Created by Tad Mueller, Northeast Iowa Community College Marketing Basics

Four Marketing Alternatives Cash Sales Cash Sales Forward Contracts Forward Contracts Futures Contracts Futures Contracts Options on Futures Contracts Options on Futures Contracts

Cash Sales Deliver your commodity and receive a price for that day Deliver your commodity and receive a price for that day –Get cash right away –Easy to complete –Only one chance to sell You take what you get You take what you get –Actually the “riskiest” marketing choice

Forward Contracts Negotiated now for delivery later Negotiated now for delivery later Easy to understand Easy to understand Specifies Specifies –Quantity –Quality –Price –Time of Delivery

Forward Contracts Price is locked in Price is locked in Protected against falling prices Protected against falling prices Can not benefit from higher prices Can not benefit from higher prices Somewhat inflexible Somewhat inflexible –Crop Failure? –Poor Quality Crop? Delivery place fixed Delivery place fixed

Futures Contract Agreement to buy or sell a commodity at a date in the future Agreement to buy or sell a commodity at a date in the future Must go through a brokerage firm Must go through a brokerage firm Requires a performance bond Requires a performance bond Highly standardized Highly standardized –Quality, quantity, delivery date, and settlement

Futures Contract Can be offset Can be offset Used to hedge cash price Used to hedge cash price –Loss in cash price offset by gain in futures –Opposite is also true.

Options Gives you the right to buy (or sell) a futures contract. Gives you the right to buy (or sell) a futures contract. Are not obligated to futures contract Are not obligated to futures contract Requires a premium to be paid Requires a premium to be paid Protects from falling prices while still being able to gain from rising prices. Protects from falling prices while still being able to gain from rising prices.

Basis

Relationship between futures and cash prices Basis = Cash - Futures Basis = Cash - Futures Grain Grain Typically quote the absolute value “30 cents under” = $.30 basis Cash is $.30 less than futures Livestock Livestock The sign is important

Basis Reflects local conditions Reflects local conditions –Supply and demand Yields, storage availability, processing capacity, rail cars, local usage Yields, storage availability, processing capacity, rail cars, local usage Individual basis impacted by factors that effect the local cash price relative to the delivery point price. Individual basis impacted by factors that effect the local cash price relative to the delivery point price.

Basis: Two Main Components Time Time Distance Distance

Basis generalities Cash and futures move together Cash and futures move together Basis narrows at contact maturity Basis narrows at contact maturity –Cash and futures converge –Arbitrage of delivery

Basis generalities Basis is more predictable than price Basis is more predictable than price Basis generally follows a pattern Basis generally follows a pattern –Seasonal patterns Lean Hog Basis

What would happen to basis if: A foreign country purchased a large amount of grain for immediate delivery A foreign country purchased a large amount of grain for immediate delivery Fuel costs doubled Fuel costs doubled Pattison Brothers mines collapsed Pattison Brothers mines collapsed Interest rates dropped 5 percent Interest rates dropped 5 percent Local crop at harvest is larger than expected Local crop at harvest is larger than expected An earthquake strikes and moves Iowa 500 miles farther west. An earthquake strikes and moves Iowa 500 miles farther west.

What decisions will basis help you make? To accept or reject a given price To accept or reject a given price If and when to store your crop If and when to store your crop If, when, and what delivery month to hedge. If, when, and what delivery month to hedge. When to close a hedge When to close a hedge How to turn an unusual basis into profit. How to turn an unusual basis into profit.

Ag Decision Maker Activity Corn Basis Corn Basis File A2-41 File A2-41

Ag Decision Maker Activity Understanding Livestock Basis Understanding Livestock Basis File B2-40 and B2-41 File B2-40 and B2-41

Fluid Milk Basis (Upper Midwest Mailbox Price)

Current Futures Corn Corn Beans Beans Cattle Cattle Hogs Hogs Milk Milk

History of the Futures Market

Started in Chicago in 1840’s Started in Chicago in 1840’s Needed reliable steady supply of grain Needed reliable steady supply of grain –Not just at harvest CBOT organized in 1848 CBOT organized in 1848 Basically served the same function as forward contracts through your local elevator today. Basically served the same function as forward contracts through your local elevator today.

Early Rules CBOT issued general rules in 1865 CBOT issued general rules in 1865 –Requirement for margin deposit –Standardized contracts –Payment Terms

Expansion CME organized in 1874 CME organized in 1874 –Traded butter, eggs, poultry, and other farm products. As many as 1600 commodity exchanges in the 1880’s As many as 1600 commodity exchanges in the 1880’s There are 9 Exchanges as of January 2006 There are 9 Exchanges as of January 2006

Evolution Cash Settlement Cash Settlement –No actual physical delivery of product Electronic Trading Electronic Trading –Overnight Trading Financial Futures (now the biggest part of the exchanges) Financial Futures (now the biggest part of the exchanges) Weather Futures Weather Futures

Regulation The first 50 years government attitude was anti futures trading. The first 50 years government attitude was anti futures trading. Grain Futures Act of 1922 Grain Futures Act of 1922 –First federal law regulating future trading –Dealt with licensing and providing continuous information –Purpose was to prevent price manipulation

Regulation Commodity Futures Trading Act of 1974 Commodity Futures Trading Act of 1974 –Created the CFTC Oversees all futures trading in the U.S. –Futures exchanges were required to receive approval from CFTC for any regulatory changes.

Regulation National Futures Association National Futures Association –Regulated the activities of brokerage firms and their agents Commodity Futures Modernization Act Commodity Futures Modernization Act –Varied regulation depending on the participant Big institutions such as oil and metals are regulated more lightly. Big institutions such as oil and metals are regulated more lightly.

Video The Agriculture Marketplace The Agriculture Marketplace

Commodity Categories

The Participants

Traders Scalpers Scalpers Day Traders Day Traders Position Traders Position Traders Floor Brokers Floor Brokers E-traders E-traders Commodity Pool Operators Commodity Pool Operators

Market participants Speculators buy or sell in an attempt to profit from price movements. Speculators buy or sell in an attempt to profit from price movements. Hedgers are producers or users of commodity and attempt to maintain a level price by offsetting a loss in one market by a gain in another. Hedgers are producers or users of commodity and attempt to maintain a level price by offsetting a loss in one market by a gain in another.

Video Power, Performance, Possibilities Power, Performance, Possibilities

Assignment Futures Challenge Futures Challenge