Price Risk Management

and
the Futures Market
Hedging

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

Examples of Your Risk

Management
W Plant Now, Price Now by Contract
W College Tuition (Pay in 1uly for Year)
W College Study (Protect Against Low Pay
1ob)
W Magazine Subscription: Pay for copies in
advance
W Home rental contract ; Insurance

rain Farmers` Market Risk

W Plant in Spring Without Knowing Fall
Harvest Price
W Sell in Spring Without Knowing Fall
Yield
W Sell in Fall Without Knowing Spring
Price
W Store in Fall Without Knowing Spring
Price

Farmer Tools For Managing

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

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

Date Price per Bushel Action Margin Action Account Balance

nitial margin = $500
Maintenance margin = $350
17-Jan $2.50 Sell July corn Deposit $500 $500
18-Jan $2.52 $400
19-Jan $2.54 $300
Margin Call $200 $500
20-Jan $2.53 $550
21-Jan $2.60 $200
Margin Call $300 $500
24-Jan $2.57 $650
25-Jan $2.55 $750
26-Jan $2.51 $950
Withdraw $450 $500
27-Jan $2.49 $600
28-Jan $2.44 Buy July corn $800
Futures Market Participants
W Speculators:
Risk Takers
Profit From
Correctly
Anticipating Price
Changes
Could Not Deliver or
Take Delivery of
Futures Commodities
W edgers:
Have Inherent
Price Risk
Wish to Reduce or
Manage Risk
Could Deliver
Against Futures
Contract

Hedge: Definitions
W Using the Futures or Options Markets To
Manage Price Risks
W A Temporary Substitution of A Futures
Market Transaction for a Planned Cash
Market Transaction
W Taking Equal and Opposite Positions on the
Cash and Futures Markets

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

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

Production and Marketing

Periods
Spring
Planting
Fall
Harvest
Spring/
Summer
Pre-Harvest Period Storage Period
#sk: Plant wthout
knowng Fall Prce
#sk: Store wthout
knowng Sprng Prce

The Perfect Hedge

Fallng Prce Perod)
Cash
Price
Futures
Price
Bass
Nov.
Dec.
Buy $.
Sell $. $.
Sell $.9
Buy $. $.
Cash sale $.9
Futures ain .
Return to Hedge $.
cent gain

Perfect Hedge Returns

For a Perfect edge Bass Constant), 1he
#eturn 1o 1he edge Cash Prce + Futures)
Wll Always Be the Same.

The Perfect Hedge

#sng Prce Perod)
Cash
Price
Futures
Price
Bass
Nov.
Dec.
Buy $.
Sell $. $.
Sell $.
Buy $. $.
Cash sale $.
- Futures Loss .
Return to Hedge $.
cent loss

The Slightly Imperfect

Hedge
Cash
Price
Futures
Price
Bass
Nov.
Dec.
Buy $.
Sell $. $.
Sell $.9
Buy $. $.
Cash sale $.9
Futures ain .
Return to Hedge $.9
$.9 is better
than $.9
But not $.

Characteristics of a Successful
Hedge
W Equal and Opposite Positions on Cash and
Futures Markets
W Cash and Futures Markets Move In Same
Direction
W Predictable Basis Pattern
W Nullify Futures Position, Sell on Cash Market
W Loss on One Market ain on Other Market
W Transfer of Risk from Hedgers to Speculators
W No Tears, No Regrets
9
Types of Hedges
W Short Hedge (Protects Against Falling Prices)
Long Cash, Short Futures
Sell Cash, Buy Back Futures
W Long Hedge (Protects Against Rising Prices)
Short Cash, Long Futures
Buy Cash, Sell Futures
W Texas ~Hedge (Not a True Hedge)
Same Position on Cash and Futures Markets
Doubles the Risk

Three Farmer Hedges

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

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

The Storage Hedge

Cash
Price
Futures
Price
Bass
Nov.
1une
Buy/Store $. Sell $.
$.
Sell $. Buy $. $.
Cash sale $.
Futures ain .
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

Hedging Principle
1he Bass Determnes
the Success
of A edge

Date Cash Market Futures

Market
October Harvest Price $. Sell 1uly Fut. $.
Est. 1une Bass $.1
Storage Cost $.3
Forward Price $.-. $.
Storage Profit $. -. - . $.
1une Cash Sale $. Buy Back Fut. $.
Return to Hedge: $. $. $ .
Corn Storage Hedge

Pre-Harvest Hedge
W Set During Planting or rowing Period
W Protects Against Harvest Price Risk
Wll arvest Prce Cover Producton Costs?
W Locks-In Fall Harvest Target Price
W Key to Success: Requires Accurate
Harvest Basis Prediction

The PreHarvest Hedge

Cash
Price
Futures
Price
Bass
May
Planting
Nov.
Harvest
Plant at 1arget
Prce:
$.-.$.
Sell $.
Sell $.
Buy $.
Expected
$.
Cash Sale $.
Futures ain .
Return to Hedge $. Spring Target

Date Cash Market Futures

Market
May Sell Dec Fut. $.
Cost of Producton $2.1
Forward Price $.-. basis $.
Expected Profit $. -. $.
Oct. Cash Sale $. Buy Back Fut. $.
Net Return to Hedge: $. $.- $. $ .
Corn Pre-Harvest Hedge
Expected bass $.3
9
Calculating the Return
To a Hedge
1oday: Current Futures Price...$.
Less: Expected Basis at Sale Time .. .
Equals: Lock-In Forward Price..$.
Future Sale: Cash Price..$.
Plus/Minus Futures Transaction $.
Equals: Total Return to Hedge... $.
Less: Costs (Prodn. Or Storage).$.
Equals: Net Return To Hedge...$.

Combination Pre-Harvest
and Storage Hedge
May 99 Target $. Sell$.
$.-. Est. Spr.
$. basis$.
Cash Dec. 98 1une 99
Market Futures Futures
May 999 $. xxxx Buy$.
Return to Hedge: $. .9 $.

Why Don`t More Farmers

Hedge?
W Lack of Understanding of Hedging
W Mistrust of Futures Market
W Prefer Ease of Forward Contracts
W Like Risk; Prefer to Speculate on Cash
Market
W Dislike Margin Calls
W Other????

Summary: Risk Management

Tools
W Hedging
W Options
W Forward Cash Contracts
W Basis Contracts
W Minimum Price Contracts