1. Econ 337, Spring 2012 ECON 337: Agricultural Marketing Chad Hart Assistant Professor chart@iastate.edu 515-294-9911

2. Econ 337, Spring 2012 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/Speculator$2,363$1,750 SoybeansHedger/Speculator$3,375$2,500 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.

3. Econ 337, Spring 2012 Margin Calls  Margin accounts are rebalanced each day  Depending on the value of futures  Settlement price  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) and the balance is brought back up to the Initial amount

4. Econ 337, Spring 2012 Margin Example  Let’s say I went short on May 2012 corn  $6.5825/bushel on Jan. 11  Along with selling a corn futures contract, I have to establish a margin account and deposit $2,363 in it  On Jan. 12, the May 2012 corn futures price moved to $6.1825/bushel  Since I’ll be selling the futures contract later, this price move is in my favor

5. Econ 337, Spring 2012 Margin Example  I gained 40 cents per bushel and since the contract is for 5,000 bushels, that’s a gain of $2,000  At the end of the day (Jan. 12), $2000 is deposited into my margin account, raising the account balance to $4,363  Since $4,363 is greater than the “Maintenance” level, I will not receive a margin call

6. Econ 337, Spring 2012 Margin Example #2  Let’s say, instead of going short, I went long on May 2012 corn  $6.5825/bushel on Jan. 11  Along with buying a corn futures contract, I have to establish a margin account and deposit $2,363 in it  On Jan. 12, the May 2012 corn futures price moved to $6.1825/bushel  Since I’ll be selling back the futures contract later, this price move is not in my favor

7. Econ 337, Spring 2012 Margin Example #2  I lost 40 cents per bushel and since the contract is for 5,000 bushels, that’s a loss of $2,000  At the end of the day (Jan. 12), $2,000 is to be taken from my margin account, lowering the account balance to $363  Since $363 is less than the “Maintenance” level, I will receive a margin call and be asked to deposit $2,000 more into the account or to close out the futures position  The $2,000 brings the account balance back up to the initial requirement

8. Econ 337, Spring 2012 Margin Example – Going Short DatePriceGainMargin Call Account Balance 1/6/12$6.5075$2,363 1/9/12$6.595-$437.50$1,925.50 1/10/12$6.5925+$12.50$1,938 1/11/12$6.5825+$50$1,988 1/12/12$6.1825+$2,000$3,988 1/13/12$6.065+$587.50$4,575.50

9. Econ 337, Spring 2012 Margin Example – Going Long DatePriceGainMargin Call Account Balance 1/6/12$6.5075$2,363 1/9/12$6.595+$437.50$2,800.50 1/10/12$6.5925-$12.50$2,788 1/11/12$6.5825-$50$2,738 1/12/12$6.1825-$2,000$1,625$2,363 1/13/12$6.065-$587.50$1,775.50

10. Econ 337, Spring 2012 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

11. Econ 337, Spring 2012 Hedgers  Farmers, livestock producers  Merchandisers, elevators  Food processors, feed manufacturers  Exporters  Importers What happens if futures market is restricted to only hedgers?

12. Econ 337, Spring 2012 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

13. Econ 337, Spring 2012 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

14. Econ 337, Spring 2012 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

15. Econ 337, Spring 2012 Cash vs. Futures Prices Iowa Corn in 2011

16. Econ 337, Spring 2012 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

17. Econ 337, Spring 2012 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

18. Econ 337, Spring 2012 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

19. Econ 337, Spring 2012 Short Hedge Expected Price  Expected price = Futures prices when I place the hedge + Expected basis at delivery – Broker commission

20. Econ 337, Spring 2012 Short Hedge Example  As of Jan. 13, ($ per bushel) Nov. 2012 soybean futures11.70 Historical basis for Nov. -0.30 Rough commission on trade -0.01 Expected price11.39  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

21. Econ 337, Spring 2012 Prices Went Up, Hist. Basis  In November, buy back futures at $14.00 per bushel ($ per bushel) Nov. 2012 soybean futures14.00 Actual basis for Nov. -0.30 Local cash price13.70 Net value from futures -2.31 ($11.70 - $14.00 - $0.01) Net price11.39

22. Econ 337, Spring 2012 Prices Went Down, Hist. Basis  In November, buy back futures at $10.00 per bushel ($ per bushel) Nov. 2012 soybean futures10.00 Actual basis for Nov. -0.30 Local cash price 9.70 Net value from futures+1.69 ($11.70 - $10.00 - $0.01) Net price11.39

23. Econ 337, Spring 2012 Short Hedge Graph Hedging Nov. 2012 Soybeans @ $11.70

24. Econ 337, Spring 2012 Prices Went Down, Basis Change  In November, buy back futures at $10.00 per bushel ($ per bushel) Nov. 2012 soybean futures10.00 Actual basis for Nov. -0.10 Local cash price 9.90 Net value from futures+1.69 ($11.70 - $10.00 - $0.01) Net price11.59  Basis narrowed, net price improved

25. Econ 337, Spring 2012 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

26. Econ 337, Spring 2012 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

27. Econ 337, Spring 2012 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

28. Econ 337, Spring 2012 Long Hedge Expected Price  Expected price = Futures prices when I place the hedge + Expected basis at delivery + Broker commission

29. Econ 337, Spring 2012 Long Hedge Example  As of Jan. 13, ($ per bushel) Dec. 2012 corn futures 5.55 Historical basis for Dec. -0.25 Rough commission on trade+0.01 Expected local net price 5.31  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

30. Econ 337, Spring 2012 Prices Went Up, Hist. Basis  In December, sell back futures at $6.00 per bushel ($ per bushel) Dec. 2012 corn futures 6.00 Actual basis for Nov.-0.25 Local cash price 5.75 Less net value from futures-0.44 - ($6.00 - $5.55 - $0.01) Net cost of corn 5.31  Futures gained in value, reducing net cost of corn to the plant

31. Econ 337, Spring 2012 Prices Went Down, Hist. Basis  In December, sell back futures at $4.00 per bushel ($ per bushel) Dec. 2012 corn futures 4.00 Actual basis for Nov. -0.25 Local cash price 3.75 Less net value from futures+1.56 - ($4.00 - $5.55 - $0.01) Net cost of corn 5.31  Futures lost value, increasing net cost of corn

32. Econ 337, Spring 2012 Long Hedge Graph Hedging Dec. 2012 Corn @ $5.55

33. Econ 337, Spring 2012 Prices Went Down, Basis Change  In December, sell back futures at $4.00 per bushel ($ per bushel) Dec. 2012 corn futures 4.00 Actual basis for Dec. -0.10 Local cash price 3.90 Less net value from futures+1.56 - ($4.00 - $5.55 - $0.01) Net cost of corn 5.46  Basis narrowed, net cost of corn increased

34. Econ 337, Spring 2012 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

35. Econ 337, Spring 2012 Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/ Spring2012/