Hedging with Futures Contracts Hedging – Taking a position in the futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change in price contracts, or from an adverse change in production in yield contracts.

Basis Basis – Difference between cash market price (CP) and futures price (FP) Basis = CP – FP Use futures contract for month closest to but beyond the delivery month. Perfect hedge occurs when basis turns out as expected.

Dimensions which affect Basis Time – cost of storage, expectations Space – Availability of storage, cost of transportation Quality – Differences from contract specifications Availability and price of substitutes

Basis Studies There are repeatable patterns in the relationship between cash market price and futures price. Consequently, evaluating historical patterns in this relationship can give indications on what the Expected Basis will be.

Two types of risk that are important to hedgers Business risk – variation in income caused by variations in price and production. Financial risk – risk associated with the ability to repay creditors Business risk leads to financial risk Controlling business risk is important to controlling financial risk.

Managing production and price risk are keys to managing business and financial risk Production risk can be managed by production insurance (crop insurance), product diversification and sound production management practices. Futures contracts for factors affecting yield have been traded for some commodities to manage production risk.

Managing production and price risk are keys to managing business and financial risk Price risk depends on the level of competition and the demand for the product. Agriculture is often characterized as a competitive industry. There are many buyers and sellers and no single individual can influence price. Market participants are price takers.

Hedging provides a tool for managing general risk outside the control of management. Price risk includes risk associated with changes in the general level of prices (general price risk) and risk associated with changes in the relationship between cash and futures prices (basis risk). Using futures contracts for price risk management can eliminate general price risk with basis risk as the only remaining price risk. The more we know about basis risk the more of that risk that can be managed. This illustrates the importance of good basis studies for helping hedgers in managing risk.

Keys to Decision Making for Risk Management 1. Develop management objectives – be specific and quantifiable. You can’t manage risk unless you know the goals of your organization. 2. Identify alternative marketing strategies. Analyze the potential of alternative marketing strategies to satisfy management objectives. 3. Develop business plans and strategies that will meet your management objectives within acceptable levels of risk and implement those strategies as opportunities arise. 4. Use Feedback to evaluate your business plan during implementation and adjust to prevailing conditions.

Perfect Short Hedge Actual Basis = Expected Basis Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Prod. Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0. 25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Sell Cash @ 2.70/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Actual Basis –0.25 10/1 Act. Net Price = 3.25 - 0.25 = 3.00 =3.00 Net from cash 2.70 Net from futures +0.30

Short Hedge Basis Wider than Expected Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Prod. Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0.25 10/1 Target price = 3.25-0.25 = 3.00 Actual price received is lower than the target price because actual basis is wider than the expected basis. 10/1 Buy Dec. @ 2.95 Actual Basis –0.30 10/1 Act. Net Price = 3.25 - 0.30 = 2.95 =2.95 10/1 Sell Cash @ 2.65/bu. Net from cash 2.65 Net from futures +0.30 Actual price received is less than Target Price because Actual Basis is wider than Expected Basis

Short Hedge Basis Narrower than Expected Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Prod. Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0.25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Sell Cash @ 2.85/bu. 10/1 Buy Dec. @ 2.95 Actual Basis –0.10 10/1 Act. Net Price = 3.25 - 0.10 = 3.15 =3.15 Actual price received is higher than the target price because actual basis is more narrow than the expected basis. Net from cash 2.85 Net from futures +0.30 Actual Price received is more than Target Price because Actual Basis is narrower than Expected Basis

Why does hedging work? 1. Basis is somewhat predictable. Cash and futures prices will merge to reflect transaction cost differences as the contract matures. Why? Delivery options Arbitrage Exchange For Physicals (EFP) – transaction to exchange futures for cash position.

Why does hedging work? 2. For storables, basis reflects carrying charge Agriculture Storage (time dimension) – rations product Location (spatial dimension) – to par delivery point Difference in quality in physical from contract specifications (quality dimension) Non-Agricultural Cost of acquiring and holding until delivery. Depends on short term interest rate Cash flow earned while holding instrument. Depends on long term interest rate.

Why does hedging work? 3. Nonstorables – Basis depends on other factors Agriculture Production decisions Current supply and demand conditions Current expectations Financials Basis becomes expected change in price. Almost totally dependent on interest rates.

Important concepts to hedging Basis =CP - FP somewhat predictable CP and FP must merge in the delivery month to represent transaction cost differences, or arbitrage should correct the inefficiencies. Develop Expected Basis for when you will sell (or buy) your cash commodity to better understand the potential for marketing alternatives to satisfy management objectives.

Important concepts to hedging Target Price - Net price you expect to receive (or pay) for products you will sell (buy) when hedging in the Futures Market. TP = FP + EB If you assume that on October 1 the Expected Basis for cash corn relative to November contract will be -0.25 and the October contract is $2.95, then TP = $2.95 - 0.25 = $2.70

Important concepts to hedging When you hedge, you eliminate General Price Level Risk and are left with Basis Risk. The more we understand about basis patterns, the better we will be at managing risk to meet our organization objectives.

Important concepts to hedging T-Bar Method of Accounting Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Prod. Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0. 25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Sell Cash @ 2.70/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Actual Basis –0.25 10/1 Act. Net Price = 3.25 - 0.25 = 3.00 =3.00 Net from cash 2.70 Net from futures +0.30 Separate the cash from futures to follow the dynamics of the hedging process with an additional column for basis, expected basis, target price and actual price received.

Important concepts to hedging Net price equals cash price in the beginning plus gains and losses in the cash and futures markets. Also, Net Price equals the ending cash price plus gains/losses in futures market. Net price equals beginning cash price plus change in basis.

Types of Hedges Short Hedge - first action is to sell the futures. Long the basis. Why? If basis increases (narrows), net price is higher, profits higher. If basis decreases (widens), net price is lower, profits lower. Long Hedge - first action is to buy the futures. Short the basis. Why? If basis increases (narrows), net price is higher, costs increase, profits decrease. If basis decreases (widens), net price is lower, costs decrease, profits increase.

Short Hedge - Long the basis Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Prod. Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0. 25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Sell Cash @ 2.85/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Actual Basis –0.10 10/1 Act. Net Price = 3.25 - 0.10 = 3.15 =3.15 Net from cash 2.85 Net from futures +0.30 Because basis increased (narrowed), actual price received increased, resulting in higher profits.

Long Hedge - Short the Basis Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Feeding Cattle Cash Corn 3.10/bu. 5/1 Buy Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0. 25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Buy Cash @ 2.85/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Sell Dec. @ 2.95 Actual Basis –0.15 10/1 Act. Net Price = =3.25 - 0.10 = 3.15 =2.85 + 0.30 = 3.15 Net paid cash 2.85 Net from futures -0.30 Actual price paid is the cash price plus losses (minus gains) in the futures market. Because basis increased (narrowed), actual price paid increased, resulting in lower profits.

Types of Hedging Carrying Charge Hedge - Merchant purchases and stores product and hedges to profit from storage. Operational Hedge - Establish price of input or output. Usually for short term, ignoring changes in basis because you don’t expect it to change much over the short period the hedge is in effect. Seeking protection against rapid price change. Selective Hedge - Hedge according to price expectations. Hedge according to objectives and risk tolerance. Differentiate from Texas hedge (add to cash spec position with similar futures spec position). Anticipatory Hedge- Substitute for merchandising to be done later (expect future sale or purchase). Cross Hedge - Hedge in commodity market different from product in cash, but with high price correlation with cash product. Example, hedge corporate bonds with Treasury Bonds

Carrying Charge Hedge Cash Futures Basis/Expected Basis/ Target Price/Actual Price Cash Futures 9/1 Buy Cash 2.90/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.35 12/1Expected Basis –0. 20 10/1 Target price = 3.25-0.20 = 3.05 Exp. RS = 3.05 - 2.90 = 0.15 10/1 Sell Cash @ 2.80/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Actual Basis –0.15 10/1 Act. Price = 3.25 - 0.15 = 3.10 Act. RS = 3.10 - 2.90 = 0.20 Net from cash -0.10 Net from futures +0.30 ARS = 0.20 Because basis increased (narrowed) more than expected, actual price received increased, resulting in higher actual returns to storage (Act. RS).

Operational Short Hedge Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0. 25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Sell Cash @ 2.80/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Actual Basis –0.15 10/1 Act. Net Price = 3.25 - 0.15 = 3.10 =3.10 Net from cash 2.80 Net from futures +0.30 Because basis remains unchanged, actual price received equals beginning cash price.

Anticipatory Short Hedge Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Begin Prod. Cash 3.10/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.15 10/1Expected Basis –0. 25 10/1 Target price = 3.25-0.25 = 3.00 10/1 Sell Cash @ 2.80/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Actual Basis –0.15 10/1 Act. Net Price = 3.25 - 0.15 = 3.10 =3.10 Net from cash 2.80 Net from futures +0.30 Because basis was as expected, actual price received equaled Target Price.

Rolling a Hedge Feasible if Storage is available Cash flow can be carried Opportunity for profit

Rolling a Hedge Cash Futures Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Buy Cash 2.90/bu. 5/1 sell Dec. @ 3.25 Current Basis –0.35 10/1Expected Basis –0. 20 10/1 Target price = 3.25-0.20 = 3.05 Exp. NRS = 3.05 - 2.90 = 0.15 10/1 Cash @ 2.80/bu A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 10/1 Buy Dec. @ 2.95 Sell May @3.05 10/1 Actual Basis –0.15 10/1 Act. Price = 3.25 - 0.15 = 3.10 Act. RS = 3.10 - 2.90 = 0.20 5/1(next) Expected Basis = -0.10 5/1 Target price = 3.05 - 0.10 = 2.90 ERS 10/1 - 5/1 = 2.90 - 2.80 = 0.10 Roll the hedge from Dec. to May to capitalize on additional expected returns to storage (ERS)

Rolling a Hedge Cash Futures Basis/Expected Basis/ Target Price/Actual Price Cash Futures 5/1 Buy Cash 2.90/bu. 5/1 sell Dec. @ 3.25 10/1 Cash @ 2.80/bu 10/1 Buy Dec. @ 2.95 Sell May @3.05 10/1 Actual Basis –0.15 10/1 Act. Price = 3.25 - 0.15 = 3.10 5/1to10/1Act. RS = 3.10 - 2.90 = 0.20 5/1 Expected Basis = -0.10 5/1 Target price = 3.05 - 0.10 = 2.95 ERS 10/1 - 5/1 = 2.95 - 2.80 = 0.15 A perfect Hedge occurs when the expected basis equals the actual basis when the cash is sold. 5/1 Sell cash 2.70/bu. 5/1 Buy May @2.80 5/1 Act. P = 3.05–0.10 = 2.95 10/1to5/1 ARS = 2.95-2.80 = 0.15 Net from Cash = -0.20 Net from futures = +0.30(Dec) +0.25(May Tot. Ret Stor. = 0.35

Rolling a Hedge Decisions and Outcomes 5/1 EB Dec(10/1) = -0.10 TP(10/1) = 3.25 – 0.10 = 3.15 Current cash price = 2.90 ERS(5/1-10/1) = 3.15-2.90 = 0.25 10/1 AB = -0.15 AP = 3.25 – 0.15 = 3.10 ARS = 3.10 – 2.90 = 0.20 Current cash price = 2.80 EB May(5/1) = -0/10 TP(5/1) = 3.05 – 0.10 = 2.95 ERS(10/1-5/10) = 2.95 – 2.80 = 0.15 Assuming costs of storage (5/1-10/1) <0.25, we decide to store. ARS(5/1-10/1) = 0.20 ERS(10/1-5/1) = 0.15 Assuming storage costs (10/1 – 5/1) <0.15, then decide to continue storing and Roll Hedge to May

Rolling a Hedge Decisions and Outcomes 5/1 AB May = -0.15 AP = 3.25 – 0.15 = 3.10 Current cash price = 2.70 ARS(10/1-5/1) = 3.10-2.95 = 0.15 ARS(10/1-5/1) = 0.15 Sell Cash corn for $2.70 per bushel. Add profits of $0.30 from the Dec futures contract. Add profits of $0.25 from the May futures contract. A total return of $3.25, giving a total of $0.35 per bushel return to storing this corn for one year.