New Generation Grain Contracts Decision Contracts MARKET BASED

New Generation Grain Contracts Decision Contracts MARKET BASED RISK MANAGEMENT FOR AGRICULTURE September 2007 Iowa State University Regis Lefaucheur Decision Commodities, LLC 614 Billy Sunday Rd. , Suite 600 Ames, Iowa 50010 515. 956. 7880 www. decisioncommodities. com

Decision Commodities • Based in Ames, IA • Provides innovative forward contracts to grain producers to help them take the emotion, stress and guesswork out of grain pricing • Customer base: Iowa, Illinois, Minnesota, North Dakota, Wisconsin, Missouri • Decision Contracts enable producers to put discipline into grain marketing 2

Decision Commodities • What does Decision Commodities do? – Take the EMOTION out of selling – Take the GUESSWORK out of selling – Consistently outguessing or outperforming the market is impossible. 3

What are producers saying? “ forward contracts are always terrible ways to market… 20% of the time I sold too soon, and 80% of the time I didn’t market enough…” “ I only sell grain when prices are in the top third of the market…” 4

Grain Industry Vocabulary • Definitions: – Futures price – Basis September 17, 2007 Corn Basis – Cash Price – Spread • Relationships 5

Producer Hedging 01 Feb 2007 Harvest Price Decrease Scenario Futures $3. 50 Sell @ $3. 50 Lower $3. 10 Buy @ $3. 10 -$0. 40 +$0. 40 Producer Goal: Lock in an attractive price (higher is better) – Protection against lower prices 01 Feb 2007 Harvest Price Increase Scenario Futures $3. 50 Sell @ $3. 50 Higher $3. 90 Buy @ $3. 90 +$0. 40 6 -$0. 40

Elevator Hedging Harvest January 15 sale Price Decrease Scenario Futures $3. 20 Sell @ $3. 20 Lower $3. 00 Buy @ $3. 00 -$0. 20 +$0. 20 Elevator Goal: Lock in the price of the grain he bought to protect his margins (storage, drying, basis, hedging) Harvest January 15 Sale Price Increase Scenario Futures $3. 20 Sell @ $3. 20 Higher $3. 40 Buy @ $3. 40 +$0. 20 7 -$0. 20

End User: feed mill, ethanol 01 Feb 2007 Harvest Price Decrease Scenario Futures $3. 40 Buy @ $3. 40 Lower $3. 10 Sell @ $3. 10 +$0. 30 -$0. 30 End User Goal: Lock in an attractive price (lower is better) – Protection against higher prices 01 Feb 2007 Harvest Price Increase Scenario Futures $3. 40 Buy @ $3. 40 Higher $3. 60 Sell @ $3. 60 -$0. 20 8 +$0. 20

Decision Contracts Risk Management Continuum Insurance against low prices Put Option Contract Insurance against high prices Futures Contract Elevator Farmers Price Sensitive 9 Margin Dependent Call Option Contract End-User Price Sensitive

Relationship Between Futures, Basis And Cash Price Futures Price - Basis = Cash Price (paid to the producer) $3. 5225 (Dec 2007) - $0. 48 = $3. 0425 See: http: //www. hoic. com/grain/bids. asp 10

Example 11

BASIS What is BASIS? Chicago Board of Trade - Corn Futures Price = $3. 50 Processor Bid - $3. 25 BASIS = “ 0. 25 under” Warehouse Bid - $3. 20 BASIS = “ 0. 30 under” Producer Bid - $3. 10 BASIS = “ 0. 40 under” How can a user increase or decrease the movement of grain locally if they can’t change the price on the Chicago Board of Trade? 12

What factors contribute to determining the BASIS? Feed Ethanol River Processing 13 BASIS

BASIS What factors contribute to determining the BASIS? Industrial Export Dairy Ethanol Feed Poultry Export • • 14 What impact does a BASIS change in one area have on other areas? Which markets have the greatest influence on basis, spreads and the futures market?

SPREAD Spread = price difference between various futures reference months The Spread can be Carry or Inverted Dec July Spread= - $ 2. 79 - / Inverted July Sept Spread = + $ 0. 04 + / Carry CBOT WHEAT 15

STORE or SELL ? What decision should a producer make? STORE Wide Carry Low SELL Basis Narrow Spread Inverted Futures price High Result: Decrease in the movement of grain Increase in the movement of grain 16

EFFICIENT MARKET HYPOTHESIS RANDOMNESS 17

Efficient Market Hypothesis • According to Fama, an efficient market is one that accurately incorporates all known information in determining price. This is know as the efficient market hypothesis. • Although there is considerable disagreement about the degree to which EMH holds, it has become the dominant paradigm used by economists to understand investigate the behavior of financial and commodity markets. • Markets for commodities and products that are widely traded in agriculture and the food industry are a model of efficiency. The compile all the information and knowledge of traders, businesses and producers, and express this data in the form of a price. 18

Efficient Market Hypothesis • The daily pricing process in the market is usually referred to as a random walk. A commonly used analogy of a random walk is the flipping of a fair coin. Overtime, the expected change is price is zero. • The market is all-knowing. Consistently outguessing or outperforming it is very difficult (if not impossible) 19

Randomness • What does randomness looks like? 20

Randomness and Unpredictability Randomness CBOT Corn December Futures 2007 It is easy to see patterns in random events 21

SOYBEAN – Up/Down days 22

SOYBEAN – Up/Down days By year (days) Up Down Total 1997 126 252 1998 123 127 250 1999 114 136 250 2000 123 127 250 2001 119 129 248 2002 134 115 249 2003 145 104 249 2004 126 123 249 2005 131 119 250 2006 128 123 251 SOYBEAN TOTALS 1997 -2006 Average of up/down $0. 00 Standard deviation $0. 08 Minimum $-0. 49 Maximum $0. 50 Total Days 2581 Up Days 1315 Down Days 1266 Nov 01 to Oct 31 - 1997 -2007 - NOV Soybean CBOT 23

Randomness and Unpredictability • • 24 Another way to view markets is that while prices can’t be predicted, prices aren’t all that random either. While we can’t guarantee that the “pattern” depicted below will be repeated in the future, this 25 year frequency histogram tends to suggest that there is some central tendency around $2. 15 to $2. 95 range.

BEHAVIORAL FINANCE AND EMOTIONS 25

Behavioral Finance and Emotions 2004 December Corn Futures 06 -2003 to 09 -2004 26

Behavioral Finance • Regret: Regret management is probably a more accurate term for risk management. There is a very natural tendency to avoid regret. In grain marketing, this is often embodied into a decision not to decide. Regret is the more powerful behavioral issue. Obviously, regret can significantly impair our ability to make rational choices. • Risk aversion: Most people are risk averse and seek to avoid risk. However, there tends to be identifiable biases in human behavior that lead to irrational decision making. One of these biases is the tendency to accept increases risk over a guaranteed loss. It reflects a tendency to underestimate the chances of “extreme” market situation occurring. In grain marketing, this tendency leads some to accept price risk rather than pay for insurance – such as a put option purchase or guaranteed minimum price contract. Why don’t producers want to pay 5 cents to protect 50 cents? 27

Long Term Corn Prices 2007 December Corn Futures 07 -2006 to 09 -2007 Reference price anchoring: It is the tendency for a person to “fix” a specific figure in their mind as the perceived value. – An example of driving with eyes fixed on the rear view mirror is establishing a target price based on last year’s market price. “Bull” or “bear” forecasts coming from newsletters, magazines, market advisors, radio shows… – Reality takes a long time to soak in, and when it does, it is usually too late as opportunities are long gone. 28

Behavioral Finance • Escalation: too much invested to quit. A situation where a person enters a transaction hoping for a favorable outcome but after circumstances change to unfavorable, the person finds it difficult to escape or even adds to it. • Endowment: Associated with the fear of giving up something. It is more painful to give up an asset than it is pleasurable to obtain. Ownership as a positive feeling. Producers have a tendency to store grain beyond economic justification, because when it is sold, there is no opportunity to gain anymore. For grain under storage, the perceived value increases with the duration of ownership. 29

Behavioral Finance • • 30 Which one of the following would you choose? – A. Winning a guaranteed $3, 000 – B. Taking an 80% chance of winning $4, 000 Now consider this option – A. Lose $3, 000 – B. Take an 80% chance of losing $4, 000

Behavioral Finance Results: • You are not alone if you said you would take the $3, 000 but roll the dice and risk losing the $4, 000 • As human being, we don’t deal with losses the same way we do with gains • We will ride a loss to the bitter end while cutting a gain short • Contributing to this mindset is a condition known as the Gambler’s fallacy, which is the belief that a successful outcome is due after a run of back luck. But chance – or the randomness of an efficient market – is not self-correcting. Flipping 10 consecutive heads does not increase the chance that the eleventh toss will yield a tails, any more than a trend of lower grain prices ensures an up- or downswing in tomorrow’s market. 31

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Agricultural Market Advisory Services • AGMAS – Agmas study (U of I Urbana): provide a neutral evaluation of the performance of market advisory services for corn, soybean and wheat. – Tracking about 25 -35 advisory programs per year since 1994 – Paid subscriptions obtained for each services – Recommendations recorded in “real-time” – Two important issues: . Market advisory service performance relative to appropriate benchmarks. Predictability of market advisory service from yearto-year – Result data available for the period 1995 -2003 33

Agricultural Market Advisory Services • Benchmarks: – average of two-year marketing window (24 months) : price offered by the market – USDA producer average : an “indicator” of marketing performance of farmers 34

Performance relative to Benchmark 35

Predictability from year-to-year 36

Agricultural Market Advisory Services • Limited evidence that advisory services outperform market benchmarks, particularly after taking risk into account • Substantial evidence that advisory services outperform farmer benchmarks, even after taking risk into account • Little evidence that past performance can be used to predict future performance 37

Decision Contracts Farmers continue to identify price and income risk as their greatest management challenge 38

Setting goals Upper Third Average Price Lower Third 39 Price series for CZ contract : Average Price = $2. 50 Upper Third = $ 2. 51 and above Lower Third = $ 2. 31 and below

Daily Average Corn Prices – 1998 -2005 – – 40 Based on December Corn (CZ) In the last 23 years for corn: • Marketing at harvest was high price point = 4 years (93, 95, 02, 06) • High price point was spring/summer = 7 years (84, 87, 88, 90, 94, 96, 04) • High price point was before spring = 12 years (85, 86, 89, 92, 94, 97, 98, 99, 00, 01, 03, 05)

Corn - High Low Average Historical Prices 41

Decision Contracts • Decision Commodities automated pricing models : – Index – Rally – Accelerator – Topper 42

Decision Contracts • . . . a tool that delivers execution discipline without major time requirements – Example • You want to pre-harvest market 20, 000 bushels of corn for Fall delivery, starting in January. • The Index pricing model can, for example, price an even increment of bushels every day between January and September, achieving an average price for that time period. • Assuming 100 (market) days between January and September, 200 bushels will be priced every day at the price of the underlying futures contract. • You sign a forward contract with local grain elevator (specifying Decision Contracts as pricing mechanism), and deliver grain in same manner as usual. 43

Decision Contracts Producer Cash Contract Basis Grain Elevator Ethanol Plant Forward futures price Decision Contracts provides pricing mechanism for the futures price 44

Decision Contracts – “Index” Pricing Model Index: Average Price Contract • Prices an even increment of bushels each day for a given pricing period. • Producer settings: – Pricing period beginning – Pricing Period end – Delivery Period – Bushels Example: 10, 000 bu 100 days 100 bu would be priced each day 2007 Soybeans The Index price model will result in the average price for the specified time pricing period. 45

Decision Contracts – “Rally” Pricing Model Rally: Bushels price on days during the pricing period when: 1) the day’s closing price is above the floor price and 2) the one day price change is less than the sensitivity level. Producer Settings: – – – Pricing period beginning Pricing period end Bushels price if one Price Floor day price change Up. Point less than Up. Point – Throttle Bushels to Price = Remaining Bu X Throttle Remaining Days Floor 46 If Up. Point = 0 pricing occurs when price goes down.

Rally Example 10, 000 bu = 100 X 5 (Throttle) = 500 bu 100 days 500 bu on the first day 47

Decision Contracts – “Accelerator” Pricing Model Accelerator: • The daily amount of bushels priced “accelerates” as the futures prices increase, and vice versa • Bushels price on days during the pricing period when: 1) the day’s closing price is above the floor price 2) pricing factor increases (decreases) as futures prices go up (or go down) • Producer Settings: – – Pricing period beginning Pricing period end Bushels Floor and Pivot Bu priced = (remaining bushels) X Throttle remaining days 48

Decision Contracts – “Accelerator” Pricing Model December Corn Range (CZ) Pivot Floor 49 Min Max Throttle $4. 10 > 10 Very Aggressive $4. 00 $4. 10 4 Aggressive $3. 90 $4. 00 3 Moderate $3. 80 $3. 90 1 Slow – Throttle acts as a multiplier of daily bushels priced

Decision Contracts – “Accelerator” Pricing Model December Corn 2003 Accelerator (red) = $2. 41 Bu priced = 90. 37 % Floor price (purple) = $2. 30 Daily bushels sold increase when futures prices move into upper ranges, and vice versa 50

Decision Contracts – “Topper” Pricing Model • Topper: – Bushels will price on days when grain prices close up sharply from the previous day, during the pricing period. Producer Settings: – – – Pricing period beginning Pricing period end Bushels Price Floor Trigger – Throttle 51

Rally Results – CBOT CZ 07 – Jan 01 to July 15 52

Topper Results – CBOT CZ 07 – Jan 01 to July 15 53

Rally Topper Results – CZ 08 54 • • Rally: CZ 08 – Jan 07 to July 08 Floor: $3. 50 – Throttle: 2 – Up. Point: $0. 00 $3. 89 – 42% Priced • • Topper: CZ 08 – Jan 07 to July 08 Floor: $3. 50 – Throttle: 7 – Trigger: $0. 05 $3. 96 – 40% Priced

Thank you. Decision Commodities, LLC 614 Billy Sunday Rd. , Suite 600 Ames, Iowa 50010 515. 956. 7880 www. decisioncommodities. com 55