ECON 337 Agricultural Marketing Chad Hart Associate Professor

ECON 337: Agricultural Marketing Chad Hart Associate Professor chart@iastate. edu 515 -294 -9911

Short Hedgers Ø Producers with a commodity to sell at some point in the future ØAre hurt by a price decline Ø Sell the futures contract initially Ø Buy the futures contract (offset) when they sell the physical commodity

Short Hedge Example Ø A soybean producer will have 25, 000 bushels to sell in November Ø The short hedge is to protect the producer from falling prices between now and November Ø Since the farmer is producing the soybeans, they are considered long in soybeans

Short Hedge Example Ø To create an equal and opposite position, the producer would sell 5 November soybean futures contracts Ø Each contract is for 5, 000 bushels Ø The farmer would short the futures, opposite their long from production Ø As prices increase (decline), the futures position loses (gains) value

Short Hedge Expected Price Ø Expected price = Futures prices when I place the hedge + Expected basis at delivery – Broker commission

Short Hedge Example Ø As of Jan. 20, Nov. 2017 soybean futures Historical basis for Nov. 0. 30 Rough commission on trade Expected price ($ per bushel) $10. 29 $$-0. 01 $ 9. 98 Ø Come November, the producer is ready to sell soybeans Ø Prices could be higher or lower Ø Basis could be narrower or wider than the historical average

Prices Went Up, Hist. Basis Ø In November, buy back futures at $11. 50 per bushel Nov. 2017 soybean futures Actual basis for Nov. Local cash price Net value from futures ($ per bushel) $11. 50 $-0. 30 $11. 20 $-1. 22 ($10. 29 - $11. 50 - $0. 01) Net price $ 9. 98

Prices Went Down, Hist. Basis Ø In November, buy back futures at $7. 00 per bushel Nov. 2017 soybean futures Actual basis for Nov. Local cash price Net value from futures ($ per bushel) $ 7. 00 $-0. 30 $ 6. 70 $ 3. 28 ($10. 29 - $7. 00 - $0. 01) Net price $ 9. 98

Short Hedge Graph Hedging Nov. 2017 Soybeans @ $10. 29

Prices Went Down, Basis Change Ø In November, buy back futures at $7. 00 per bushel Nov. 2017 soybean futures Actual basis for Nov. Local cash price Net value from futures ($ per bushel) $ 7. 00 $-0. 10 $ 6. 90 $ 3. 28 ($10. 29 - $7. 00 - $0. 01) Net price Ø Basis narrowed, net price improved $10. 18

Long Hedgers Ø Processors or feeders that plan to buy a commodity in the future ØAre hurt by a price increase Ø Buy the futures initially Ø Sell the futures contract (offset) when they buy the physical commodity

Long Hedge Example Ø An ethanol plant will buy 50, 000 bushels of corn in December Ø The long hedge is to protect the ethanol plant from rising corn prices between now and December Ø Since the plant is using the corn, they are considered short in corn

Long Hedge Example Ø To create an equal and opposite position, the plant manager would buy 10 December corn futures contracts Ø Each contract is for 5, 000 bushels Ø The plant manager would long the futures, opposite their short from usage Ø As prices increase (decline), the futures position gains (loses) value

Long Hedge Expected Price Ø Expected price = Futures prices when I place the hedge + Expected basis at delivery + Broker commission

Long Hedge Example Ø As of Jan. 20, Dec. 2017 corn futures Historical basis for Dec. Rough commission on trade Expected local net price ($ per bushel) $ 3. 96 $ -0. 25 $+0. 01 $ 3. 72 Ø Come December, the plant manager is ready to buy corn to process into ethanol Ø Prices could be higher or lower Ø Basis could be narrower or wider than the historical average

Prices Went Up, Hist. Basis Ø In December, sell back futures at $5. 00 per bushel Dec. 2017 corn futures Actual basis for Dec. Local cash price Less net value from futures -($5. 00 - $3. 96 - $0. 01) Net cost of corn ($ per bushel) $ 5. 00 $-0. 25 $ 4. 75 $-1. 03 $ 3. 72 Ø Futures gained in value, reducing net cost of corn to the plant

Prices Went Down, Hist. Basis Ø In December, sell back futures at $3. 00 per bushel Dec. 2017 corn futures Actual basis for Dec. Local cash price Less net value from futures -($3. 00 - $3. 96 - $0. 01) Net cost of corn ($ per bushel) $ 3. 00 $ -0. 25 $ 2. 75 $+0. 97 $ 3. 72 Ø Futures lost value, increasing net cost of corn

Long Hedge Graph Hedging Dec. 2017 Corn @ $3. 96

Prices Went Down, Basis Change Ø In December, sell back futures at $3. 00 per bushel Dec. 2017 corn futures Actual basis for Dec. Local cash price Less net value from futures -($3. 00 - $3. 96 - $0. 01) Net cost of corn ($ per bushel) $ 3. 00 $ -0. 10 $ 2. 90 $+0. 97 $ 3. 87 Ø Basis narrowed, net cost of corn increased

Hedging Results Ø In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis. Ø So basis estimation is critical to successful hedging. Ø Narrowing basis, good for short hedgers, bad for long hedgers Ø Widening basis, bad for short hedgers, good for long hedgers

Class web site: http: //www. econ. iastate. edu/~chart/Classes/econ 337/ Spring 2017/ Have a great weekend!