Chap 15 - Hedging and Risk Farming & Risk (quantity, quality, price) Hedging transfer of risk to a counterparty (incomplete) similar to insurance cost - margin account, brokerage fees weather & pests > crop insurance price > forward or futures contract

Example: Perfect Short Hedge Simplifying Assumptions: October - post harvest; crop in storage (long physical corn) Return to storage = f(spot sale in May) Target return to storage = $0.25/bu(October to May) Current spot price= $3.50spot market = delivery point Current May futures= $3.75 Return to storage= $0.25(expected)

The Short Hedge October:SELL May $3.75 May: May Futures and May Spot price (rises) = $3.75 SELL (deliver)Physical $3.75 Futures contract satisfied Return to storage = $0.25 = Target return Spot and Futures Convergence at contract expiry Arbitrage between spot and futures

Spot & Futures Convergence March Contract Oct March Price Spot Futures Basis

The Hedge: Prices Change October: SELL May $3.75 Assume: Unexpected large crop in Argentina Lower cash price in May= $3.60 Farmer still protected (October cash price = $3.50) May: BUY May $3.60NET = $ 0.15 SELL physical $3.60NET = $ 0.10 Return to storage = $ 0.25 The Result: The same regardless of price increase or decrease

Hedging & the Basis Space: Local Spot Price ≠ Delivery Point Spot Price Basis: Price difference between two locations in Space OR Time OR Both Basis = cost of transfer (transport + storage + insurance etc.) B t = F t - P t Current May Futures - Current Local Spot Price Successful Hedge <= Basis now vs Basis in May (time of delivery) Time: Current local Price ≠ Current May Futures Price Perfect Hedge <= Basis now = Basis in May

Ontario Basis December 2011

Hedging, the Basis & the Return to Storage Result: Actual return to storage > or < anticipated return Generally: The basis is not stable over time Cash Market (physical) Futures Market NOW:BUY/OWN P 1 SELL May F 1 MAY:SELL P 2 BUY May F 2

Hedging, the Basis & the Return to Storage Return to storage = (P 2 - P 1 ) + (F 1 - F 2 ) Buy LOW and Sell HIGH in both markets Return = (F 1 - P 1 ) - (F 2 - P 2 ) = B 1 - B 2 B 1 > B 2 => Positive Return B 1 Negative Return

Hedging: Using Futures to Target Price Solution: Use futures to “price” the crop & profitability Problem: Pre-planting, farmers need to “price” the future crop Futures provide “price discovery” Banks want insurance against loan to farmer Locked in Price => less bank risk Planting Decision: Hedged or not – it is a commitment to sell Not using futures/forward = Speculation

Futures & the Pre-Plant Decision Cash return:(P 2 - C 1 ) C 1 = Cost of production Futures return:(F 1 – F 2 ) Sell - Buy Profit = Returns in Cash and Futures Markets Total Return=(P 2 - C 1 ) + (F 1 – F 2 ) =F 1 – ((C 1 + (F 2 – P 2 )) = (F 1 – C 1 ) - B 2 Anticipated Return – delivery + BUY offset Complication – Anticipated yield ≠ Actual yield (uncertain)

Futures & the Pre-Plant Decision Cash return:(P 2 - C 1 ) = ($ $4.00)= $1.25 Futures return:(F 1 – F 2 ) = ($ $5.25)= - $0.25 Profit = Cash Return + Futures Return Total Return= $1.00 above cost of production $5.00/bu Rising Futures & Spot Price

Futures & the Pre-Plant Decision Cash return:(P 2 - C 1 ) = ($ $4.00)= $0.25 Futures return:(F 1 – F 2 ) = ($ $4.25)= $0.75 Profit = Cash Return + Futures Return Total Return= $1.00 above cost of production Falling Futures & Spot Price

Speculative Spread Across Delivery Months Principal => Buy LOW, sell HIGH Spread => Trade commodity across different delivery months Arbitrage the price spread NOW:BUY MaySELL SeptB 1 LATER:SELL MayBUY SeptB 2 May too LOW & Sept too HIGH ? => Basis too big ? RETURN:Profit (loss) on MAY & SEPT Contracts π = B 1 - B 2

Speculative Straddle Across Commodities Principal: Act on abnormal price relationship between commodities Wheat vs corn NOW:BUY wheat & SELL cornB 1 LATER:SELL wheat & BUY corn B 2 Wheat too LOW relative to Corn? => Basis too small ? RETURN:Profit (loss) on wheat & corn contracts π = B 2 - B 1