ECON 337 Agricultural Marketing Chad Hart Associate Professor

ECON 337: Agricultural Marketing Chad Hart Associate Professor chart@iastate. edu 515 -294 -9911 Econ 337, Spring 2015 Lee Schulz Assistant Professor lschulz@iastate. edu 515 -294 -3356

Sources of economic risk… • Livestock prices (feeder and finished) • Feed prices • Interest rates • Equipment/facilities • Capacity utilization • Labor • Health/performance • Other? ? ? How are these risks managed? (and which are most important) Econ 337, Spring 2015

Managing price risk is essential… • Volatility over the past 5 years has increased to unprecedented levels. Overriding factors: – Domestic and foreign political policy – Domestic and foreign economic policy – Changing global supply and demand balance – Weather/natural occurrences affecting supply and logistics • The equity and working capital necessary to operate the same volume of business has nearly doubled • MORE IS AT STAKE: Greater potential for profit, greater potential for substantial loss Econ 337, Spring 2015

Methods of managing price risk… • Cash sales (purchases) • Forward contract • Hedge with futures contract, i. e. , sell (buy) futures • Buy put (call) option • Other option marketing strategies • Livestock Risk Protection (LRP) • Livestock Gross Margin (LGM) Price risk management → Coordinated and economical application of strategies to minimize, monitor, and control the probability of adverse price movements Econ 337, Spring 2015

Cash sales (purchases)… • Characteristics – easy to understand – retain price and basis* risk – no quantity or quality obligations (within reason) – no futures broker or margin calls – financial risk (i. e. , risk of not getting paid) depends on financial strength/integrity of buyer * basis = cash price – futures price Econ 337, Spring 2015

Forward contract… • Characteristics – locks in a “fixed” price – basis risk is eliminated – pay a premium for transferring basis risk – no margin account or maintenance required – may or may not involve broker / brokerage commission – contract specifications and size flexible (within reason) – obligated to deliver – low quality cattle might be excluded/refused – weight price slide risk – risk of other party not honoring contract – not always available – prices are not very transparent Econ 337, Spring 2015

Types of Contracts Ø Formula ØMost common contract ØPrice tied to another market, typically spot (cash) ØExamples: Ø 3 -Day rolling average of Iowa/So. Minnesota weighted average +$1. 50 ØLast week’s average excluding the high and low Ø 92% of the previous day cutout value Ø Buyer does not share risk Econ 337, Spring 2015

Types of Contracts Ø Fixed window ØFormula tied to cash price ØPredetermined upper and lower bounds ØShare pain and gain outside window ØExample: $50 and split 50/50 above and below Ø Floating window ØFormula tied to cash price ØBoundaries move with feed prices ØDo not share outside of window Ø Buyer shares risk Econ 337, Spring 2015

Types of Contracts Ø Cost-Plus Ø Price direct function of feed prices Ø Fixed amount for non-feed costs + known margin Ø Buyer assumes all price risk Ø Ledger Ø Floor price is fixed or based on feed prices Ø Producer is “loaned” the difference between floor and lower cash prices Ø Loan is repaid at higher cash prices Ø Buyer provides line of credit but not risk share Econ 337, Spring 2015

Hedge with futures contract… • Characteristics – locks in a “fixed” price (CME futures price) – subject to basis risk – fixed contract specifications and size – deal with broker / brokerage commission – margin account and maintenance required – easy to enter and liquidate – transparent price quotes – no risk of other party “backing out” – feeder cattle futures is cash settled contract § No delivery ability / obligation § No risk of low quality cattle being “refused” Econ 337, Spring 2015

Buy put (call) option contract… • Characteristics – locks in a “floor” price (ceiling for call) (strike price) – subject to basis risk – fixed contract specifications and size – deal with broker / brokerage commission – pay premium for option – no margin calls (unless option is exercised) – easy to enter and liquidate – transparent price quotes – no risk of other party “backing out” – cash settled contract (no delivery ability / obligation) Econ 337, Spring 2015

Other options strategies… • Characteristics – anything goes… – buy / sell puts(s), call(s), sell futures, forward contract… – selling options requires margin account and maintenance – make sure you know what you are doing Several of the more common option strategies – Synthetic put – hedge (sell futures) or forward contract and buy call option (works similar to buying put option) – Window / fence – establish minimum (floor) and maximum (ceiling) prices by buying a put option and selling a call option(s) Econ 337, Spring 2015

Econ 337, Spring 2015

Risk management using futures… Hedging defined… Use of the futures market as a temporary substitute for an intended transaction in the cash market which will occur at a later date Econ 337, Spring 2015

Relationship Between Cash & Futures Prices is Critical for Risk Management • Basis = Cash Price – Futures Price Rearranging formula gives • Basis + Futures Price = Cash Price Econ 337, Spring 2015

Decomposing a Cash Price • Cash Price = Basis + Futures Price • Recall definition of hedging • Hedging effectively “locks in” the Futures Price when the hedger sells (for a short hedger) the futures contract • Hedging does not lock in the Basis • Therefore the Cash Price is not locked in and the hedger is still exposed to basis risk Econ 337, Spring 2015

Evaluating a Hedge At the time the hedge is placed, we can estimate the Expected Selling Price (i. e. , what the hedger expects to receive for the commodity net any gains or losses in the futures, minus the brokerage commission) Futures Price at which futures contract is sold + Expected Basis - Brokerage commission Expected Selling Price Econ 337, Spring 2015

Futures Hedge Example Assume JUN LC are $124. 57/cwt when hedge is initiated (Nov 22) Expect June basis to be +$1. 00/cwt (for 1250 lb steer) Assume brokerage commission = $60/ round turn or $0. 15/cwt What is the Expected Selling Price? Futures Price at which hedge is initiated $124. 57 + Expected Basis + 1. 00 - Brokerage commission - 0. 15 Expected Selling Price $125. 42/cwt Econ 337, Spring 2015

Basis… Generally, basis is more predictable than cash or futures prices due to: Ø Convergence Ø Futures and cash prices move together (same fundamental conditions generally affect both markets) Ø Year-to-year stability implies the ability to rely upon historical data for predictions Ø Sources of basis information § Ag Decision Maker (www. extension. iastate. edu/agdm/) § Beef Basis – feeder cattle (www. beefbasis. com) Econ 337, Spring 2015

Basis… • Strong • Weak • Narrow • Wide • Over • Under

At Hedge’s Conclusion Calculate Actual Sale Price received in the cash market + Net on futures transaction - Brokerage commission Actual Sale Price Econ 337, Spring 2015

Futures Hedge Example Assume JUN LC are $127. 07/cwt on 6/15 when hedge is concluded Assume cash 1250 lb steer price = $128. 07/cwt when hedge concludes What is your net gain on the futures trade? Sold JUN LC futures @ $124. 57 - Offset (buy) JUN LC futures @ - 127. 07 Net gain on futures transaction - 2. 50 Econ 337, Spring 2015

Futures Hedge Example So, if JUN LC are $127. 07/cwt on 6/15 when hedge concludes And cash 1250 lb steer price = $128. 07/cwt when hedge concludes What is the Actual Sale Price? Price received in cash market $128. 07 + Net on futures transaction - 2. 50 - Brokerage commission - 0. 15 Actual Sale Price Expected = Actual $125. 42/cwt Why? Because Expected Basis = Actual Basis Econ 337, Spring 2015

$128. 070 $125. 420 Econ 337, Spring 2015

Option Hedging Strategies • Buying a PUT (CALL) gives the option buyer the right but not the obligation to SELL (BUY) a futures contract at a specified price known as the “strike price” • So, we can use the purchase price of the PUT (CALL) in place of selling (buying) a futures contract • Therefore, a producer can buy a PUT option to establish a Minimum Expected Selling Price • Similarly, buying a CALL option will establish a Maximum Expected Purchase Price Econ 337, Spring 2015

Minimum Expected Selling Price Buy a Put • start with a put option strike price • subtract the put option premium This creates a “futures equivalent” • then add basis forecast • subtract brokerage commission – remember that many brokers charge once to buy an option and once to sell an option – have to account for possibility of “double” brokerage commission in calculations Econ 337, Spring 2015

Minimum Expected Selling Price Buy a Put • Example: Buy CME $124. 00 JUN Live Cattle PUT (when JUN LC futures are @ $124. 57) • Put option premium = $3. 85/cwt • Mid June basis forecast = +$1. 00/cwt (1250 lb steer) • Assume brokerage commission is $30 ($0. 075/cwt) to buy an option contract and $30 ($0. 075/cwt) to sell an option contract • For the buyer of a $124. 00 JUN LC Put What is the Minimum Expected Selling Price? Econ 337, Spring 2015

Minimum Expected Selling Price Buy a Put $124. 00 - 3. 85 $120. 15/cwt Option Strike Price Put Premium Futures equivalent + 1. 00 Expected mid June basis - 0. 15 Maximum possible commission $121. 00/cwt Econ 337, Spring 2015 Minimum Expected Selling Price

Actual Sale Price • start with price received in cash market • add the “net” from the option trade • subtract actual brokerage commission -- Sell cash cattle in mid June for $128. 07/cwt -- JUN live cattle futures are $127. 07/cwt -- What is the value of $124. 00 put option? Econ 337, Spring 2015

Actual Sale Price (for buyer of CME Put Option) $128. 070 Cash Market Price - 3. 850 + Net on Option Trade - 0. 075 - Brokerage Commission $124. 145 Actual Net Sale Price Actual > Expected Minimum Why? Prices went up after Put Option purchase and the Put Option buyer retained the right to benefit from future price increases Econ 337, Spring 2015

$128. 070 $125. 420 $124. 145 Econ 337, Spring 2015

Comparing pricing alternatives… Cash vs. Hedging vs. Options… Because the various risk management tools have different characteristics (e. g. , flat price vs. minimum price), it is useful to compare them under alternative price outcomes Econ 337, Spring 2015

Class web site: http: //www. econ. iastate. edu/~chart/Classes/econ 337/ Spring 2015/ Econ 337, Spring 2015