1. Assistant Professor/Grain Markets Specialist
ECON 338C:
Topics in Grain Marketing
Chad Hart
Assistant Professor/Grain Markets Specialist 1

2. Today’s Topic Risk Management Tools Price Risk
Futures, Options, Revenue Insurance
Yield Risk
Yield Insurance

3. Iowa Corn Revenues Source: USDA, NASS
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.
Source: USDA, NASS

4. Iowa Corn Yields Source: USDA, NASS
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.
Source: USDA, NASS

5. Iowa Corn Prices Source: USDA, NASS
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.
Source: USDA, NASS

6. Nearby Corn Futures Prices
Corn users are worried about this
Corn suppliers are worried about this
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.
Source: CBOT

7. Crop Price Variability
Price distributions for corn based on March prices for the following July futures

8. Futures and Options Market tools to help manage (share) price risks
Mechanisms to establish commodity trades among participants at a future time
Available from commodity exchanges / futures markets

9. Futures Markets
A market where contracts for physical commodities are traded, the contracts set the terms of quantity, quality, and delivery
Chicago: Corn, soybeans, wheat (soft red), oats, rice
Along with the livestock complex
Kansas City: Wheat (hard red winter)
Minneapolis: Wheat (hard red spring)
Tokyo: Corn, soybeans, coffee, sugar
Has a market for Non-GMO soybeans
Other markets in Argentina, Brazil, China, and Europe 9 9

10. Agricultural Futures Markets
Has some unique features due to the nature of the grain business
Supply comes online once (or twice) a year
So at harvest, supply spikes, then diminishes until the next harvest
Production decisions are based price forecasts
Planting decisions can be made a full year (or more) before the crop price is realized
Users provide year-round demand
Livestock feeding, biofuel production, food demand 10 10

11. Futures Market Exchanges
Competitive markets
Open out-cry and electronic trading
Centralized pricing
Buyers and sellers are both in the market
Relevant information is conveyed through the bids and offers for the trades
Bid = the price at which a trader would buy the commodity
Offer = the price at which a trader would sell the commodity 11 11

12. The View from the Corn Pit
Source: M. Spencer Green, AP Photo 12 12

13. Futures Contracts
A legally binding contract to make or take delivery of the commodity
Trading the promise to do something in the future
You can “offset” your promise
Standardized contract
Form (weight, grade, specifications)
Time (delivery date)
Place (delivery location)

14. Soybean Futures on CBOT
Form
5,000 bushels
No. 2 Yellow Soybeans (at price), No. 1 Yellow soybeans (at 6 cents over price), and No. 3 Yellow Soybeans (at 6 cents under price)
Time
Contract months: Sept, Nov, Jan, Mar, May, July, and August
Source: CBOT

15. Soybean Futures on CBOT
Partial listing of delivery points
Source: CBOT Rulebook

16. Futures Contracts
No physical exchange takes place when the contract is traded (no actual corn moves)
Payment is based on the price established when the contract was initially traded (prices can and will change before delivery is taken)
Deliveries can be made when the contract expires or the offsetting futures position must be taken to settle up

17. Market Positions
You can either buy or sell initially to open a position in the futures market
“Make” a promise to make or take delivery
Do the opposite to close the position at a later date
“Offset” the promise (and no commodity changes hands)
Trader may also hold the position until expiration and make or take physical delivery of the commodity

18. Terms and Definitions Basis Margin
The difference between the spot or cash price and the futures price of the same or a related commodity.
Margin
The amount of money or collateral deposited by a client with his or her broker for the purpose of insuring the broker against loss on open futures contracts.

19. Historical Basis for Iowa
Basis = Cash price – Futures price
Factors that affect basis:
Transportation costs
Storage and interest costs
Local supply and demand
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.

20. 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.
Crop Trader Type Initial Maintenance
Corn Hedger $1,500 $1,500
Corn Speculator $2,025 $1,500
Soybeans Hedger $3,500 $3,500
Soybeans Speculator $4,725 $3,500
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.
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.

21. 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
But the world has higher than usual soybean stocks. Corn stocks have been tight worldwide for several years.

22. 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

23. 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

24. Short Hedge Graph
Hedging Nov $8.93

25. 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

26. 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

27. Short Hedge Example As of Friday,
($ per bushel)
Nov soybean futures
Historical basis for Nov
Rough commission on trade
Expected local hedged price
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

28. Prices Went Up, Hist. Basis
In November, buy back futures at $9.75 per bushel
($ per bushel)
Nov soybean futures
Actual basis for Nov
Local cash price
Net value from futures
($ $ $0.01)
Net price

29. Prices Went Down, Hist. Basis
In November, buy back futures at $7.75 per bushel
($ per bushel)
Nov soybean futures
Actual basis for Nov
Local cash price
Net value from futures
($ $ $0.01)
Net price

30. Prices Went Down, Basis Change
In November, buy back futures at $7.75 per bushel
($ per bushel)
Nov soybean futures
Actual basis for Nov
Local cash price
Net value from futures
($ $ $0.01)
Net price
Basis narrowed, net price improved

31. 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

32. Long Hedge Graph
Hedging Dec $4.28

33. 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

34. 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

35. Long Hedge Example As of Friday,
($ per bushel)
Dec corn futures
Historical basis for Dec
Rough commission on trade
Expected local net price
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

36. Prices Went Up, Hist. Basis
In December, sell back futures at $5.00 per bushel
($ per bushel)
Dec corn futures
Actual basis for Nov
Local cash price
Less net value from futures
-($ $ $0.01)
Net cost of corn
Futures gained in value, reducing net cost of corn to the plant

37. Prices Went Down, Hist. Basis
In December, sell back futures at $3.75 per bushel
($ per bushel)
Dec corn futures
Actual basis for Nov
Local cash price
Less net value from futures
-($ $ $0.01)
Net cost of corn
Futures lost value, increasing net cost of corn

38. Prices Went Down, Basis Change
In December, sell back futures at $3.75 per bushel
($ per bushel)
Dec corn futures
Actual basis for Dec
Local cash price
Less net value from futures
-($ $ $0.01)
Net cost of corn
Basis narrowed, net cost of corn increased

39. 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

40. Forward Contracts Contract for delivery Tied to the futures market
Defines time, place, form
Tied to the futures market
Buyer offering the contract must lay off the market risk elsewhere
The buyer does the hedging for you

41. Futures Summary Today’s price for delivery of commodity in the future
Standardized contract for commodity delivery
Positions in the market can be offset before delivery
Several participants use the market in different ways
Basis estimation important to hedgers of all types

42. Options What are options?
An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period.
Options on futures are the right to buy or sell a specific futures contract.
Option buyers pay a price (premium) for the rights contained in the option.

43. Option Types Two types of options: Puts and Calls
A put option contains the right to sell a futures contract.
A call option contains the right to buy a futures contract.
Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets.

44. Put Option
The Buyer pays the premium and has the right, but not the obligation, to sell a futures contract at the strike price.
The Seller receives the premium and is obligated to buy a futures contract at the strike price if the Buyer uses their right.

45. Call Option
The Buyer pays a premium and has the right, but not the obligation, to buy a futures contract at the strike price.
The Seller receives the premium but is obligated to sell a futures contract at the strike price if the Buyer uses their right.

46. Options as Price Insurance
The person wanting price protection (the buyer) pays the option premium.
If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages.
The seller keeps the premium, but must pay for damages.

47. Options as Price Insurance
The option buyer has unlimited upside and limited downside risk.
If prices moves in their favor, the option buyer can take full advantage.
If prices moves against them, the option seller compensates them.
The option seller has limited upside and unlimited downside risk.
The seller gets the option premium.

48. Option Issues and Choices
The option may or may not have value at the end
The right to buy at $4.00 has no value if the market is below $4.00.
The buyer can choose to offset, exercise, or let the option expire.
The seller can only offset the option or wait for the buyer to choose.

49. Strike Prices
The predetermined prices for the trade of the futures in the options
They set the level of price insurance
Range of strike prices determined by the futures exchange

50. Options Premiums Determined by trading in the marketplace
Different premiums
For puts and calls
For each contract month
For each strike price
Depends on five variables
Strike price
Price of underlying futures contract
Volatility of underlying futures
Time to maturity
Interest rate

51. Option References In-the-money At-the-money Out-of-the-money
If the option expired today, it would have value
Put: futures price below strike price
Call: futures price above strike price
At-the-money
Options with strike prices nearest the future price
Out-of-the-money
If the option expired today, it would have no value
Put: futures price above strike price
Call: futures price below strike price

52. Options Premiums In-the-money Out-of-the-money Calls Dec. 2009
Corn Futures
$4.28 per bushel
Puts
Source: CBOT, 3/20/09

53. Setting a Floor Price Short hedger Buy put option
Floor Price = Strike Price + Basis – Premium – Commission
At maturity
If futures < strike, then Net Price = Floor Price
If futures > strike, then Net Price = Cash – Premium – Commission

54. Put Option Graph
Put Option Dec $4.30
Premium = $0.62

55. Put Option Graph
Put Option Dec $4.30
Premium = $0.62

56. Out-of-the-Money Put
Put Option Dec $3.00
Premium = $0.12

57. In-the-Money Put
Put Option Dec $5.60
Premium = $1.58

58. Setting a Ceiling Price
Long hedger
Buy call option
Ceiling Price = Strike Price + Basis + Premium + Commission
At maturity
If futures < strike, then Net Price = Cash + Premium + Commission
If futures > strike, then Net Price = Ceiling Price

59. Call Option Graph
Call Option Dec $4.30
Premium = $0.60

60. Call Option Graph
Call Option Dec $4.30
Premium = $0.60

61. Combination Strategies
Option fence
Buy put and sell call
Higher floor, but you now have a ceiling
Put spread
Buy At-the-money put and sell Out-of-the-money put
Higher middle and higher prices, but no floor below Out-of-the-money strike price

62. Fence Buy Put Option Dec. 2009 Corn @ $3.70 Premium = $0.32
Sell Call Option Dec $4.70
Premium = $0.46

63. Spread Buy Put Option Dec. 2009 Corn @ $4.30 Premium = $0.62
Sell Put Option Dec $3.70
Premium = $0.32

64. Summary on Options Buyer Seller Buying puts Buying calls
Pays premium, has limited risk and unlimited potential
Seller
Receives premium, has limited potential and unlimited risk
Buying puts
Establish minimum prices
Buying calls
Establish maximum prices

65. Crop Insurance One of many risk management strategies
Traditionally set up to protect farmers in times of low crop yields
Now offers coverage for low prices
Available on over 100 commodities

66. Why Crops Fail

67. Types of Crop Insurance
Individual Yield (APH)
Area Yield (GRP)
Individual Revenue (CRC, IP, RA)
Area Yield - Individual Revenue Combination (GRIP)

68. Example Farm
A 100 acre corn farm in Story County, Iowa with a 5-year average yield of 180 bu/acre
Purchases insurance at the 75% coverage level
Initial prices: $4.00/bu for Individual Yield Ins. $4.04/bu for Individual Rev. Ins.

69. Individual Yield Insurance (APH)
Farmer chooses percentage of expected yield to insure
Expected yield measured by average yield
Price at which the crop is valued is set up front and does not change
If yields are 100 bushels per acre, the farmer receives $140 per acre = $4.00/bu * (75% * 180 bu/ac bu/ac)

70. Yield Insurance Payout Graph
No Payout
Payout

71. Individual Revenue Insurance (CRC, IP, RA)
Farmer chooses percentage of expected revenue to insure
Expected revenue measured by average yield times initial crop price
Price at which the crop is valued can move with price changes in the market

72. Individual Revenue Insurance (CRC, IP, RA)
In our example, the farmer has insured $ of revenue per acre (75% * $4.04/bu * 180 bu/ac)
Final value of the crop determined by average futures prices over harvest period

73. Individual Revenue Insurance (CRC, IP, RA)
If yields are 100 bushels per acre and harvest prices average $3.50, the farmer receives $ per acre
0.75*$4.04/bu.*180 bu./acre $3.50/bu.*100 bu./acre

74. Revenue Insurance Payout Graph
No Payout
Payout

75. Individual Revenue Insurance (CRC and RA)
These policies have a “harvest price option”
If the harvest price is greater than the planting price, then the harvest price is used in all calculations
In essence, the policy is giving you a put option with the strike price at the planting price

76. Harvest Price Option

77. Individual Revenue Insurance (CRC and RA)
If yields are 100 bushels per acre and harvest prices average $5.00, the farmer receives $ per acre
0.75*$5.00/bu.*180 bu./acre $5.00/bu.*100 bu./acre

78. Insurance Payout Graph
Only
RI Pays
Neither Pay
Only YI Pays
Both Pay

79. Crop Insurance Subsidies
Coverage Level Subsidy %
50% %
55% & 60% 64%
65% & 70% 59%
75% %
80% %
85% %

80. Insurance Premiums Per Acre Premiums ($ per acre)
Cov. Level Yield Revenue Rev w/ HPO
50%
55%
60%
65%
70%
75%
80%
85%
For our example farm in Story County, Iowa for corn

81. Choosing Insurance Policy
Choice depends on several factors
Type of farm and crop mix
How well the county average yield represents your farm
Your marketing strategy

82. Class web site: http://www. econ. iastate
Class web site: See you next week!