1 Price Risk Management and the Futures Market Hedging

2 Market Risk Economic vs. Product Risk –product deterioration in value ; product destruction Risk is a Marketing Function (Facilitative function) Risk as Cost; Risk Taking for Profit Farmers Have Unavoidable Price Risk Risk Transfer May Be Desirable, Profitable

3 Examples of Your Risk Management Plant Now, Price Now by Contract College Tuition (Pay in July for Year) College Study (Protect Against Low Pay Job) Magazine Subscription: Pay for copies in advance Home rental contract ; Insurance

4 Grain Farmers Market Risk Plant in Spring Without Knowing Fall Harvest Price Sell in Spring Without Knowing Fall Yield Sell in Fall Without Knowing Spring Price Store in Fall Without Knowing Spring Price

5 Farmer Tools For Managing Price Risk Cash Sale (at Harvest or From Storage) Forward Pricing: –Forward Contracts: Cash and Basis contracts –Hedging using Futures –Options Minimum Price Contract

6 Futures Markets Futures Exchanges : CBOT, CME, KCBT etc., Futures price is todays price for products to be delivered in the future. –Contract specifications –Order execution process (open outcry) –Margin requirements

9 Futures Market Participants Speculators: –Risk Takers –Profit From Correctly Anticipating Price Changes –Could Not Deliver or Take Delivery of Futures Commodities Hedgers: –Have Inherent Price Risk –Wish to Reduce or Manage Risk –Could Deliver Against Futures Contract

10 Hedge: Definitions Using the Futures or Options Markets To Manage Price Risks A Temporary Substitution of A Futures Market Transaction for a Planned Cash Market Transaction Taking Equal and Opposite Positions on the Cash and Futures Markets

11 Hedging Decisions What is my attitude toward price risk? What do I expect price to do? What are my costs? When should I set the hedge? When to lift it? What are my alternatives to hedging?

12 Hedging Guidelines Decide on a definite hedging objective - reasons, month Discuss hedging plan with those involved; e.g. bankers Know how to calculate your productions costs - FC, VC, BEP Follow basis patterns Hedge reasonable amounts of commodity Keep adequate records

13 Production and Marketing Periods Spring Planting Fall Harvest Spring/ Summer Pre-Harvest PeriodStorage Period Risk: Plant without knowing Fall Price Risk: Store without knowing Spring Price

14 The Perfect Hedge (Falling Price Period) Cash Price Futures Price Basis Nov. 1 Dec. 1 $2.00 $2.50 $.50 $1.90 $2.40$.50 Cash sale = $ Futures Gain =.10 Return to Hedge = $ cent gain

15 Perfect Hedge Returns For a Perfect Hedge (Basis = Constant), The Return To The Hedge (Cash Price + Futures) Will Always Be the Same.

16 The Perfect Hedge (Rising Price Period) Cash Price Futures Price Basis Nov. 1 Dec. 1 $2.00 $2.50 $.50 $2.10 $2.60$.50 Cash sale = $ Futures Loss =.10 Return to Hedge = $ cent loss

17 The Slightly Imperfect Hedge Cash Price Futures Price Basis Nov. 1 Dec. 1 $2.00 $2.50 $.50 $1.90 $2.45$.55 Cash sale = $ Futures Gain =.05 Return to Hedge = $1.95 $1.95 is better than $1.90… But not $2.00

18 Characteristics of a Successful Hedge Equal and Opposite Positions on Cash and Futures Markets Cash and Futures Markets Move In Same Direction Predictable Basis Pattern Nullify Futures Position, Sell on Cash Market Loss on One Market = Gain on Other Market Transfer of Risk from Hedgers to Speculators No Tears, No Regrets

19 Types of Hedges Short Hedge (Protects Against Falling Prices) –Long Cash, Short Futures –Sell Cash, Buy Back Futures Long Hedge (Protects Against Rising Prices) –Short Cash, Long Futures –Buy Cash, Sell Futures Texas Hedge (Not a True Hedge) –Same Position on Cash and Futures Markets –Doubles the Risk

20 Three Farmer Hedges Perfect Hedge –Useful for Learning; Rare in Practice Storage Hedge –Set During Storage; Oct. to May –Protects Against Falling Prices –Helps Earn Storage Returns Pre-Harvest Hedge –Set in Spring –Protects Fall Harvest Price

21 Storage Hedges Harvest-to-Sale Period (Storage Season) Risk of Price Decline, Inventory Loss Will Price Rise Cover Storage Costs? Carrying Charges: –Storage Costs –Handling Charges –Insurance and Interest Costs Key to Success: Narrowing Basis Pattern

22 The Storage Hedge Cash Price Futures Price Basis Nov. 1 June 1 $2.50 $.50 $2.40 $.10 Cash sale = $ Futures Gain =.10 =Return to Hedge = $ Original Cost = $2.00 = Storage Return = $.40 - $.40

23 Storage Hedge Rule The Storage Hedgers Carrying Charge (Return to Storage) Will Always Equal The Change in Basis Over the Storage Period The Storage Hedge Transfers the Basis Change From the Speculators to Hedgers

24 Hedging Principle The Basis Determines the Success of A Hedge

25 Date Cash Market Futures Market October Harvest Price = $3.00 Sell July Fut. = $3.50 Est. June Basis = $.10 Storage Cost = $.30 Forward Price = $ = $3.40 Storage Profit= $ = $.10 June Cash $3.30 Buy Back $3.40 Return to Hedge: $ $.10 = $ 3.40 Corn Storage Hedge

26 Pre-Harvest Hedge Set During Planting or Growing Period Protects Against Harvest Price Risk –Will Harvest Price Cover Production Costs? Locks-In Fall Harvest Target Price Key to Success: Requires Accurate Harvest Basis Prediction

27 The PreHarvest Hedge Cash Price Futures Price Basis May 1 Planting Nov. 1 Harvest Plant at Target Price: $ =$2.60 $3.00 $2.40 $2.80 Expected $.40 Cash Sale = $ Futures Gain =.20 Return to Hedge = $2.60 = Spring Target

28 Date Cash Market Futures Market May Sell Dec Fut. = $2.80 Cost of Production = $2.10 Forward Price = $ basis= $2.50 Expected Profit= $ = $.40 Oct. Cash $2.40 Buy Back $2.70 Net Return to Hedge: $ $.10- $2.10 = $.40 Corn Pre-Harvest Hedge Expected basis = $.30

29 Calculating the Return To a Hedge Today: Current Futures Price……...$4.00 Less: Expected Basis at Sale Time …...50 Equals: Lock-In Forward Price……..$3.50 Future Sale: Cash Price…………………..$3.00 Plus/Minus Futures Transaction……… $.50 Equals: Total Return to Hedge…..…. $3.50 Less: Costs (Prodn. Or Storage)….…$3.20 Equals: Net Return To Hedge……….…..$.30

30 Combination Pre-Harvest and Storage Hedge May 1998 Target $3.00 $ Est. Spr. = $3.20 basis=$.20 Cash Dec. 98 June 99 Market Futures Futures May 1999 $2.30 xxxx Return to Hedge: $ =$3.20

31 Why Dont More Farmers Hedge? Lack of Understanding of Hedging Mistrust of Futures Market Prefer Ease of Forward Contracts Like Risk; Prefer to Speculate on Cash Market Dislike Margin Calls Other????

32 Summary: Risk Management Tools Hedging Options Forward Cash Contracts Basis Contracts Minimum Price Contracts