Price Risk Management

and
the Futures Market

Hedging

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 Market Risk
 Economic vs. Product Risk
product deterioration in value ; product destruction
 Risk is a Marketing Function (Facilitative
function)
 Risk as Cost; Risk Taking for Profit
 Farmers Have Unavoidable Price Risk
 Risk Transfer May Be Desirable, Profitable


 Examples of Your Risk
Management
 Plant Now, Price Now by Contract
 College Tuition (Pay in July for Year)
 College Study (Protect Against Low Pay
Job)
 Magazine Subscription: Pay for copies in
advance
 Home rental contract ; Insurance

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 rain Farmers¶ Market Risk
 Plant in Spring Without Knowing Fall
Harvest Price
 Sell in Spring Without Knowing Fall
Yield
 Sell in Fall Without Knowing Spring
Price
 Store in Fall Without Knowing Spring
Price


 Farmer Tools For Managing
Price Risk
 Cash Sale (at Harvest or From Storage)
 Forward Pricing:
Forward Contracts: Cash and Basis
contracts
Hedging using Futures
Options
 Minimum Price Contract

V
 Futures Markets
 Futures Exchanges : CBOT, CME,
KCBT etc.,
 Futures price is today¶s price for
products to be delivered in the future.
Contract specifications
Order execution process (open outcry)
Margin requirements

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ÕDateÕ Price per BushelÕ ActionÕ Margin ActionÕ Account BalanceÕ
Initial margin = $500Õ
Maintenance margin = $350Õ

17-JanÕ $2.50Õ Sell July cornÕ Deposit $500Õ $500Õ

18-JanÕ $2.52Õ $400Õ
19-JanÕ $2.54Õ $300Õ
Margin Call $200Õ $500Õ
20-JanÕ $2.53Õ $550Õ
21-JanÕ $2.60Õ $200Õ
Margin Call $300Õ $500Õ
24-JanÕ $2.57Õ $650Õ
25-JanÕ $2.55Õ $750Õ
26-JanÕ $2.51Õ $950Õ
Withdraw $450Õ $500Õ
27-JanÕ $2.49Õ $600Õ
28-JanÕ $2.44Õ Buy July cornÕ $800Õ
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 Futures Market Participants
 h

 



Risk Takers Have Inherent

Profit From Price Risk
Correctly
Anticipating Price Wish to Reduce or
Changes Manage Risk
Could Not Deliver or Could Deliver
Take Delivery of Against Futures
Futures Commodities Contract
 Hedge: Definitions

 Using the Futures or Options Markets To

Manage Price Risks

 A Temporary Substitution of A Futures

Market Transaction for a Planned Cash
Market Transaction

 Taking Equal and Opposite Positions on the

Cash and Futures Markets
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 Hedging Decisions
 What is my attitude toward price risk?
 What do I expect price to do?
 What are my costs?
 When should I set the hedge? When to
lift it?
 What are my alternatives to hedging?

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 Hedging uidelines
 Decide on a definite hedging objective -
reasons, month
 Discuss hedging plan with those involved; e.g.
bankers
 Know how to calculate your productions costs -
FC, VC, BEP
 Follow basis patterns
 Hedge reasonable amounts of commodity
 Keep adequate records

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 Production and Marketing
Periods

Spring Fall Spring/

Planting Harvest Summer

Pre-Harvest Period Storage Period

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 The Perfect Hedge
—  

 
Cash Futures
Price Price 

Nov. m Buy @ $. Sell @ $.V $.V

Dec. m Sell @ $m.9 Buy @ $. $.V

Cash sale = $m.9 m cent gain

Futures ain = .m
Return to Hedge = $. m
 Perfect Hedge Returns



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The Perfect Hedge
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Cash Futures
Price Price 

Nov. m Buy @ $. Sell @ $.V $.V

Dec. m Sell @ $.m Buy @ $.± $.V

Cash sale = $.m m cent loss

- Futures Loss = .m
Return to Hedge = $. m±
The Slightly Imperfect
Hedge
Cash Futures
Price Price 

Nov. m Buy @ $. Sell @ $.V $.V

Dec. m Sell @ $m.9 Buy @ $.V $.VV

Cash sale = $m.9 $m.9V is better

Futures ain = . V
Return to Hedge = $m.9V than $m.9 m
But not $.
 Characteristics of a Successful
Hedge
 Equal and Opposite Positions on Cash and
Futures Markets
 Cash and Futures Markets Move In Same
Direction
 Predictable Basis Pattern
 Nullify Futures Position, Sell on Cash Market
 Loss on One Market = ain on Other Market
 Transfer of Risk from Hedgers to Speculators
 No Tears, No Regrets

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 Types of Hedges
 Short Hedge (Protects Against Falling Prices)
Long Cash, Short Futures
Sell Cash, Buy Back Futures
 Long Hedge (Protects Against Rising Prices)
Short Cash, Long Futures
Buy Cash, Sell Futures
 Texas ³Hedge´ (Not a True Hedge)
Same Position on Cash and Futures Markets
Doubles the Risk

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 Three Farmer Hedges
 Perfect Hedge
Useful for Learning; Rare in Practice
 Storage Hedge
Set During Storage; Oct. to May
Protects Against Falling Prices
Helps Earn Storage Returns
 Pre-Harvest Hedge
Set in Spring
Protects Fall Harvest Price


 Storage Hedges
 Harvest-to-Sale Period (Storage Season)
 Risk of Price Decline, Inventory Loss
 Will Price Rise Cover Storage Costs?
 Carrying Charges:
Storage Costs
Handling Charges
Insurance and Interest Costs
 Key to Success: Narrowing Basis Pattern
m
The Storage Hedge
Cash Futures 
Price Price

Nov. m Buy/Store @ $. Sell @ $.V $.V

June m Sell @ $.Ô Buy @ $. $.m

Cash sale = $.Ô - $.

Futures ain = .m
=Return to Hedge = $.
- Original Cost = $.

= Storage Return = $.
 Storage Hedge Rule

The Storage Hedger¶s Carrying Charge

(Return to Storage) Will Always Equal
The Change in Basis Over the Storage Period

The Storage Hedge Transfers the Basis

Change From the Speculators to Hedgers

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 Hedging Principle


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



 Corn Storage Hedge
!
 "


"


October Harvest Price = $Ô. Sell July Fut. = $Ô.V

#  $
 % &'
h
 % ('
Forward Price = $Ô.V -.m = $Ô.
Storage Profit= $Ô. -Ô. - .Ô = $.m
June Cash Sale @ $Ô.Ô Buy Back Fut. @ $Ô.
V
Return to Hedge: $Ô.Ô
$.m = $ Ô.
 Pre-Harvest Hedge
 Set During Planting or rowing Period
 Protects Against Harvest Price Risk
 )
 
)
   *

 Locks-In Fall Harvest Target Price

 Key to Success: Requires Accurate
Harvest Basis Prediction

±
The PreHarvest Hedge
Cash Futures 
Price Price

May m 
 Sell @ $Ô.

 

Planting
$Ô. -. =$.±
Nov. m Sell @ $. Buy @ $. Expected
$.
Harvest
Cash Sale = $.

Futures ain = .
Return to Hedge = $.± = Spring Target 
 Corn Pre-Harvest Hedge

!
 "


"

May Sell Dec Fut. = $.
  %+ &'
#,

- % ('

Forward Price = $. -.Ô basis= $.V

Expected Profit= $.V -.m = $.
Oct. Cash Sale @ $. Buy Back Fut. @ $.

Net Return to Hedge: $.
$.m - $.m = $ .
 Calculating the Return
To a Hedge


Current Futures Price...$.
Less: Expected Basis at Sale Time .. .V
Equals: Lock-In Forward Price..$Ô.V

h

Cash Price..$Ô.
Plus/Minus Futures Transaction $.V
Equals: Total Return to Hedge... $Ô.V
Less: Costs (Prodn. Or Storage).$Ô.
9
Equals: Net Return To Hedge...$.Ô
 Combination Pre-Harvest
and Storage Hedge
 !
 ./$
..
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May m99 Target $Ô. Sell@$Ô.
$Ô. -. Est. Spr.
= $Ô. basis=$.

May m999 $.Ô xxxx Buy@$.V

Return to Hedge: $.Ô
.9 =$Ô.

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 Why Don¶t More Farmers
Hedge?
 Lack of Understanding of Hedging
 Mistrust of Futures Market
 Prefer Ease of Forward Contracts
 Like Risk; Prefer to Speculate on Cash
Market
 Dislike Margin Calls
 Other????
Ôm
 Summary: Risk Management
Tools
 Hedging
 Options
 Forward Cash Contracts
 Basis Contracts
 Minimum Price Contracts

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