Hedging with Futures

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Hedging with Futures
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Central Illinois Cash Corn Price
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What does 1-Cent Mean to a Corn Farmer?

• Corn Variable Production Costs140/acre
• Corn Fixed Production Costs145/acre
• Normal Production 130 bushels/acre
• Break-even price2.20 per bushel
• On a 1000 Acre Farm
• 3.00 Market Price 100,000 profit
• 2.00 Market Price -25,000 loss
• 1-cent move equals 1,300!

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What does 1-Cent per cwt Mean to a Maryland Dairy
Farmer?

• Total Production Costs13/cwt
• Average Farm Milk Price (94-99)13.75/cwt
• On a 200-Cow Farm
• 15 Annual Price 96,000 profit
• 12 Annual Price -48,000 loss
• 1-cent move equals 480!

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Hedging

• The use of a futures contract to offset price
  risk in the cash market.
• Commercials
• Use futures as a temporary substitute for a later
  transaction in the cash (physicals) market.
• Do today in the futures market what you will do
  tomorrow in the cash market.

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Hedging

• No guarantees that you will get a better price by
  hedging as compared to waiting to sell or buy on
  the cash market.
• Routine hedging vs. Selective Hedging

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December Corn Futures Contract Price Range and
Harvest Time Close
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Kevin McNew, University of Maryland
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Kevin McNew, University of Maryland
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Mechanics of Hedging What you Do Today.

• Plan for the future. Right price, right outlook?
• Delivery month closest to when cash transaction
  will be made, but will still trade on cash date.
• Equal position in the futures market (sellers go
  short, buyers go long).

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Short Hedger

• Today 9/99 An Oklahoma farmer is planting his
  wheat to be harvested and sold in June 2000.
• Sell July 2000 Futures at 3.00.

Long Hedger

• Today 9/99 A Pennsylvania flour miller wants to
  price wheat it will buy in June 2000.
• Buy July 2000 Futures at 3.00.

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Mechanics of Hedging What you Do Tomorrow.

• Buy or sell in the cash market as planned.
• Offset futures position (equal, but opposite
  position in the futures market).
• Profit/Loss on Futures Transaction.
• Net-price (accounts for cash and futures
  transactions)

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Net-Price Formula

• As a Seller
• Net-Price Cash Price Profit on Futures
• As a Buyer
• Net-Price Cash Price - Profit on Futures

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June 2000--Lower Prices

• Farmer harvests wheat and delivers it to his
  local market.
• Cash Price 2.40
• Offset futures contract (buy July 2000 futures)
  at 2.55.
• Net-Price Cash Price Profit on Futures
• Cash Price(F. price sold - F. price bought
• 2.40 (3.00-2.55)
• 2.85

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June 2000--Higher Prices

• Farmer harvests wheat and delivers it to his
  local market.
• Cash Price 3.60
• Offset futures contract (buy July 2000 futures)
  at 3.75.
• Net-Price Cash Price Profit on Futures
• 3.60 (3.00-3.75)
• 2.85

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June 2000--Lower Prices

• Flour miller buys cash wheat.
• Cash Price 2.80
• Offset futures contract (sell July 2000 futures)
  at 2.55.
• Net-Price Cash Price - Profit on Futures
• Cash Price - (F. price sold - F. price
  bought)
• 2.80 - (2.55-3.00)
• 3.25

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June 2000--Higher Prices

• Farmer harvests wheat and delivers it to his
  local market.
• Cash Price 4.00
• Offset futures contract (sell July 2000 futures)
  at 3.75.
• Net-Price Cash Price - Profit on Futures
• 4.00 - (3.75-3.00)
• 3.25

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Net-Prices

• Prices in June 2000 OK Farmer PA Miller
• High Prices 2.85 3.25
• Low Prices 2.85 3.25

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DEFINING THE BASIS

• Basis Cash - Futures
• "The cash price is cents under/over the
  futures price"
• Basis is defined for a specific place, time, and
  futures contract.
• Cash Price Basis Nearby Futures.

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Cash and Futures Prices

• July Futures in June 2000 OK Cash PA Cash
• 3.75 3.60 4.00
• 2.55 2.40 2.80

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Basis

• July Futures in June 2000 OK Basis PA Basis
• 3.75 -15 25
• 2.55 -15 25

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FUTURES HEDGE The Formula

• The Expected Price is...
• Current Futures Price Expected Basis
• For Wheat Example
• Expected Farmer Price (OK) 300 - 15 285
• Expected Miller Price (PA) 300 25 325
• Does not matter whether the price level is higher
  or lower.
• Actual Price only changes if the Basis is
  different then what was expected.
• Can Compare Expected Price to Forward Contracts.
• Retain Flexibility in Cash Market.

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Calculating Pessimistic/Optimistic Basis

• The Average Basis reflects what value is most
  likely for the Actual Basis.
• In Reality, however, the Actual Basis can be
  Either Stronger (larger) or Weaker (smaller) than
  the Average.
• To reflect this variation, one can calculate an
  Optimistic Basis and a Pessimistic Basis.
• Optimistic Basis Average Basis SD
• Pessimistic Basis Average Basis - SD
• About 2/3 of the time the Actual Basis will be
  between the Optimistic and Pessimistic Basis.

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Optimistic and Pessimistic Basis

• Example Basis forecast for CMD Corn in October.
• Average Basis15 SD10
• Optimistic Basis 15 10 25
• Pessimistic Basis 15 - 10 5
• So, 2/3 of the time the Basis will be 5,25
• Effective Selling Price 28915304
• Lower ESP 289 5 294
• Upper ESP 289 25 314