Price Risk Management for Cattle Producers

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Price Risk Management for Cattle Producers

• Why worry about price risk
• Futures
• Forward Contract
• Options
• Insurance

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Feedlot Profit Factors

• Steer feeding profit variation explained ()
• Placement wt lt600 700-800
• Fed price 58.07 50.46
• Feeder price 2.30 19.31
• Corn price 5.29 4.19
• Feed/gain 7.22 3.55
• ADG 1.36 6.31
• Interest rate 1.55 -.38
• Total explained 75.79 83.44

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Fed Cattle Price Forecast Error, 1995-2004
Seasonal Index and Basis Adjusted Futures
http//www.econ.iastate.edu/faculty/lawrence/
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68 of time
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Futures Market Exchanges

• Chicago Mercantile Exchange
• Centralized pricing
• Buyers and sellers represented by brokers in the
  pits
• All information represented through bids and
  offers
• Perfectly competitive market
• Open out-cry trading
• Beginning electronic trading

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The futures contract

• 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 (wt, grade, specifications)
• Time (delivery date)
• Place (delivery location)

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Standardized contract

• Certain delivery (contract) months
• Fixed size of contract
• Grains 5,000 bushels
• Corn, Wheat, Soybeans
• Livestock in pounds
• Lean Hogs 40,000 lbs carcass
• Live Cattle 40,000 lbs live
• Feeder Cattle 50,000 lbs live
• Specified delivery points
• Relatively few delivery points

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The futures contract

• No physical exchange takes place when the
  contract is traded.
• Payment is based on the price established when
  the contract was initially traded.
• Deliveries are made when the contract expires
  (delivery time).

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Hedging definition

• Holding equal and opposite positions in the cash
  and futures markets
• The substitution of a futures contract for a
  later cash-market transaction

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Terms and Definitions

• Basis
• 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.

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Hedging Example

• April 1, a cattle feeder as 300 fed cattle to
  market in October.
• October futures on 4/1 98.50
• Expected basis in October -3.25
• Commission -.15
• Expected hedge price 95.10

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Hedging Example

• Now October 1 and the cattle are ready to sell.
• Higher prices, Same basis
• October futures on 10/1 103.00
• Actual basis in October -3.25
• Cash price received for cattle 99.75
• Offset futures 98.50-103.00 -4.50
• Commission -.15
• Futures gain/loss -4.65
• Net hedge price 99.75-4.65 95.10

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Hedging Example

• Now October 1 and the cattle are ready to sell.
• Lower prices, wider basis
• October futures on 10/1 93.00
• Actual basis in October -4.25
• Cash price received for cattle 88.75
• Offset futures 98.50-93.00 5.50
• Commission -.15
• Futures gain/loss 5.35
• Net hedge price 99.75-4.65 94.10

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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.
• Basis estimation is critical to successful hedging

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Futures Summary

• Todays price for delivery in future
• Standardized contract/promise to make or take
  delivery
• Contract/promise can be offset
• Several participants for different positions
• Basis estimation important to hedgers

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Net Price
Hedger Position
Long Cash Adjust for basis
Hedge Adjust for basis
Futures _at_ Maturity
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Forward Contracts

• Contract for delivery
• 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

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Forward contract advantages

• No margin account or margin call
• Working with local people
• Flexible sizes
• Known basis
• Tangible
• Simple

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Forward contract disadvantage

• Inflexible
• Replace price risk with production risk
• Difficult to offset
• Must deliver commodity
• Buyer takes protection
• The known basis may be wider

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OPTIONS

• Options on futures are contracts.
• The buyer of an option has the RIGHT (but not the
  obligation) to trade a futures contract under
  certain conditions.
• The seller of an option MUST trade a futures
  contract under certain conditions IF the option
  buyer so desires.

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Hedgers Price Floor

• Buy a put option with selected strike price
• Adjust for basis
• Pay premium and commission
• Floor SP- Prem Basis- Comm
• Establish the minimum expected price, but can
  receive higher prices if they occur. The net
  price is
• PricesltStrike price Floor price
• PricesgtStrike price Cash price prem - comm

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Hedgers Price Floor

• In April for cattle to sell in October
• Buy Oct put with strike price 96.00
• Premium for this strike -3.20
• Expected basis -3.25
• Commission -0.15
• Floor price 89.40

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Hedgers Price Floor

• It is now October and prices are 103.00
• Cash price 103.00-3.25 99.75
• Value of put 0
• Cost of put 3.20 .15 -3.35
• Net cash price 96.40

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Hedgers Price Floor

• It is now October and prices are 93.00
• Cash price 93.00-3.25 89.75
• Value of put 96.00-93.00 3.00
• Cost of put 3.20 .15 -3.35 -.35
• Net cash price 89.40

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Net Price
Hedger Position
Long Cash Adjust for basis
Buy Put
Hedge Adjust for basis
Strike Price
Futures
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Hedgers Price Ceiling

• Buy a call option with selected strike price
• Adjust for basis
• Pay premium and commission
• Floor SP Prem Basis Comm
• Establish the maximum expected price, but can
  receive lower prices if they occur. The net
  price is
• PricesgtStrike price ceiling price
• PricesltStrike price Cash price prem comm

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Net Price
Hedger Position
Long Cash Adjust for basis
Buy Call
Hedge Adjust for basis
Strike Price
Futures
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Livestock Risk Protection (LRP)

• Coverage for hogs, fed cattle and feeder cattle
• 70 to 95 guarantees available, based on CME
  futures prices.
• Coverage is available for up to 26 weeks out for
  hogs and 52 for cattle.

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Size of Coverage

• Futures and options have fixed contract sizes
• Hogs 400 cwt. or about 150 head
• Fed cattle 400 cwt. or about 32 head
• Feeder cattle 500 cwt., 60-100 head
• LRP can be purchased for any number of head or
  weight

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Some Risks Remain

• LRP, LGM do not insure against production risks
• Futures prices and cash index prices may differ
  from local cash prices (basis risk)
• Selling weights and dates may differ from the
  guarantees

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Expiration Date of Coverage

• LRP ending date is fixed. Price may change after
  date of sale.
• Hedge or options can be lifted at any time before
  the contract expires.

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Livestock Gross Margin

• Insures a margin between revenue and cost of
  major inputs
• Hogs
• Value of hog corn and SBM costs
• Cattle
• Value of cattle feeder cattle and corn
• Protects against decreases in cattle/hog prices
  increases in input costs

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LGM-Cattle

• Yearling GM 12.5 x Basis adjusted LC futures
• - 7.5 x Basis adjusted FC futures
• - 57.5 x Basis adjusted Corn futures
• Calf  GM 11.5 x Basis adjusted LC futures
• - 5.5 x Basis adjusted FC futures
• - 55.5 x Basis adjusted Corn futures

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Summary

• Price risk management is essential
• Fed, feeder and feed
• Tools are available to manage risk
• Do not guarantee a profit, only a tool to manage
  price risk
• Knowledge and skill are important
• Insurance products are relatively new
• Useful where size and simplicity are important