© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 5 Fundamentals of Futures Hedging

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Chapter 5Chapter 5

Fundamentals of Fundamentals of Futures HedgingFutures Hedging


Futures Contracts IntroductionFutures Contracts Introduction

Futures contracts have long been the standard for Futures contracts have long been the standard for price risk management.price risk management.

In a simple contract, two people decide to trade In a simple contract, two people decide to trade something. One agrees to sell and one to buy at a something. One agrees to sell and one to buy at a specific price and time.specific price and time.

Futures contracts are simple contracts.Futures contracts are simple contracts. With the understanding of a few terms and concepts, With the understanding of a few terms and concepts,

anyone can hedge or speculate with futures contracts.anyone can hedge or speculate with futures contracts.


Futures ContractsFutures Contracts

A futures contract is nothing more than a forward A futures contract is nothing more than a forward contract traded on an organized exchange.contract traded on an organized exchange.

It is open to all buyers and sellers.It is open to all buyers and sellers. It is an agreement between the buyer to accept It is an agreement between the buyer to accept

delivery of a product from the seller with delivery of a product from the seller with standardizedstandardized terms. terms.

The buyer and seller are immediately able to retrade The buyer and seller are immediately able to retrade the contract after the contract is completed.the contract after the contract is completed.


Standardization and LeverageStandardization and Leverage

Figure 5-1 shows the major agricultural commodities Figure 5-1 shows the major agricultural commodities and the specifications on each contract.and the specifications on each contract.

Standardization gives futures contracts the ability to Standardization gives futures contracts the ability to be retraded easily.be retraded easily.

The market is also very The market is also very liquidliquid allowing buyers and allowing buyers and sellers easy entry and exit of the market.sellers easy entry and exit of the market.

(continued)(continued)


Standardization and LeverageStandardization and Leverage(continued)(continued)

LeverageLeverage– The full value of a contract generally does not have to be The full value of a contract generally does not have to be

advanced to get control of the contract.advanced to get control of the contract.

– Only a portion of the value has to be posted to gain control; Only a portion of the value has to be posted to gain control; this portion is called the this portion is called the marginmargin..

– The margin is normally roughly 10 percent of the contract The margin is normally roughly 10 percent of the contract value and is set by each exchange.value and is set by each exchange.


Margin CallsMargin Calls If the contract’s value changes, the buyer is responsible If the contract’s value changes, the buyer is responsible

for the additional losses—known as the margin call.for the additional losses—known as the margin call. The margin will have a prespecified value called the The margin will have a prespecified value called the

maintenance marginmaintenance margin. This value is approximately 75 . This value is approximately 75 percent of the value of the initial margin.percent of the value of the initial margin.

The difference between the maintenance margin and The difference between the maintenance margin and margin level is the amount of money that is allowed to margin level is the amount of money that is allowed to be lost before additional money is requested.be lost before additional money is requested.

The trader can also gain paper profits as shown in The trader can also gain paper profits as shown in Table 5-2.Table 5-2.


Concept of CounterbalanceConcept of Counterbalance

Hedging is the process of counterbalance—one action Hedging is the process of counterbalance—one action is offset by another.is offset by another.

Hedging is an attempt to overcome some aspect of risk Hedging is an attempt to overcome some aspect of risk with another action; therefore the two actions must be with another action; therefore the two actions must be opposite.opposite.

Hedging entails having opposite cash and futures Hedging entails having opposite cash and futures positions.positions.

The hope is that the losses exactly cover the gains.The hope is that the losses exactly cover the gains. Table 5-3 shows the effect of counterbalance in a Table 5-3 shows the effect of counterbalance in a

hedge.hedge.


An initial sell position is called a An initial sell position is called a short hedgeshort hedge—used —used to protect against declining spot (cash) market values.to protect against declining spot (cash) market values.

An initial buy position in the futures market is An initial buy position in the futures market is known as a known as a long hedgelong hedge—used to protect against —used to protect against increasing spot (cash) market values.increasing spot (cash) market values.

The example in Table 5-3 is a perfect short hedge. The example in Table 5-3 is a perfect short hedge. This type of hedge is widely used in agriculture.This type of hedge is widely used in agriculture.

Table 5-4 shows a long hedge used by a food Table 5-4 shows a long hedge used by a food company.company.


Two Types of HedgesTwo Types of Hedges


Two Types of Hedges Two Types of Hedges (continued)(continued)

Short hedges are also known as bear hedges or sell Short hedges are also known as bear hedges or sell hedges.hedges.

Long hedges are also known as bull hedges or buy Long hedges are also known as bull hedges or buy hedges.hedges.


Absolute Price MovementsAbsolute Price Movements

When the price of an item changes in the cash market, When the price of an item changes in the cash market, the price activity is called an absolute price the price activity is called an absolute price movement.movement.

Figure 5-2 demonstrates the movements for the corn Figure 5-2 demonstrates the movements for the corn market.market.

These movements are the source of price risk that These movements are the source of price risk that producers face.producers face.



Absolute Price MovementsAbsolute Price Movements (continued)(continued)

Historical price information can be used to calculate Historical price information can be used to calculate certain statistical values to help analyze the risk of the certain statistical values to help analyze the risk of the movements.movements.

Futures contracts have their own absolute price Futures contracts have their own absolute price movements.movements.

Figure 5-3 exhibits futures price movements for corn.Figure 5-3 exhibits futures price movements for corn.


Relative Price MovementsRelative Price Movements

Due to the need for counterbalance, cash and futures Due to the need for counterbalance, cash and futures absolute price movements exist side by side.absolute price movements exist side by side.

The importance in hedging is how the two prices The importance in hedging is how the two prices relate to each other.relate to each other.

Figure 5-4 shows relative price movements between Figure 5-4 shows relative price movements between cash and futures corn prices.cash and futures corn prices.

The risk of relative price movements is known as The risk of relative price movements is known as basis riskbasis risk..

Hedging removes the risk of absolute price movements Hedging removes the risk of absolute price movements and replaces it with basis risk.and replaces it with basis risk.


BasisBasis

Basis values exist for every cash market.Basis values exist for every cash market. Basis is the most important aspect of hedging to Basis is the most important aspect of hedging to

understand.understand. Basis is defined as the difference between the futures Basis is defined as the difference between the futures

price and the cash price.price and the cash price. Markets that have futures prices that are higher than Markets that have futures prices that are higher than

cash prices are in cash prices are in contangocontango—positive basis.—positive basis. Markets that have the cash or spot price higher than Markets that have the cash or spot price higher than

futures prices are in futures prices are in backwardationbackwardation—negative basis.—negative basis.


Perfect HedgesPerfect Hedges

A perfect hedge eliminates the cash market risk and A perfect hedge eliminates the cash market risk and has no basis risk effects.has no basis risk effects.

Tables 5-5 and 5-6 reveal the effects of a perfect Tables 5-5 and 5-6 reveal the effects of a perfect hedge with a cash price decrease and increase hedge with a cash price decrease and increase respectively.respectively.

If the If the beginning basisbeginning basis remains the same as the remains the same as the ending basisending basis, then it was a perfect hedge., then it was a perfect hedge.

Hedgers really want imperfect hedges; in the Hedgers really want imperfect hedges; in the examples given, the hedger would have been just as examples given, the hedger would have been just as well off without hedging.well off without hedging.


Imperfect HedgesImperfect Hedges

Imperfect hedges have a beginning basis and an Imperfect hedges have a beginning basis and an ending basis that are different.ending basis that are different.

Table 5-7 shows a basis change that results in a net Table 5-7 shows a basis change that results in a net gain for the hedger.gain for the hedger.

Price direction is unimportant, only relative Price direction is unimportant, only relative movements between the cash and futures markets—movements between the cash and futures markets—basis—matters.basis—matters.


Imperfect Hedges Imperfect Hedges (continued)(continued)

Table 5-8 shows a basis that has deteriorated, Table 5-8 shows a basis that has deteriorated, resulting in a net loss for the hedger.resulting in a net loss for the hedger.

Table 5-9 shows the results of a feed company in a Table 5-9 shows the results of a feed company in a long hedge with an improving basis on their hedge.long hedge with an improving basis on their hedge.

Short hedgers want the basis to narrow, and long Short hedgers want the basis to narrow, and long hedgers want the basis to widen.hedgers want the basis to widen.


Net Hedged PricesNet Hedged Prices

The net hedged selling price (NHSP) is equal to the final The net hedged selling price (NHSP) is equal to the final cash selling price (FCSP) plus the net futures gain/loss cash selling price (FCSP) plus the net futures gain/loss (NF).(NF).

The NHSP for Figure 5-8 would be $1.98 per bushel.The NHSP for Figure 5-8 would be $1.98 per bushel. The net hedged buying price (NHBP) is equal to the final The net hedged buying price (NHBP) is equal to the final

cash buying price (FCBP) less the net futures gain/loss cash buying price (FCBP) less the net futures gain/loss (NF).(NF).

Using this formula in Table 5-9 results in a NHBP of Using this formula in Table 5-9 results in a NHBP of $1.98 per bushel.$1.98 per bushel.


Futures in the Grain Market and Futures in the Grain Market and Basis FactorsBasis Factors

Traders in grain range from a wheat farm hedger to Traders in grain range from a wheat farm hedger to complex trading giants like Cargill.complex trading giants like Cargill.

Higher value uses for these major crops necessitate a Higher value uses for these major crops necessitate a higher understanding of price risk management.higher understanding of price risk management.

A factor that influences basis is the seasonality of A factor that influences basis is the seasonality of crops. crops.

Seasonal movements create changes in prices and Seasonal movements create changes in prices and thus changes in basis.thus changes in basis.


Cost of Carry ModelCost of Carry Model

The cost of carry is the term used to reflect not only The cost of carry is the term used to reflect not only the physical cost of storage but financial costs as the physical cost of storage but financial costs as well.well.

The model is given as the price in next time period The model is given as the price in next time period equals the price in time period equals the price in time period tt plus the cost of carry plus the cost of carry from from tt to the next time period to the next time period tt+1.+1.

See Figure 5-6.See Figure 5-6.


Basis COC, COT, and Basis COC, COT, and Grain Basis ModelGrain Basis Model

Basis and the Cost of Carry.Basis and the Cost of Carry. Basis and the Cost of Transportation.Basis and the Cost of Transportation. See Figure 5-7.See Figure 5-7. The basis for grain crops and oilseed is the basis at The basis for grain crops and oilseed is the basis at

time time tt is equal to the futures price at time is equal to the futures price at time t+nt+n less the less the cash price at time cash price at time tt..

Estimates of basis value are very important to Estimates of basis value are very important to hedgers.hedgers.


Production HedgeProduction Hedge

Production hedges need futures positions that are Production hedges need futures positions that are short initially so that a price decrease will yield a gain short initially so that a price decrease will yield a gain in the futures position.in the futures position.

Regardless of the product or time, production price Regardless of the product or time, production price risk will always be short hedges.risk will always be short hedges.

Wheat producer example, Table 5-10.Wheat producer example, Table 5-10.– This example has the farmer under-hedged by 2,000 This example has the farmer under-hedged by 2,000

bushels.bushels. If there had been a price increase, then the farmer If there had been a price increase, then the farmer

would have gained in the cash market and had a loss would have gained in the cash market and had a loss in the futures market, as shown in Table 5-11.in the futures market, as shown in Table 5-11.


The Decision to Over- or Under-HedgeThe Decision to Over- or Under-Hedge

A hedger should under-hedge if he believes there is a A hedger should under-hedge if he believes there is a strong probability of cash prices moving in his favor strong probability of cash prices moving in his favor rather than against him. He should over-hedge if the rather than against him. He should over-hedge if the chance that cash prices will move against him is chance that cash prices will move against him is greater than the chance that prices will move in his greater than the chance that prices will move in his favor.favor.


Storage HedgeStorage Hedge

Grain and oilseed crops can be stored for long periods Grain and oilseed crops can be stored for long periods of time and often are being stored by grain elevators.of time and often are being stored by grain elevators.

Grain elevators run the risk of declining prices after Grain elevators run the risk of declining prices after purchase of the grain or seed.purchase of the grain or seed.

Storage hedges are short hedges.Storage hedges are short hedges. Table 5-12 summarizes a grain merchant using a Table 5-12 summarizes a grain merchant using a

storage hedge.storage hedge.


Forward Pricing HedgingForward Pricing Hedging

Grain merchants, food processors, and feed Grain merchants, food processors, and feed processors have the opportunity to forward price processors have the opportunity to forward price grain and oilseeds.grain and oilseeds.

This type of processor must be a long hedger.This type of processor must be a long hedger. Table 5-13 illustrates the hedge by a cereal Table 5-13 illustrates the hedge by a cereal

manufacturer.manufacturer.


Basis Traders and Basis ContractsBasis Traders and Basis Contracts

Once a hedge is properly placed, all that really Once a hedge is properly placed, all that really matters is the movement in basis.matters is the movement in basis.

Grain traders will make offers at “under” or “off,” Grain traders will make offers at “under” or “off,” meaning the cash price is below the futures price. If meaning the cash price is below the futures price. If they offer “on” or “over,” then they are offering they offer “on” or “over,” then they are offering above the futures price.above the futures price.

Table 5-14 illustrates a basis trade with a grain Table 5-14 illustrates a basis trade with a grain merchant.merchant.



Basis Traders and Basis Contracts Basis Traders and Basis Contracts (continued)(continued)

A basis contract must haveA basis contract must have– the futures contract.the futures contract.

– a negotiated differential for the cash commodity relative to a negotiated differential for the cash commodity relative to the futures price.the futures price.

– an ending point.an ending point.

– knowledge of when the title passes and how storage costs knowledge of when the title passes and how storage costs are handled.are handled.


Call ContractsCall Contracts

A call provision added to a basis contract specifies A call provision added to a basis contract specifies that the contract holder must call the broker of the that the contract holder must call the broker of the contract provider to stipulate the day the basis contract provider to stipulate the day the basis contract will be exercised. Call contracts allow contract will be exercised. Call contracts allow certain hedgers to fix both sides of a trade.certain hedgers to fix both sides of a trade.

An example of this is illustrated in Tables 5-15 and An example of this is illustrated in Tables 5-15 and 5-16.5-16.

In a seller’s call, the call responsibility lies with the In a seller’s call, the call responsibility lies with the producer.producer.

In a buyer’s call, the call responsibility lies with the In a buyer’s call, the call responsibility lies with the processor.processor.


Crush HedgesCrush Hedges

Soybeans go through a crush process that separates Soybeans go through a crush process that separates the raw beans into meal and oil.the raw beans into meal and oil.

Crush yields are reported on a regular basis. The Crush yields are reported on a regular basis. The difference between the value of the meal and oil and difference between the value of the meal and oil and the price of the soybeans is called the crush margin.the price of the soybeans is called the crush margin.

A processor will enter into a type of hedge called A processor will enter into a type of hedge called putting on crushputting on crush when the crush margin is greater when the crush margin is greater than the cost of crushing.than the cost of crushing.

The The reverse crushreverse crush hedge is used when the margin is hedge is used when the margin is less than the cost.less than the cost.

See Tables 5-17 and 5-18.See Tables 5-17 and 5-18.


Using Futures in the Using Futures in the Livestock IndustryLivestock Industry

Livestock has a rich history in the futures industry.Livestock has a rich history in the futures industry. Live animals cannot be stored for more than a few Live animals cannot be stored for more than a few

days before the growth and aging process changes days before the growth and aging process changes their form.their form.

Live animal futures have a basis that does not follow Live animal futures have a basis that does not follow the cost of carry model for price differences. the cost of carry model for price differences.

Expectations of future supply and demand are the Expectations of future supply and demand are the basis components of live animal futures.basis components of live animal futures.

Traders resort to empirical data to get trends and Traders resort to empirical data to get trends and patterns. See Figure 5-8.patterns. See Figure 5-8.


Production HedgesProduction Hedges

Live animals go through a growing process that Live animals go through a growing process that subjects them to the risk of price decline.subjects them to the risk of price decline.

Only slaughter-ready animals can be hedged in the Only slaughter-ready animals can be hedged in the hog market. Feeder and live animals can be hedged in hog market. Feeder and live animals can be hedged in the cattle market.the cattle market.

See Table 5-19, Hog Production HedgeSee Table 5-19, Hog Production Hedge See Table 5-20, Cow-Calf HedgeSee Table 5-20, Cow-Calf Hedge

– Cross hedge: a hedge whereby the cash and futures Cross hedge: a hedge whereby the cash and futures specifications do not match exactlyspecifications do not match exactly



Production Hedges Production Hedges (continued)(continued)

See Table 5-21, Feedlot HedgeSee Table 5-21, Feedlot Hedge– Total hedging: the process of a manufacturer that hedges all Total hedging: the process of a manufacturer that hedges all

available outputs and inputsavailable outputs and inputs See Table 5-22, Dairy Processor HedgeSee Table 5-22, Dairy Processor Hedge

– Margin-based hedging: fixing the profit margin in advance Margin-based hedging: fixing the profit margin in advance by hedgingby hedging


Using Nonagricultural Futures in Using Nonagricultural Futures in AgricultureAgriculture

Agribusinesses use large amounts of credit and Agribusinesses use large amounts of credit and therefore have credit risks pertaining to changes in therefore have credit risks pertaining to changes in interest rates.interest rates.

Also agribusinesses that deal overseas have foreign Also agribusinesses that deal overseas have foreign exchange risks.exchange risks.

Interest Rate RiskInterest Rate Risk– Several contracts exist on interest rates (see Figure 5-9).Several contracts exist on interest rates (see Figure 5-9).

These contracts can be used to mitigate certain risks These contracts can be used to mitigate certain risks with interest rates via cross hedging.with interest rates via cross hedging.– See Table 5-23.See Table 5-23.



Using Nonagricultural Futures in Using Nonagricultural Futures in Agriculture Agriculture (continued)(continued)

Foreign Currency RiskForeign Currency Risk– The dollar changes value in relation to other currencies on The dollar changes value in relation to other currencies on

a continuous basis.a continuous basis.

– The exchange rates reflect the price of one unit of currency The exchange rates reflect the price of one unit of currency necessary to buy one unit of another currency.necessary to buy one unit of another currency.

Table 5-24 presents an example of a U.S. cotton Table 5-24 presents an example of a U.S. cotton merchant dealing with a Mexican mill.merchant dealing with a Mexican mill.

If the dealer forward sells cotton for delivery in two If the dealer forward sells cotton for delivery in two weeks, he covers his risk.weeks, he covers his risk.

Proper hedging can counterbalance the currency risk.Proper hedging can counterbalance the currency risk.


Synopsis Synopsis

Futures contracts allow agricultural businesses and Futures contracts allow agricultural businesses and producers to manage the risk of price change.producers to manage the risk of price change.

Contracts are simple to use to protect against Contracts are simple to use to protect against increasing or decreasing prices.increasing or decreasing prices.

The down side is that if the price moves in favor of the The down side is that if the price moves in favor of the hedger, then the hedge will take the gain away.hedger, then the hedge will take the gain away.

To compensate, futures hedgers use basis trades and To compensate, futures hedgers use basis trades and speculate on when is the best time to place a hedge, speculate on when is the best time to place a hedge, called called selective hedgingselective hedging..

It is critical to understand the fundamentals of future It is critical to understand the fundamentals of future hedging as it is 90 percent of all price risk management.hedging as it is 90 percent of all price risk management.

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© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 5 Fundamentals of Futures Hedging