The Role of Basis in Your Hedging Strategy

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1 The Role of Basis in Your Hedging Strategy Brian W. Gould Wisconsin Center for Dairy Research and Department of Agricultural and Applied Economics Remember that for those whose price risk is in down markets (e.g., a dairy farm operator with respect to BFP or a cheese plant owner with respect to cheese price), they would want to sell futures to hedge. Alternatively, for those whose price risk is in up markets (e.g., cheese plant owner with respect to the BFP) would want to buy futures to hedge. To be a successful hedger you take equal and opposite stances in the cash and futures markets. Because of these opposite stances, the losses (gains) experienced in one market is offset by the gains (losses) in the other market. For example, if you are a dairy farm operator, you are long in the cash market as you are producing milk that you would like to sell. To hedge your milk production, you need to go short (sell contracts) in the futures market to cover this production. Even if you successfully hedge your net hedged price may vary from what you initially estimated. This is due to the way milk is priced in the U.S. dairy industry. That is, your mailbox price is based not only on the BFP but also on the utilization of the milk in your area between the various milk classes, premiums due to low somatic cell counts, protein premiums, and other competitive factors. The importance of these factors in determining the outcome of your short hedge is that they can impact your mailbox/bfp basis. If these impacts are unexpected than the net results from your initial estimates may be unknown. Below is an example to illustrate this point. Calculation of Mailbox/BFP Relationship As an example, assume we have a dairy farm operator in the Upper Midwest region who in May desires to protect the mailbox price for his August milk by selling August BFP futures. Since the futures contract is concerned with BFP and the farmer receives a mailbox price which differs from the BFP, the producer needs to estimate his average August mailbox/bfp basis which provides a link between his price and the BFP. For August, the average basis can be calculated via the following:

2 Aug. Basis = Aug. Mailbox - Aug. BFP. The following table shows the August BFP and Upper Midwest Mailbox price over the period. The resulting basis is also shown. Table 1. Calculation of Expected August Basis in the Upper Midwest Region ($/cwt) Date Mailbox BFP Basis Aug $11.73 $11.57 $0.16 Aug $15.73 $14.97 $0.76 Aug $12.64 $12.07 $0.57 Aug $15.31 $14.99 $0.32 Average $13.85 $13.40 $0.45 From Table 1 the producer sees that over the last 4 years, his mailbox price has averaged $0.45/cwt more than the announced BFP. Thus, by undertaking a hedge using an August futures, the farm operator can add $0.45 to the contract price to provide an estimate of his hedged mailbox price. (It should be noted that we are not accounting for futures commissions and the interest costs associated with maintaining margin accounts in this example). From Table 1, we also see that the August BFP has ranged from a high of $0.76 in 1996 to $0.16 in Thus there is some variation in the relationship between the producer s mailbox price and BFP. This variation is often referred to as basis risk. This basis risk is usually much smaller than the risk of the underlying cash price without hedging. Appendix Tables A.1-A.4 provides the average mailbox prices for each of the Federal Orders over the period which can be used estimate your average mailbox/bfp basis Steps to Undertaking a Successful Hedge: A BFP Example With the above basis estimate, the producer can now decide whether to enter into a short hedge for all or part of his August milk production. It should be remembered that the objective of undertaking a futures market hedge is not to maximize profits but to minimize risk or variation in your net returns. By undertaking a hedging, you are essentially locking in the price of your milk

3 for as long as the hedge is in effect or until contract maturity. Since you are locking in this price the producer must ensure that he is locking in a price that generates an acceptable return. If not, the producer needs to consider the tradeoffs between risk protection and possibility of higher (or lower) prices. If at the time of considering whether to undertake a hedge, the current settle price for August BFP generates an acceptable rate of return, the producer will enter into a hedge if he is more concerned about possible lower prices than higher prices. The following steps need to be undertaken to undertake the hedge:! Open a futures account! Project current hedged price for August by using your estimate of the August mailbox/bfp basis. In this case the producer uses the $0.45/cwt average. If the current settle price for August BFP futures contract is $12.35 than the producer s current estimate of his August mailbox will be: $ $0.45 = $12.80.! Sell August BFP futures at $12.35! Either offset the August BFP futures contract by entering a buy order prior to the cash settled date for the August BFP announcement on the Sept.5 th or let the contract expire and have it cash settle automatically against the announced BFP. The net price received by the operator will not be known until his announced mailbox is determined. If the demand for milk is strong, the hedge may reflect a wider mailbox/bfp basis which implies that the actual net hedge price will be greater than initial estimates. If the demand is weak, the basis may weaken or be smaller than the initial $0.45 estimate which implies a smaller net price than original estimates. Alternatively, if there are dramatic changes in milk utilization patterns, the basis relationship will be impacted. The above example has involved a short hedger. Long (buy) hedgers estimate their net price in a similar manner as above but also need to factor in a price differential for the intended usage of the milk in the estimated basis. In general, even with basis risk and the costs associated with undertaking the hedge, the overall hedged price projection is more defined than the open market price risk assumed by the producer if he does not hedge.

4 Hedging and Basis Illustrations Again, remember that basis is calculated as the difference between the cash price and the futures price in the month of the cash sale/purchase. To continue with our farm operator example, we assume that an operator located in the upper Midwest wants to hedge his August s milk production. We present the following three scenarios and show the impacts of changing basis. Scenario I! Hedge at $12.75! Estimated basis: $0.45! moves down after initiating the basis! At offset, actual basis equals estimated basis Date Action Cash Basis May Sell Aug. Expected August Hedge = $13.20 $12.75 $0.45 (Est.) Sept. Let Expire $ Sell Cash $ $0.45 (Actual.) Net Hedged Cash Gain Net Net Hedged $12.20 $1.00 $13.20 In this example, the Net Hedged received after the futures contract expires on Sept. 5 th equals the expected price forecast at the time of initiation of the hedge due to the fact that the actual basis equals the estimated basis of $0.45. It should be remembered that the BFP futures price cash settles at the announced BFP, that is, equals the cash price, if the contract is allowed to expire. Note also that with the selling of the futures contract in May at $12.75 and then purchasing back at $11.75, the $1.00 futures gain can be applied to the reduction in cash price observed over the May-September period to generate the $13.20 Net Hedged.

5 Scenario II! Hedge at $12.75! Estimated basis: $0.45! moves down after initiating the basis! At offset, actual basis is less than estimated basis Date Action Cash Basis May Sell Aug. Expected August Hedge = $13.20 $12.75 $0.45 (Est.) Sept. Let Expire $ Sell Cash $ $0.15 (Actual.) Net Hedged Cash Gain Net Net Hedged $11.90 $1.00 $12.90 In this example, the Net Hedged received after the futures contract expires on Sept. 5 th is less than the expected price forecast at the time of initiation of the hedge due to the actual basis being less than the estimated basis of $0.45 determined at hedge initiation. Note that with the selling of the futures contract in May at $12.75 and then purchasing back at $11.75, the $1.00 futures gain can be applied to the reduction in cash price observed over the May-September period to generate the $12.90 Net Hedged.

6 Scenario III! Hedge at $12.75! Estimated basis: $0.45! moves up after initiating the basis! At offset, actual basis is less than estimated basis Date Action Cash Basis May Sell Aug. Expected August Hedge = $13.20 $12.75 $0.45 (Est.) Sept. Let Expire $ Sell Cash $ $0.15 (Actual.) Net Hedged Cash Loss Net Net Hedged $ $0.85 $12.90 Under this scenario, the Net Hedged received after the futures contract expires on Sept. 5 th is less than the expected price forecast at the time of hedge initiation due to the actual basis being less than the estimated basis of $0.45. Note that with the selling of the futures contract in May at $12.75 and then purchasing back at $13.60, the $0.85 futures loss is applied to the reduction in cash price observed over the May-September period to generate the $12.90 Net Hedged. This points again to the principle of hedging: you give up the opportunity for potential positive gains while exclude the possibility of experiencing losses. If the producer had a perfect BFP forecast, the producer would have been better off than the $12.90 net hedging result. However, without having such perfect foresight, the producer must be willing to accept the implied risk/return tradeoff.

7 Scenario IV! Hedge at $12.75! Estimated basis: $0.45! moves up after initiating the basis! At offset, actual basis is greater than estimated basis Date Action Cash Basis May Sell Aug. Expected August Hedge = $13.20 $12.75 $0.45 (Est.) Sept. Let Expire $ Sell Cash $ $0.85 (Actual.) Net Hedged Cash Loss Net Net Hedged $ $0.85 $13.60 Under this scenario, the Net Hedged received after the futures contract expires on Sept. 5 th is greater than the expected price forecast at the time of hedge initiation due to the actual basis being greater than the estimated basis of $0.45 by $0.40. Note that with the selling of the futures contract in May at $12.75 and then purchasing back at $13.60, the $0.85 futures loss is applied to the reduction in cash price observed over the May-September period to generate the $13.60 Net Hedged. This points again to the principle of hedging: you give up the opportunity for potential positive gains while exclude the possibility of experiencing losses. If the producer had a perfect BFP forecast, the producer would have been better off than the $13.60 net hedging result. However, without having such perfect foresight, the producer must be willing to accept the implied risk/return tradeoff.

8 BFP Hedge Worksheet To project a hedged price for you milk, the basis is added to the current futures price for the particular cash month. The following table can be used as a template to assist you in projecting your hedged price. Month +/- Basis = Projected Hedge March 99 April 99 May 99 June 99 July 99 August 99 Sept. 99 Oct. 99 Nov. 99 Dec. 99 Jan. 00 Feb. 00

9 Monthly Mailbox s by Federal Milk Order, 1995 and BFP Source: Dairy Market News, various issues 1995 Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. New England New York-New Jersey Middle Atlantic Carolina Tennessee Valley Southeast Flordia Southern Michigan Eastern Ohio-Western Pa Ohio Valley Indiana Chicago Regional S. Illinois-E. Missouri Louis. - Lex.-Evans Upper Midwest Nebraska-Western Iowa Iowa Texas Southwest Plains Eastern Colorado S.W. Idaho - E. Oregon Great Basin New Mexico - West Texas Pacific Northwest BFP

10 Monthly Mailbox s by Federal Milk Order, 1996 and BFP Source: Dairy Market News, various issues 1996 Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. New England New York-New Jersey Middle Atlantic Carolina Tennessee Valley Southeast Flordia Southern Michigan Eastern Ohio-Western Pa Ohio Valley Indiana Chicago Regional S. Illinois-E. Missouri Louis. - Lex.-Evans Upper Midwest Nebraska-Western Iowa Iowa Texas Southwest Plains Eastern Colorado S.W. Idaho - E. Oregon Great Basin New Mexico - West Texas Pacific Northwest BFP

11 Monthly Mailbox s by Federal Milk Order, 1997 and BFP Source: Dairy Market News, various issues 1997 Jan. Feb. Mar. Apr. May June Jul. Aug. Sep. Oct. Nov. Dec. New England New York-New Jersey Middle Atlantic Carolina Tennessee Valley NA NA NA Southeast Florida Southern Michigan E. Ohio/Western Penn Ohio Valley Indiana Chicago Regional S. Illinois-E. Missouri Louis.-Lex.-Evans Upper Midwest Nebraska-Western Iowa Iowa Texas Southwest Plains Eastern Colorado S.W. Idaho-E. Oregon Great Basin New Mexico/West Texas Pacific Northwest BFP

12 Monthly Mailbox s by Federal Milk Order, 1998 and BFP Source: Dairy Market News, various issues 1998 Jan. Feb. Mar. Apr. May June July Aug Sep. Oct. Nov. Dec. New England New York-New Jersey Middle Atlantic Carolina Tennessee Valley NA NA NA NA NA NA NA NA NA NA NA NA Southeast Florida Southern Michigan E. Ohio/Western Penn Ohio Valley Indiana Chicago Regional S. Illinois-E. Missouri Louis.-Lex.-Evans Upper Midwest Nebraska-Western Iowa Iowa Texas Southwest Plains Eastern Colorado S.W. Idaho-E. Oregon Great Basin New Mexico/West Texas Pacific Northwest BFP