ECON 337:

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ECON 337 Agricultural Marketing

Chad Hart Associate Professor chart_at_iastate.edu 51
5-294-9911
Lee Schulz Assistant Professor lschulz_at_iastate.edu
515-294-3356
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Market Participants

• Hedgers are willing to make or take physical
  delivery because they are producers or users of
  the commodity
• Use futures to protect against a price movement
• Cash and futures prices are highly correlated
• Hold counterbalancing positions in the two
  markets to manage the risk of price movement

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Hedgers

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

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Market Participants

• Speculators have no use for the physical
  commodity
• They buy or sell in an attempt to profit from
  price movements
• Add liquidity to the market
• May be part of the general public, professional
  traders or investment managers
• Short-term day traders
• Long-term buy or sell and hold

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Market Participants

• Brokers exercise trade for traders and are paid a
  flat fee called a commission
• Futures are a zero sum game
• Losers pay winners
• Brokers always get paid commission

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Hedging

• Holding equal and opposite positions in the cash
  and futures markets
• The substitution of a futures contract for a
  later cash-market transaction
• Who can hedge?
• Farmers, merchandisers, elevators, processors,
  exporter/importers

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Cash vs. Futures Prices
Iowa Corn in 2013
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Short Hedgers

• Producers with a commodity to sell at some point
  in the future
• Are hurt by a price decline
• Sell the futures contract initially
• Buy the futures contract (offset) when they sell
  the physical commodity

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Short Hedge Example

• A soybean producer will have 25,000 bushels to
  sell in November
• The short hedge is to protect the producer from
  falling prices between now and November
• Since the farmer is producing the soybeans, they
  are considered long in soybeans

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Short Hedge Example

• To create an equal and opposite position, the
  producer would sell 5 November soybean futures
  contracts
• Each contract is for 5,000 bushels
• The farmer would short the futures, opposite
  their long from production
• As prices increase (decline), the futures
  position loses (gains) value

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Short Hedge Expected Price

• Expected price
• Futures prices when I place the hedge
• Expected basis at delivery
• Broker commission

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Short Hedge Example

• As of Jan. 21,
• ( per bushel)
• Nov. 2014 soybean futures 11.09
• Historical basis for Nov. -0.30
• Rough commission on trade -0.01
• Expected price 10.78
• Come November, the producer is ready to sell
  soybeans
• Prices could be higher or lower
• Basis could be narrower or wider than the
  historical average

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Prices Went Up, Hist. Basis

• In November, buy back futures at 12.00 per
  bushel
• ( per bushel)
• Nov. 2014 soybean futures 12.00
• Actual basis for Nov. -0.30
• Local cash price 11.70
• Net value from futures -0.92
• (11.09 - 12.00 - 0.01)
• Net price 10.78

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Prices Went Down, Hist. Basis

• In November, buy back futures at 10.00 per
  bushel
• ( per bushel)
• Nov. 2014 soybean futures 10.00
• Actual basis for Nov. -0.30
• Local cash price 9.70
• Net value from futures 1.08
• (11.09 - 10.00 - 0.01)
• Net price 10.78

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Short Hedge Graph
Hedging Nov. 2014 Soybeans _at_ 11.09
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Prices Went Down, Basis Change

• In November, buy back futures at 10.00 per
  bushel
• ( per bushel)
• Nov. 2014 soybean futures 10.00
• Actual basis for Nov. -0.10
• Local cash price 9.90
• Net value from futures 1.08
• (11.09 - 10.00 - 0.01)
• Net price 10.98
• Basis narrowed, net price improved

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Long Hedgers

• Processors or feeders that plan to buy a
  commodity in the future
• Are hurt by a price increase
• Buy the futures initially
• Sell the futures contract (offset) when they buy
  the physical commodity

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Long Hedge Example

• An ethanol plant will buy 50,000 bushels of corn
  in December
• The long hedge is to protect the ethanol plant
  from rising corn prices between now and December
• Since the plant is using the corn, they are
  considered short in corn

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Long Hedge Example

• To create an equal and opposite position, the
  plant manager would buy 10 December corn futures
  contracts
• Each contract is for 5,000 bushels
• The plant manager would long the futures,
  opposite their short from usage
• As prices increase (decline), the futures
  position gains (loses) value

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Long Hedge Expected Price

• Expected price
• Futures prices when I place the hedge
• Expected basis at delivery
• Broker commission

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Long Hedge Example

• As of Jan. 21,
• ( per bushel)
• Dec. 2014 corn futures 4.47
• Historical basis for Dec. -0.25
• Rough commission on trade 0.01
• Expected local net price 4.23
• Come December, the plant manager is ready to buy
  corn to process into ethanol
• Prices could be higher or lower
• Basis could be narrower or wider than the
  historical average

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Prices Went Up, Hist. Basis

• In December, sell back futures at 5.00 per
  bushel
• ( per bushel)
• Dec. 2014 corn futures 5.00
• Actual basis for Dec. -0.25
• Local cash price 4.75
• Less net value from futures -0.52
• -(5.00 - 4.47 - 0.01)
• Net cost of corn 4.23
• Futures gained in value, reducing net cost of
  corn to the plant

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Prices Went Down, Hist. Basis

• In December, sell back futures at 3.00 per
  bushel
• ( per bushel)
• Dec. 2014 corn futures 3.00
• Actual basis for Dec. -0.25
• Local cash price 2.75
• Less net value from futures 1.48
• -(3.00 - 4.47 - 0.01)
• Net cost of corn 4.23
• Futures lost value, increasing net cost of corn

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Long Hedge Graph
Hedging Dec. 2014 Corn _at_ 4.47
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Prices Went Down, Basis Change

• In December, sell back futures at 3.00 per
  bushel
• ( per bushel)
• Dec. 2014 corn futures 3.00
• Actual basis for Dec. -0.10
• Local cash price 2.90
• Less net value from futures 1.48
• -(3.00 - 4.47 - 0.01)
• Net cost of corn 4.38
• Basis narrowed, net cost of corn increased

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Hedging Results

• In a hedge the net price will differ from
  expected price only by the amount that the actual
  basis differs from the expected basis.
• So basis estimation is critical to successful
  hedging.
• Narrowing basis, good for short hedgers, bad for
  long hedgers
• Widening basis, bad for short hedgers, good for
  long hedgers

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• Class web site
• http//www.econ.iastate.edu/chart/Classes/econ337
  /Spring2014/
• Lab in Heady 68!