Econ 339X, Spring 2011 ECON 339X: Agricultural Marketing Chad Hart Assistant Professor John Lawrence Professor

Econ 339X, Spring 2011 Margin Accounts A margin account is an account that traders maintain in the market to ensure contract performance. There are minimum limits on the size of the account. CropTrader TypeInitialMaintenance CornHedger$1,500$1,500 CornSpeculator$2,025$1,500 SoybeansHedger$3,250$3,250 SoybeansSpeculator$4,388$3,250 To trade, you must create a margin account with at least the “Initial” amount and maintain at least the “Maintenance” amount in the account at the end of each trading day.

Econ 339X, Spring 2011 Margin Calls  Margin accounts are rebalanced each day  Depending on the value of futures  If your futures are losing value, money is taken out of the margin account to cover the loss  If the account value falls below the “Maintenance” level, you receive a margin call (a call to put additional money in your margin account)  If your futures position is gaining value, money is put into your margin account

Econ 339X, Spring 2011 Margin Example  Earlier, I went long on Dec corn  $5.48/bushel on 1/11/11  Let’s say I’m a farmer, so I am considered a hedger  Along with buying a corn futures contract, I have to establish a margin account and deposit $1,500 in it  On 1/12/11, the Dec corn futures price moved to $5.60/bushel  Since I’ll be selling the futures contract later, this price move is in my favor

Econ 339X, Spring 2011 Margin Example  I gained 12 cents per bushel and since the contract is for 5,000 bushels, that’s a gain of $600  At the end of the day (1/12/11), $600 is deposited into my margin account, raising the account balance to $2,100  Since $2,100 is greater than the “Maintenance” level, I will not receive a margin call

Econ 339X, Spring 2011 Margin Example #2  Earlier, I also went short on Nov soybeans  $12.73/bushel on 1/11/11  Along with selling a soybean futures contract, I have to establish a margin account and deposit $3,250 in it  On 1/12/11, the Nov soybean futures price moved to $13.08/bushel  Since I’ll be buying back the futures contract later, this price move is not in my favor

Econ 339X, Spring 2011 Margin Example #2  I lost 35 cents per bushel and since the contract is for 5,000 bushels, that’s a loss of $1,750  At the end of the day (1/12/11), $1,750 is be taken from my margin account, lowering the account balance to $1,500  Since $1,500 is less than the “Maintenance” level, I will receive a margin call and be asked to deposit $1,750 more into the account or to close out the futures position  The $1,750 brings the account balance back up to the initial requirement

Econ 339X, Spring 2011 Margin Example #2 DatePriceGainMargin Call Account Balance 1/11/11$12.73$3,250 1/12/11$13.08-$1,750$1,750$3,250 1/13/11$13.00+$400$3,650 1/14/11$13.05-$250$3,400 1/18/11$13.10-$250$100$3,250

Econ 339X, Spring 2011 Market Participants  Hedgers are willing to make or take physical delivery because they are producers or users of the commodity  Use futures to protect against a price movement  Cash and futures prices are highly correlated  Hold counterbalancing positions in the two markets to manage the risk of price movement

Econ 339X, Spring 2011 Hedgers  Farmers, livestock producers  Merchandisers, elevators  Food processors, feed manufacturers  Exporters  Importers What happens if futures market is restricted to only hedgers?

Econ 339X, Spring 2011 Market Participants  Speculators have no use for the physical commodity  They buy or sell in an attempt to profit from price movements  Add liquidity to the market  May be part of the general public, professional traders or investment managers  Short-term – “day traders”  Long-term – buy or sell and hold

Econ 339X, Spring 2011 Market Participants  Brokers exercise trade for traders and are paid a flat fee called a commission  Futures are a “zero sum game”  Losers pay winners  Brokers always get paid commission

Econ 339X, Spring 2011 Hedging  Holding equal and opposite positions in the cash and futures markets  The substitution of a futures contract for a later cash-market transaction  Who can hedge?  Farmers, merchandisers, elevators, processors, exporter/importers

Econ 339X, Spring 2011 Cash vs. Futures Prices Iowa Corn in 2010

Econ 339X, Spring 2011 Short Hedgers  Producers with a commodity to sell at some point in the future  Are hurt by a price decline  Sell the futures contract initially  Buy the futures contract (offset) when they sell the physical commodity

Econ 339X, Spring 2011 Short Hedge Example  A soybean producer will have 25,000 bushels to sell in November  The short hedge is to protect the producer from falling prices between now and November  Since the farmer is producing the soybeans, they are considered long in soybeans

Econ 339X, Spring 2011 Short Hedge Example  To create an equal and opposite position, the producer would sell 5 November soybean futures contracts  Each contract is for 5,000 bushels  The farmer would short the futures, opposite their long from production  As prices increase (decline), the futures position loses (gains) value

Econ 339X, Spring 2011 Short Hedge Example  As of Tuesday, ($ per bushel) Nov soybean futures12.73 Historical basis for Nov Rough commission on trade Expected local hedged price12.47  Come November, the producer is ready to sell soybeans  Prices could be higher or lower  Basis could be narrower or wider than the historical average

Econ 339X, Spring 2011 Prices Went Up, Hist. Basis  In November, buy back futures at $14.00 per bushel ($ per bushel) Nov soybean futures14.00 Actual basis for Nov Local cash price13.75 Net value from futures ($ $ $0.01) Net price12.47

Econ 339X, Spring 2011 Prices Went Down, Hist. Basis  In November, buy back futures at $10.00 per bushel ($ per bushel) Nov soybean futures10.00 Actual basis for Nov Local cash price 9.75 Net value from futures+2.72 ($ $ $0.01) Net price12.47

Econ 339X, Spring 2011 Short Hedge Graph Hedging Nov $12.73

Econ 339X, Spring 2011 Prices Went Down, Basis Change  In November, buy back futures at $10.00 per bushel ($ per bushel) Nov soybean futures10.00 Actual basis for Nov Local cash price 9.90 Net value from futures+2.72 ($ $ $0.01) Net price12.62  Basis narrowed, net price improved

Econ 339X, Spring 2011 Long Hedgers  Processors or feeders that plan to buy a commodity in the future  Are hurt by a price increase  Buy the futures initially  Sell the futures contract (offset) when they buy the physical commodity

Econ 339X, Spring 2011 Long Hedge Example  An ethanol plant will buy 50,000 bushels of corn in December  The long hedge is to protect the ethanol plant from rising corn prices between now and December  Since the plant is using the corn, they are considered short in corn

Econ 339X, Spring 2011 Long Hedge Example  To create an equal and opposite position, the plant manager would buy 10 December corn futures contracts  Each contract is for 5,000 bushels  The plant manager would long the futures, opposite their short from usage  As prices increase (decline), the futures position gains (loses) value

Econ 339X, Spring 2011 Long Hedge Example  As of Tuesday, ($ per bushel) Dec corn futures 5.48 Historical basis for Dec Rough commission on trade+0.01 Expected local net price 5.24  Come December, the plant manager is ready to buy corn to process into ethanol  Prices could be higher or lower  Basis could be narrower or wider than the historical average

Econ 339X, Spring 2011 Prices Went Up, Hist. Basis  In December, sell back futures at $6.00 per bushel ($ per bushel) Dec corn futures 6.00 Actual basis for Nov Local cash price 5.75 Less net value from futures ($ $ $0.01) Net cost of corn 5.24  Futures gained in value, reducing net cost of corn to the plant

Econ 339X, Spring 2011 Prices Went Down, Hist. Basis  In December, sell back futures at $4.00 per bushel ($ per bushel) Dec corn futures 4.00 Actual basis for Nov Local cash price 3.75 Less net value from futures ($ $ $0.01) Net cost of corn 5.24  Futures lost value, increasing net cost of corn

Econ 339X, Spring 2011 Long Hedge Graph Hedging Dec $5.48

Econ 339X, Spring 2011 Prices Went Down, Basis Change  In December, sell back futures at $4.00 per bushel ($ per bushel) Dec corn futures 4.00 Actual basis for Dec Local cash price 3.90 Less net value from futures ($ $ $0.01) Net cost of corn 5.39  Basis narrowed, net cost of corn increased

Econ 339X, Spring 2011 Hedging Results  In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis.  So basis estimation is critical to successful hedging.  Narrowing basis, good for short hedgers, bad for long hedgers  Widening basis, bad for short hedgers, good for long hedgers

Econ 339X, Spring 2011 Class web site: Spring2011/