1. Agricultural Marketing
ECON 337:
Agricultural Marketing
Lee Schulz
Assistant Professor
Chad Hart
Associate Professor 1

2. Livestock Price Risk Management Wrap-up

3. Sources of economic risk…
Livestock prices (feeder and finished)
Feed prices
Interest rates
Equipment/facilities
Capacity utilization
Labor
Health/performance
Other???
How are these risks managed?
(and which are most important)

4. Managing price risk is essential…
Volatility over the past 5 years has increased to unprecedented levels. Overriding factors:
Domestic and foreign political policy
Domestic and foreign economic policy
Changing global supply and demand balance
Weather/natural occurrences affecting supply and logistics
The equity and working capital necessary to operate the same volume of business has nearly doubled
MORE IS AT STAKE: Greater potential for profit, greater potential for substantial loss

5. Methods of managing price risk…
Cash sales (purchases)
Forward contract
Hedge with futures contract, i.e., sell (buy) futures
Buy put (call) option
Other option marketing strategies
Livestock Risk Protection (LRP)
Livestock Gross Margin (LGM)
Price risk management → Coordinated and economical application of strategies to minimize, monitor, and control the probability of adverse price movements

6. Cash sales (purchases)…
Characteristics -
easy to understand
retain price and basis* risk
no quantity or quality obligations (within reason)
no futures broker or margin calls
financial risk (i.e., risk of not getting paid) depends on financial strength/integrity of buyer
* basis = cash price – futures price

7. Forward contract… Characteristics - locks in a “fixed” price
basis risk is eliminated
pay a premium for transferring basis risk
no margin account or maintenance required
may or may not involve broker / brokerage commission
contract specifications and size flexible (within reason)
obligated to deliver
low quality cattle might be excluded/refused
weight price slide risk
risk of other party not honoring contract
not always available
prices are not very transparent

8. Types of Contracts Formula Buyer does not share risk
Most common contract
Price tied to another market, typically spot (cash)
Examples:
3-Day rolling average of Iowa/So-Minnesota weighted average +$1.50
Last week’s average excluding the high and low
92% of the previous day cutout value
Buyer does not share risk 8

9. Types of Contracts Fixed window Floating window Buyer shares risk
Formula tied to cash price
Predetermined upper and lower bounds
Share pain and gain outside window
Example: $50 and split 50/50 above and below
Floating window
Boundaries move with feed prices
Do not share outside of window
Buyer shares risk 9

10. Types of Contracts Cost-Plus Price direct function of feed prices
Fixed amount for non-feed costs + known margin
Buyer assumes all price risk
Ledger
Floor price is fixed or based on feed prices
Producer is “loaned” the difference between floor and lower cash prices
Loan is repaid at higher cash prices
Buyer provides line of credit but not risk share 10

11. Hedge with futures contract…
Characteristics -
locks in a “fixed” price (CME futures price)
subject to basis risk
fixed contract specifications and size
deal with broker / brokerage commission
margin account and maintenance required
easy to enter and liquidate
transparent price quotes
no risk of other party “backing out”
feeder cattle futures is cash settled contract
No delivery ability / obligation
No risk of low quality cattle being “refused”

12. Buy put (call) option contract…
Characteristics -
locks in a “floor” price (ceiling for call) (strike price)
subject to basis risk
fixed contract specifications and size
deal with broker / brokerage commission
pay premium for option
no margin calls (unless option is exercised)
easy to enter and liquidate
transparent price quotes
no risk of other party “backing out”
cash settled contract (no delivery ability / obligation)

13. Other options strategies…
Characteristics -
anything goes…
buy / sell puts(s), call(s), sell futures, forward contract…
selling options requires margin account and maintenance
make sure you know what you are doing
Several of the more common option strategies
Synthetic put – hedge (sell futures) or forward contract and buy call option (works similar to buying put option)
Window / fence – establish minimum (floor) and maximum (ceiling) prices by buying a put option and selling a call option(s)

15. Risk management using futures…
Hedging defined…
Use of the futures market as a temporary substitute for an intended transaction in the cash market which will occur at a later date

16. Relationship Between Cash & Futures Prices is Critical for Risk Management
Basis = Cash Price – Futures Price
Rearranging formula gives
Basis + Futures Price = Cash Price

17. Decomposing a Cash Price
Cash Price = Basis + Futures Price
Recall definition of hedging
Hedging effectively “locks in” the Futures Price when the hedger sells (for a short hedger) the futures contract
Hedging does not lock in the Basis
Therefore the Cash Price is not locked in and the hedger is still exposed to basis risk

18. Evaluating a Hedge
At the time the hedge is placed, we can estimate the Expected Selling Price (i.e., what the hedger expects to receive for the commodity net any gains or losses in the futures, minus the brokerage commission)
Futures Price at which futures contract is sold
+ Expected Basis
Brokerage commission
Expected Selling Price

19. Futures Hedge Example
Assume JUN LC are $124.57/cwt when hedge is initiated (Nov 22)
Expect June basis to be +$1.00/cwt (for 1250 lb steer)
Assume brokerage commission = $60/ round turn or $0.15/cwt
What is the Expected Selling Price?
Futures Price at which hedge is initiated $124.57
+ Expected Basis
Brokerage commission
Expected Selling Price $125.42/cwt

20. Basis…
Generally, basis is more predictable than cash or futures prices due to:
Convergence
Futures and cash prices move together
(same fundamental conditions generally affect both markets)
Year-to-year stability implies the ability to rely upon historical data for predictions
Sources of basis information
Ag Decision Maker (
Beef Basis – feeder cattle (

21. Basis…
Strong
Weak
Narrow
Wide
Over
Under

22. At Hedge’s Conclusion Calculate Actual Sale Price
Price received in the cash market
+ Net on futures transaction
Brokerage commission
Actual Sale Price

23. Futures Hedge Example
Assume JUN LC are $127.07/cwt on 6/15 when hedge is concluded
Assume cash 1250 lb steer price = $128.07/cwt when hedge concludes
What is your net gain on the futures trade?
Sold JUN LC $124.57
Offset (buy) JUN LC
Net gain on futures transaction

24. Futures Hedge Example
So, if JUN LC are $127.07/cwt on 6/15 when hedge concludes
And cash 1250 lb steer price = $128.07/cwt when hedge concludes
What is the Actual Sale Price?
Price received in cash market $128.07
+ Net on futures transaction
- Brokerage commission
Actual Sale Price $125.42/cwt
Expected = Actual Why?
Because Expected Basis = Actual Basis

25. $ $

26. Option Hedging Strategies
Buying a PUT (CALL) gives the option buyer the right but not the obligation to SELL (BUY) a futures contract at a specified price known as the “strike price”
So, we can use the purchase price of the PUT (CALL) in place of selling (buying) a futures contract
Therefore, a producer can buy a PUT option to establish a Minimum Expected Selling Price
Similarly, buying a CALL option will establish a
Maximum Expected Purchase Price

27. Minimum Expected Selling Price
Buy a Put
start with a put option strike price
subtract the put option premium
This creates a “futures equivalent”
then add basis forecast
subtract brokerage commission
remember that many brokers charge once to buy an option and once to sell an option
have to account for possibility of “double” brokerage commission in calculations

28. Minimum Expected Selling Price
Buy a Put
Example: Buy CME $ JUN Live Cattle PUT
(when JUN LC futures $124.57)
Put option premium = $3.85/cwt
Mid June basis forecast = +$1.00/cwt (1250 lb steer)
Assume brokerage commission is $30 ($0.075/cwt) to buy an option contract and $30 ($0.075/cwt) to sell an option contract
For the buyer of a $ JUN LC Put
What is the Minimum Expected Selling Price?

29. Minimum Expected Selling Price
Buy a Put
$ Option Strike Price
Put Premium
$120.15/cwt Futures equivalent
Expected mid June basis
Maximum possible commission
$121.00/cwt Minimum Expected Selling Price

30. Actual Sale Price start with price received in cash market
add the “net” from the option trade
subtract actual brokerage commission
-- Sell cash cattle in mid June for $128.07/cwt
-- JUN live cattle futures are $127.07/cwt
-- What is the value of $ put option?

31. (for buyer of CME Put Option)
Actual Sale Price
(for buyer of CME Put Option)
$ Cash Market Price
Net on Option Trade
Brokerage Commission
$ Actual Net Sale Price
Actual > Expected Minimum Why?
Prices went up after Put Option purchase and the Put Option buyer retained the right to benefit from future price increases

32. $ $ $

33. Comparing pricing alternatives…
Cash vs. Hedging vs. Options…
Because the various risk management tools have different
characteristics (e.g., flat price vs. minimum price), it is
useful to compare them under alternative price outcomes

34. Class web site:
337/Spring2016/index.htm