide basis -- hold cash
• Unusually narrow basis -- sell cash
• Compare with forward contract basis to determine
  whether its a better deal than hedging

18
Basis-how to get it

• Need cash prices at your market outlet for
  several years or more
• Need nearby futures prices for same time period
  from brokers, exchanges, etc.
• Sometimes basis history from university extension
  can be adjusted to local conditions

19
Short Hedge(Selling Hedge)

• Intends to sell cash (Physical) commodity in the
  future.
• Initiates a short futures position as a temporary
  substitute for a later cash market sale.
• Price risk basis change vs. whats expected.

20
Short Hedging Mechanics

• Cash Market Futures Market
  Transactions Transactions
• Now SELL
• Later SELL BUY

21
Short Hedging Example

• Want to lock in a price for Nov. delivery.
• Cash Market Futures Market
  Transactions Transactions
• May Not Short Dec. Corn
• Harvested Yet 2.80 (Basis -.20)
• Later Sell Corn locally Buy Dec. Corn
• 2.00 2.20

22
Expected Hedge Payoff

• Expected net price
• Futures price
• plus basis (equals expected cash price)
• minus commission (if sale)
• plus commission (if purchase)

23
Actual Hedge Payoff

• Net price equals
• Cash price
• plus/minus futures gain/loss
• plus/minus commission
• (determine whether each is going into or out of
  your pocket to get correct signs)

24
Which contract to use?

• Typically, the contract closest to and ahead of
  cash market actions
• e.g. December contract for November feeder
  cattle sale
• Cash and nearby futures will be most closely
  related, so basis is more predictable

25
Which contract to use

• If nearby contract isnt used, subject to much
  greater risk
• Spread risk may benefit you if prices are
  temporarily out of line, and move favorably
• Spread risk can be a killer-- e.g. hedging new
  crop(s) in old crop futures in short crop year

26
Which contract to use?

• Exceptions-- when spread favors a different
  contract, or expected nearby contract is not
  trading enough volume
• e.g. October-December difference unusually
  favorable for October
• May temporarily hedge in other month, and shift
  later (involves spread and basis risk)

27
Short Hedge

• Determine expected cash price
• Futures price in appropriate contract plus/minus
  typical basis
• If attractive expected price, take futures
  position to establish approximate selling price
  later in cash market

28
Short Hedging Example

• Want to lock in a price for Nov. delivery.
• Cash Market Futures Market
  Transactions Transactions
• May Sell Dec. FC _at_
• 80 (Basis0)
• Nov Sell cattle Buy Dec. FC
• 75 75

29
Hedge resullts

• Expected cash price 80 per 100
  lbs.__________________________
• Sell cash cattle at 75
• Futures gain 5
• Commission -.02
• Net sale price 79.98

30
Basis change

• If basis narrows vs. expected
• Good for shorts, bad for longs
• If basis widens vs. expected
• Bad for shorts, good for longs

31
Long Hedge Example

• Cash Market Futures Market
• Now
• Later
• Cash Price Received
• Futures Profit/Loss
• Commission
• Net Price

32
Grain storage hedges

• Establish storage returns using
• deferred futures
• - basis ( expected cash price)
• - current cash price
• - storage costs (interest, shrink, handling,
  drying)
• - commission
• net return

33
Storage hedge problemCalculate storage gain/loss

• Current May corn futures 2.86
• October cash price 2.54
• Expected basis -.15 or - .03
• Interest rate 10 annual rate
• Shrink 1, other extra costs .04
• Commission .01/bu.

34
Storage expected result

• 2.86
• - .15 basis
• -.012.71 shrink
• - (.107/122.54) value of early pay
• -.01 commission
• -.04 handling cost
• 2.48 if hedged vs 2.54 today

35
Storage hedge actual result

• Cash price 2.38
• plus futures gain .33 (2.86 - 2.53)
• minus commission .01
• minus other costs .04
• minus interest .15
• shrink .03
• 2.48 October equivalent price

36
More complicated hedges

• Fed cattle margin hedge, using fed cattle, feeder
  cattle, corn futures
• Soybean crush margin hedge, using soybean, oil,
  meal futures.

37
Hedging considerations

• Are there disadvantages to hedging?
• margin calls and costs
• lost opportunities
• quantity risk
• basis risk
• broker commission,

38
Tax Considerations

• Hedge
• individuals - ordinary income, no limits
• corporations - no limits
• Speculation
• capital gain or loss
• 3,000 loss limit per year for individuals

39
Hedging examples

• What futures position should I take if I want to
  hedge
• to establish a selling price for corn at
  harvest?
• to protect against a price decline on corn in
  storage?
• three years crops at todays high prices

40
Hedging examples

• to fix a margin for a cattle feeding operation
  when use own corn?
• to establish a merchandising/storage margin for
  corn your elevator is buying today?
• to establish a purchase price for soybean meal
  for six months in the future?

41
Hedging examples

• elevator manager establish a purchase price on a
  price later corn contract purchase she just sold
  to ADM
• to hedge hams you will buy for Christmas sales
  (fixed, formula P?)
• to hedge Pioneers seed corn purchases from
  contract growers

42
Hedging examples

• To set up a forward purchase contract with
  farmers at the local grain elevator
• To set up a forward contract with hog suppliers
  to IBP
• To set up a basis contract for farmers at the
  local grain elevator

43
Which contract to use?

• Exceptions-- when spread favors a different
  contract, or nearby is not trading yet
• e.g. March-July unusually narrow or wide
• May temporarily hedge in another, and shift later
  (somewhat speculative)

44
New innovations

• Contract changes--examples
• Lean hog, boneless beef, stocker cattle, weather,
  milk, butter, cheese, nonfat dry milk, whey
• Some mini-contracts
• Electricity, crude oil,
• Delivery changes--soybeans, corn

45
New innovations

• Cash settlement--volume wtd. 3 area average of
  two days USDA price reports -- 9th and 10th
  business days of month
• Closes after 10 days in delivery month

46
New innovations

• New delivery points--CBOT grains and soybeans
  --not in Chicago!!
• New contracts--boneless beef, butter, cheese,
  nonfat dry milk, broilers

47
New innovations

• Electronic trading
• nights--CME and CBOT
• many European exchanges with electronic trading
  taking over
• Will open outcry system continue?

48
Hedge overview

• Offers more marketing alternatives
• Can transfer risk
• Can improve or reduce returns
• Impacts many forward contracts, since that is how
  contractor often shifts risk

49
Hedge overview

• Results often considered bad by farmers
• 5 - 25 of producers use futures, and then only
  sometimes
• WHY??

50
Factors Influencing Forward Positions

• Price expectations versus current prices
  available--likelihood of this position being
  advantageous
• Ability to withstand possible adversities
  associated with taking or not taking a market
  position
• What are the factors which you should consider?

51
Forward position influences

• Diversificationoffsetting risks?
• Crop yield or revenue insurance
• Quantity risk
• Costs of cash flow shortage
• How well objectives would be met
• Evaluate tradeoffs determine NET benefit
  perceived