An Introduction to Hedging Agricultural Commodities with Futures
Producers of agricultural commodities are faced with price and production risk over time and within a marketing year. Furthermore, increased global free trade and changes in domestic agricultural policy have increased the price and production risks of agricultural producers. As price and production variability increases, producers are realizing the importance of risk management as a component of their management strategies. One means of reducing these risks is through the use of the commodity futures exchange markets. Like the use of car insurance to hedge the potential costs of a car accident, agricultural producers can use the commodity futures markets to hedge the potential costs of commodity price volatility. However, like car insurance in that the gains from an insurance claim may not exceed the cost of the cumulative sum of premiums, the gains from hedging may not cover the costs of hedging. This guide was designed to introduce agricultural hedging and aid you in better evaluating hedging opportunities. This guide is intended to provide those interested in understanding hedging an introduction, and it provides those more advanced in the understanding of hedging a refresher. The primary objective of hedging is not to make money. The primary objective of hedging is to minimize price risk and this includes using hedging to minimize losses.
Commodity Arbitrage: The Operations of a Commodity Exchange
Arbitrage is the process whereby a commodity is simultaneously bought and sold in two separate markets to take advantage of a price discrepancy between the two markets. A commodity futures exchange acts as a market place for persons interested in arbitrage. The factors driving arbitrage are the differences and perception of differences of the equilibrium price determined by supply and demand at various locations. For instance, suppose there is a shortage of corn in North Carolina to feed livestock. If I believe that I can profit from buying corn in Missouri, paying shipping costs, and selling corn in North Carolina, I will continue to do so until the supply and demand for corn are equal in North Carolina, thus the Missouri corn price plus the shipping costs equal the North Carolina corn price.
For the futures market, the arbitrage activities are carried out through the exchange of paper promissary notes to sell or buy a commodity at an agreed upon price at a future date. As persons with different perceptions of where supply and demand are currently and how supply and demand will change in the future interact, commodity prices are driven to equilibrium. As new information enters the market, peoples perceptions change and the process of arbitraging begins again.
For example, lets say Bill believes the domestic fall production of corn has been under estimated in mid-summer, and Tom believes the domestic fall production of corn has been over estimated in mid-summer. Using the commodity exchange as a market place, since Bill believes corn prices will drop, Bill sells a futures contract, and Tom buys a futures contract because he believes the price is going to go higher. Assume that Bill and Tom sell and buy their contracts for the same price and they are held by each other, and in three months, Bill must buy back his contract and Tom must sell back his contract. By both individuals ending up with no obligations, this clears the market. Furthermore, the contract price is allowed to freely change in value during the three months depending on the change in supply and demand for the underlying commodity.
Now, depending on what happens to prices over the following few months, either the contract will not change in value, appreciate, or depreciate. If the value doesn't change, neither person benefits. If the value appreciates, Tom would earn a profit by selling back his contract at the new higher price and Bill would lose money by buying back his contract back at the new higher price. If the value depreciates, Tom would lose money by selling back his contract at the new lower price and Bill would profit by buying back his contract at the new lower price.
So, is arbitrage through a commodity exchange really this simple? In some ways yes, and the rules of trading allow for the buying and selling of the contract at any time. There is no minimum time you must hold a contract. However, as you might suspect from the above scenario, arbitrage through the futures is in someways a gamble like buying insurance. Sometimes it pays for itself and sometimes it doesn't. Furthermore, the scenario described above between Bill and Tom is called speculating. That is, neither party has actual ownership of a commodity, but they believe they can "out-guess" the market. Hedging, is the process whereby a person owns the commodity and uses the commodity futures markets to transfer their risk. This will be discussed in more detail later.
Where does Futures Arbitrage Occur?
There are two main locations where arbitrage occurs for agricultural commodity futures markets. Chicago is the location of both of these main futures exchanges. The Chicago Board of Trade (CBOT) is where the agricultural commodities corn, soybean, soybean oil, soybean meal, and wheat futures are traded. The Chicago Mercantile Exchange (CME) is where the agricultural commodities lean hogs, live cattle, stocker cattle, and feeder cattle are traded. In addition to these commodity markets, cotton is traded at the New York Cotton Exchange (NYCE), and rough rice is traded at the MidAmerica Commodity Exchange. Please refer to publication Agricultural Commodity Futures Contract Specifications for more details on commodity exchanges.
Buyers equal Sellers
In a market place like a the CBOT or CME, the number of buyers equal the number of sellers. However, no specific buyer and seller are obligated to each other. Therefore, a person is allowed to sell his/her contract or buy a contract at any time within the trading specifications for the exchange. As contract months change, the market enters a contract expiration month in which all persons end up with zero contracts for that trading period. That is, if you sell (buy) one contract, you must buy (sell) back one prior to contract expiration. However, the physical delivery of commodities allows for the substituting of the commodity for the contract. Physical deliveries are discussed in more detail in the publication titled Agricultural Commodity Futures Contract Specifications.
Hedging: A Transfer of Risk through Arbitrage
Price risk can occur for a number of reasons. For agricultural commodities, price risk may occur due to drought, near record production, an increase in demand, decreased international production, etc. The commodity futures markets provide a means to transfer risk between persons holding the physical commodity (hedgers) and other hedgers or persons speculating in the market. Futures exchanges exist and are successful based on the principle that hedgers may forgo some profit potential in exchange for less risk and speculators will have access to increased profit potential from assuming this risk. For example, suppose a person works on commission and receives $2,000, $8,000, $5,000, and $13,000 in salary for four consecutive months for an average salary of $7,000/month over this period. Now suppose the person could accept a salaried position for a known $6,000/month. If the person prefers less income variability, they would pay for the decreased variability and accept the, on average, $1,000/month pay cut. Alternatively, the employer would require the $1,000/month to off-set the risk he/she now assumes from the person not being motivated to sell more.
This same concept applies to hedging in which hedgers might be willing to give up some of the revenues for a known price, and speculators would require the opportunity for more revenue by assuming the price risk. For example, suppose that in late April Joe Farmer plants 500 acres of corn. At this time, Joe Farmer notices that he can forward price a portion of his corn production through the futures market at $2.80/bushel. Knowing that his cost of production is $2.45/bushel, Joe is willing to price one-third of his anticipated production at $2.80/bushel. That is, hedging by the agricultural producer generally involves selling the commodity at the commodity exchange market because producers want to lock in a price floor (a minimum price they will receive). Joe sells a futures contract for his corn, speculators or hedgers (entities such as grain elevators looking to lock in a price ceiling for the grain they are forward contracting) simultaneously are buying the contracts. Now, what can happen? The following analysis holds basis constant. See hedging example guide sheets to allow for basis to change.
If the futures price goes higher...
|Assume the fall futures and cash price of corn goes up to $3.00/bushel when Joe is ready to harvest the crop. Joe loses $0.20/bushel in the futures market, but he gains this back in the cash market through the simultaneous cash price increase with the futures price [what happens to basis, the difference between the cash and futures market, during this time will determine how much Joe makes in the cash market (see An Introduction to Basis for a discussion of basis)]. At worst, Joe receives $2.80/bushel for his hedged grain (commissions are not used for this example which would lower the price Joe receives by a small amount).|
If the futures price goes lower...
|The fall futures and cash price of corn goes down to $2.50/bushel when Joe is ready to harvest the crop. Joe gains $0.30/bushel in the futures market, but loses in the cash market through the simultaneous price decrease with the futures price [again, what happens to basis, the difference between the cash and futures market, during this time will determine how much Joe makes in the cash market). At worst, Joe receives $2.80/bushel for his hedged grain less commissions.|
If the futures price doesn't change...
|The fall futures and cash price of corn stays at $2.80/bushel when Joe is ready to harvest the crop. Joe does not gain in either the futures or cash market except for potential basis gain or loss. At worst, Joe receives $2.80/bushel for his hedged grain less commissions.|
What do all of these scenarios have in common? Joe generally knew what price he would receive for the portion of his hedged corn. Why is this important? Joe does not need to worry about a price decline that would affect revenue; therefore, Joe knows approximately how much of a revenue stream he will have for cash flow analysis. However, there may be some types of production risks that can not be covered through futures. If persons are concerned about production risks due to natural type catastrophes, persons may want to inquire about crop insurance to cover production short-falls.
Also, the basis component of hedging was not discussed. A change in basis can increase or decrease a net price decrease or increase from hedging.
When to Hedge
By knowing the enterprise cost of production, Joe can determine at what prices he might consider forward pricing portions of this crop. Thus, it is imperative that a producer knows his/her cost of production when hedging a commodity. For instance, if Calvin knows his cost of production on 400 pound feeder calves is $60/cwt., then Calvin might consider forward pricing a portion of his calf crop through the futures market when the futures market price allows for Calvin to cover his cost of production. It is important that producers determine a target profit margin, because people have a tendency to always want to price at the market high. Some words of advice, it is nice to say you received $5/cwt. more on your calf crop then your neighbor, but it is even better to say you retired a farmer by making wise choices instead of risky choices.
What are the Costs of Hedging?
The costs of hedging are straightforward; however, these expenses can become substantial over time. Commissions are paid to a broker for administrative costs, futures exchange operation, and futures exchange regulation. These costs can range from $9 to $35 or more per order. An order is either a buy or sell order. Therefore, to enter and exit the market the total costs can range from $18 to $70 or more.
Margin money is only paid on futures positions and not options positions. Margin money refers to earnest money placed in a brokerage account to cover potential losses. The initial margin is needed to start trading. Typically, a futures position will require the initial cost of between 3% to10% of the actual cost of the contract being traded (e.g., a 5,000 bushel corn contract may require an initial margin of $750/contract). The exact percentage is determined by the commodity broker. The maintenance margin is used to step up the initial margin account. For instance, suppose the maintenance margin on the corn contract is $500/contract. Therefore, whenever the initial margin account drops to $500 because of "paper" losses in the futures market the account must be added to so that the balance in the account returns to the brokerage set minimums. There is no maximum number of times a margin call can occur.
For more Information contact:
|Joe Parcell||Vern Pierce|
|Extension Economist||Beef Economist, Commercial Agriculture Program|
|223E Mumford Hall||223D Mumford Hall|
|University of Missouri||University of Missouri|
|Columbia, MO 65211||Columbia, MO 65211|
|Ph. (573) 882-0870||Ph. (573) 882-8229|
|Fax: (573) 884-6572||Fax: (573) 884-6572|
Accompanying Publications in Risk Management Series: