This guide details the placing of an input (long) hedge in the futures market for use in reducing the price risk associated with buying an input used in your business. For example, a swine producer knows he/she will be buying a pen of feeder-pigs two months from now. To feed the pen of weaner pigs, the producer will need 5,000 bushels of corn (one full contract at the Chicago Board of Trade) during the next four months to use in the production of feed. Corn is an input into the production of swine. Currently, the local cash corn price is at $2.35/bushel, and the producer believes that the corn price may rise during the next few months exposing him to the risk of higher prices. The producers calculates his cost of production and knows that the $2.35/bushel will allow for profit potential. What can the producer do? The producer can purchase the grain now; however, he/she will have to pay storage on the grain for the next few months, increasing the price above $2.40/bushel. Alternatively, the producer could enter the futures market and off-set any potential loss in value (increase in price) with a gain in the futures market.

How do I Place a Hedge?

Placing a hedge can be a simple process. First, knowing your cost of production helps you know when to place a hedge. To place a hedge, you need to contact a broker with whom you place your order. Most large communities have a broker who will take your order for a set fee (as is common when placing any futures/options market order). The broker can be helpful in informing you on how to appropriately place and exit your hedging position. The broker has a stake, i.e., commission, in making sure your experience with hedging is a good one. After you have placed the order with the broker, the broker will contact a brokerage house at the commodity exchange and relay the order. On the trading floor of the trading commission open out-cry is used in matching market supply and demand forces. If you want to place a long hedge, there will likely be either someone wanting to place a short hedge or a speculator willing to off-set your risk. The speculator is using a process known as arbitrage which is discussed in more detail in accompanying risk management guides in this series.

What Can Happen With the Long Futures Hedge?

Any of seven scenarios can arise between the cash and futures price. The only scenario not discussed below is that of the cash and futures prices not changing while the hedge is placed. In this scenario, the producer purchases the input for the same price as when the hedge was placed. The costs of hedging would then simply be commissions. The other scenarios are discussed below. Because the cash and futures markets typically trend in the same direction over time the scenario of the cash and futures moving in opposite directions is not discussed. One final note, even though a loss may be shown from taking a futures position, the final price must be compared to purchasing the grain in advance and paying storage costs.

A. Cash and Futures Price both Increase

1. Cash Price Increases Faster than the Futures Price (Basis Strengthens)

Table 1 is used to describe the actions you might take as a hedger and the outcomes of those actions in placing an input hedge in which the cash price increases by more than the futures price during the hedging period. In this scenario basis is said to strengthen. Following from table 1, suppose today you could purchase corn for $2.35/bushel and the relevant futures contract is trading for $2.50/bushel (basis is $0.15 under). Knowing that you will need the corn at a later date and you want to protect against a price increase, you take a long position in the futures market at this time. Over the next few months the local cash price increases to $2.60/bushel and the futures price increases to $2.65/bushel. At this time you decide you need to purchase corn for the production of feed. You purchase the corn in the cash market for $2.60/bushel and sell back your futures position for $2.65/bushel. Therefore, the cost of the grain to you is $2.60/bushel less $0.15/bushel gained from the futures position plus any commission costs (a typical commission might be $25 for entry into the futures and $25 for exit, $50/round-turn or @ $0.01/bushel). Instead of paying $2.60/bushel you pay $2.46/bushel. The net price you receive is exactly equal to the original cash price plus the basis gain or loss plus commission.

2. Futures Price Increases Faster than the Cash Price (Basis Weakens)

Table 2 is used to describe the actions you might take as a hedger and the outcomes of those actions in placing an input hedge in which the futures price increases by more than the cash price during the hedging period. In this scenario basis is said to weaken. Following from table 2, suppose today you could purchase corn for $2.35/bushel and the relevant futures contract is trading for $2.50/bushel (basis is $0.15 under). Knowing that you will need the corn at a later date and you want to protect against a price increase, you take a long position in the futures market at this time. Over next few months the local cash price increases to $2.45/bushel and the futures contract price increases to $2.65/bushel. At this time you decide you need to purchase corn for the production of feed. You purchase the corn in the cash market for $2.45/bushel and sell back your futures position for $2.65/bushel. Therefore, the cost of the grain to you is $2.45/bushel less $0.15/bushel gained from the futures position plus any commission (assume $.01/bushel). Instead of paying $2.45/bushel you pay $2.31/bushel. Again, the net price you receive is exactly equal to the original cash price plus the basis gain or loss plus commissions.

3. Futures Price Increases at the same rate as the Cash Price (no change in basis)

Under this scenario the price you pay is exactly equal to the price you would have paid earlier with the exception of commissions ($0.01/bushel). Following with the first two examples, there is no basis change in this example and the net price is simply equal to the original cash price plus commissions

1. Cash Price Decreases Faster than the Futures Price (Basis Weakens)

Table 3 is used to describe the actions you might take as a hedger and the outcomes of those actions in placing an input hedge in which the cash price decreases by more than the futures price during the hedging period. In this scenario basis is said to weaken. Following from table 3, suppose today you could purchase corn for $2.35/bushel and the relevant futures contract is trading for $2.50/bushel (basis is $0.15 under). Knowing that you will need the corn at a later date and you want to protect against a price increase, you take a long position in the futures market at this time. Over the next few months the local cash price decreases to $2.20/bushel and the futures contract price decreases to $2.40/bushel. At this time you decide you need to purchase corn for the production of feed. You purchase the corn in the cash market for $2.20/bushel and sell back your futures position for $2.40/bushel. Therefore, the cost of the grain to you is $2.20/bushel plus $0.10/bushel lost from the futures position plus commission costs ($0.01/bushel). Instead of paying $2.20/bushel you pay $2.31/bushel.

2. Futures Price Decreases Faster than the Cash Price (Basis Strengthens)

Table 4 is used to describe the actions you might take as a hedger and the outcomes of those actions in placing an input hedge in which the futures price decreases by more than the cash price during the hedging period. In this scenario basis is said to strengthen. Following from table 4, suppose today you could purchase corn for $2.35/bushel and the relevant futures contract is trading for $2.50/bushel (basis is $0.15 under). Knowing that you will need the corn at a later date and you want to protect against a price increase, you take a long position in the futures market at this time. Over next few months the local cash price decreases to $2.20/bushel and the futures contract price decreases to $2.25/bushel. At this time you decide you need to purchase corn for the production of feed. You purchase the corn in the cash market for $2.20/bushel and sell back your futures position for $2.25/bushel. Therefore, the cost of the grain to you is $2.20/bushel plus $0.25/bushel lost from the futures position plus any commission costs (assume $0.01/bushel). Instead of paying $2.20/bushel you pay $2.46/bushel because basis strengthened.

3. Futures Price Decreases at the same rate as the Cash Price

Under this scenario the price you pay is exactly equal to the price you would have paid earlier with the exception of commissions ($0.01/bushel). The next price you receive is equal to the original cash price plus the commission since there was no change in the basis.

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