Managing Agricultural Price Risk

Types of Price Risk zYear-to-year price cycles zWithin year price patterns zBasis risk (local cash price vs. futures)

Iowa Yearly Average Cash Prices

Daily Soybean Prices

Daily Corn Prices

Commodity Prices zCash or spot price: Price received when a commodity is sold locally. zForward contract price: Price received for selling a commodity locally at a future date. zFutures price: Price at which a contract for a specific commodity and delivery date is sold, on a futures market exchange. yExample: Dec. corn or March CBOT zBasis = difference between cash & futures

Basis Risk for Corn--2005

Pricing Tools zSell cash zForward contract zHedge by selling a futures contract zBuy PUT options

Sell on the Cash Market  Try to guess when the highest price will occur  Sell when you need the cash  Sell a little bit throughout the year  Sell when price reaches a target, or by a certain date

Forward Contracts Fixed price contract for a set delivery location, date, quantity and quality Example: sell 3100 bu. yellow soybeans at $6.20 for delivery to Roland Co-op by November 1 Contracts can be: Preharvest (production unknown) Post-harvest (production known) Local elevator resells on the futures mkt.

Forward Contract Advantages zLock in a sure price (but give up a gain if the prices increases later) zNo broker or fees zCan contract any number of bushels

Sell with a Futures Contract (Hedge) 1. Sell with a futures contract through a commodity exchange 2. When you are ready to sell the commodity, buy back the contract 3. Sell on the local cash mkt. 4. Change in the cash market is offset by the change in the futures market

Example (price declines) * Sell corn futures contract in $3.60 per bushel  4 months later, market has declined  Buy back futures contract at $3.30 for a gain of $.25  Sell for cash price of $3.00  Net price is $ = $3.25

Example (price increases) * Sell futures contract for $3.60  4 months later, market has risen  Buy back futures contract at $4.00 for a loss of $.40  Sell for cash price of $3.70  Net price is $ = $3.25

Hedging Advantages zGive up a gain if the market rises in order to avoid a loss if the market declines zHedges can be lifted early (unlike a forward contract) zGrain can be sold anywhere on any date zHowever, futures contracts are for a fixed quantity (5000 bu. on CBOT)

Basis Risk zBasis is the difference between the futures price and the cash price zFutures and cash trend together, but not exactly zGain or loss on futures contract may not exactly offset the fall or rise of the cash price zBasis will vary (basis risk) less than the cash price varies, though

Hedging vs. Speculation z Hedging is owning both the actual commodity and a futures contract z Speculation is owning only a futures contract z Storing unpriced grain is also speculation

PUT Options zRight to sell a futures contract at a set price (strike price) zCost of buying a PUT is the premium zIf the futures market moves up or down, the PUT premium will move in the opposite directly zPremium cannot go below zero

Futures Price and PUTs

Using a PUT Option to set a minimum price 1.Buy a PUT option 2.Later-sell the cash commodity, sell the PUT 3.If the market moves down, the value of the PUT moves up by about the same value 4.If the market moves up, the value of the PUT moves down, but can’t go below $.00 5.Losses are limited, gains are not.

Example: Buy a PUT zCash price is at $2.80 (corn) zFutures market is at $3.20 zBuy a PUT for a $3.50 for a premium of $.30

Example: PUT Options Futures declines $.60 to $2.60, cash to $2.20 PUT value goes up by $.60 to $.90. Net price is: Cash price $2.20 +PUT value.90 -orig.premium.30 =net price$2.80 Futures increases $.50 to $3.70 and cash to $3.30 PUT value goes down, but only to $.00 Net price is: Cash price $3.30 +PUT value.00 -orig.premium.30 = net price$3.00

PUT Options zEstablish a minimum price (except for basis variation) zCan still benefit from higher prices zMay lose the original premium (at most)

CALL Options zRight to buy a futures contract zPremiums for CALLS move in the same direction as the futures price zProtects the buyer of a commodity against a price increase

Remember! zPUTs move opposite the market. zCALLs move with the market.

USDA Commodity Programs zAll major farm crops (and milk) zAdministered by the Farm Service Agency (FSA) zCombination of subsidy and price risk protection

Direct Payments zBased on historical acres and yields, not current production. zPaid twice a year. zAbout $ per acre in Iowa

Loan Deficiency Payments (LDPs) zEach county has a Loan Rate, which is fixed by the USDA, for each grain zEach county has a Posted County Price (PCP), which varies daily. It is roughly equal to the local cash price zWhen the PCP is below the loan rate, the LDP is equal to the difference zPaid on bushels actually produced

LDP Example zA farmer in Adair Co. raises 15,000 bu. of soybeans zThe Loan Rate is $5.13 zThe PCP on Nov. 1 is $4.80 zFarmer can receive a payment of $.33/bu ($ $4.80) x 15,000 = $12,450 zCan request payment anytime after harvest, until grain is sold (or May 31)

USDA Marketing Loan zFarmer can take out a marketing loan instead of applying for an LDP zLoan = county loan rate x bushels stored zIf the market price is lower than the loan rate, repay market price x bushels stored zFarmer keeps the difference between the loan rate and the market price

Counter Cyclical Payment--CCP zIf the national average selling price for a crop for 12 months after harvest is below the trigger price, a CCP is paid. zTrigger prices:corn$2.35 soybeans$5.36 wheat$3.40 zPaid on 85% of historical production, not current bushels. zNo decisions to make.

Dairy LDP zIf monthly milk price is below the target price ($16 in Boston), farmer is paid 40% of the difference.

Revenue Insurance for Livestock (Livestock Risk Protection—LRP) zAvailable for hogs, feeder cattle and fed cattle zBased on futures prices on the Chicago Mercantile Exchange (CME) zCan buy guarantees of 70% to 95% of the futures price each day zSpecify no. to sell, weight and date

LRP z“Actual” revenue is based on quantity insured and closing futures price on projected date of sale. zIf actual revenue is below the guarantee a payment is made for the difference. zAnother product called LGM also includes feed prices (corn and soybean meal)

LRP zAdvantages vs. PUT options: yCan insure any quantity yNo broker’s fees zDisadvantages yMay not sell on the specified date yLocal price may not match futures price yNo. and weight sold may not match plan yDo not insure production risks