Day 2 (Notice Day) Prior to open of trade, the clearinghouse matches the seller with the oldest long position and notifies both parties.

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1 Delivery Process and Convergence of Cash and Futures Prices 1-to-3% of all agricultural futures contracts are delivered upon. ex) Delivery process on CBT cleared contracts (i.e., grains) Day 1 (Position Day) Delivery is the seller s option. Seller notifies broker of intent to deliver. Broker notifies clearinghouse. Day 2 (Notice Day) Prior to open of trade, the clearinghouse matches the seller with the oldest long position and notifies both parties. Day 3 (Delivery Day) Buyer s clearinghouse member sends certified check to seller s clearinghouse member. Seller s clearinghouse member sends warehouse receipt to buyer s clearing house member. AREC 412 Lec E Basis & Basis Risk 1

2 ex) Live Cattle at the CME Seller: issues Certificate of Delivery (location) Can reclaim after retender Buyer: issues Demand Notice (location) Retender certificate if location not favorable ($1.50/cwt. cost). No certificate can be retendered more than twice. ex) Feeder Cattle, Lean Hogs, and Dairy Products at the CME No deliveries cash settlement On the final day of trading, all positions are offset at the Index (Weighted Average Price). Most financial futures use cash settlement. AREC 412 Lec E Basis & Basis Risk 2

3 Basis Convergence in the Delivery Month Arbitrage between cash and futures markets forces the convergence of prices to a predictable difference. ex) AUG17 Live Cattle contract deliverable on 8/7/2017 first business day following the first Friday of the delivery month. Suppose if the following: Case 1: futures > cash futures cash $115.00/cwt. $110.00/cwt. Producer: sell futures, deliver. Order Buyer: sell futures, buy cash cattle, deliver to self. Cost of making delivery: transportation to delivery point, grading, yardage, and meat discounts. About $ /cwt. AREC 412 Lec E Basis & Basis Risk 3

4 Case 2: if futures < cash cash $122.50/cwt. futures $115.00/cwt. Meatpacker: buy futures, and wait for delivery. Order Buyer: buy futures, wait for delivery, and sell cash cattle. Cost of accepting delivery: transportation from delivery point, risk of market price change, delivered animal quality same as needed? About $ /cwt. (The actual cash fed cattle trades late in the week so we need to look forward through the week to the Friday prices.) AREC 412 Lec E Basis & Basis Risk 4

5 Arbitrage of cash and futures markets will force cash price - futures price delivery costs in the delivery month. ex) AUG17 Live Cattle on 8/10 futures: $ /cwt. cash steers: NE $115.49/cwt. KS $115.03/cwt. TX-OK $115.03/cwt. Was there an incentive to deliver? What actions to take? ex) SEP17 Feeder Cattle on 9/8 futures: $ /cwt. cash index: $148.24/cwt. Is there an incentive to trade? Long or short the futures? And then the risk that comes with waiting for expiration at the end of the month AREC 412 Lec E Basis & Basis Risk 5

6 BASIS Definition: Basis = Cash Price Futures Price. Basis Terminology: July basis = current cash JUL futures Over cash > futures or basis (+) Under cash < futures or basis ( ) Strong or Narrow larger than normal Weak or Wide smaller than normal Estimates of basis are needed for making hedging decisions, Forward Price = Futures Price + Expected Basis. (How did we form expectations? What objective tools? We used an econometric model, a trend model, a simple average or some other means incorporating experience.) AREC 412 Lec E Basis & Basis Risk 6

7 Interpreting basis tables... (Using the CO and TX Gulf Historical tables.) SEP August (0.34) September (0.31) October (0.71) On average, the difference between the cash price for wheat at the TX Gulf Coast and the SEP futures contract price in calendar month of August is +45. Two-thirds of the time the difference is between +11 and +79. Calendar month of September? Predictability of basis in August and September versus October? How much data should be used to calculate the statistics? It depends on the commodity but research says, 3 years minimum 4-8 years tends to be best 12 years may contain data that is too old. The historical tables are being careful with data around the dramatic increase and then volatility in oil prices and transportation costs, the financial crisis, and the global recession. We will look at this in Problem Set 1. AREC 412 Lec E Basis & Basis Risk 7

8 Colorado Data Example... Futures Prices Year Mo Cash MAR MAY JUL SEP DEC AREC 412 Lec E Basis & Basis Risk 8

9 We see basis is variable. How does this variability affect hedging? ex) Wheat producer short hedge Imperfect Conservative Hedge There is basis error. Example of weak basis. Date Cash Futures Basis 10/1 Forward Price = Futures + Basis JUL $5.50/bu. Sell expected 7/1 Sell cash JUL $4.00/bu. Buy actual Gain/Loss = AREC 412 Lec E Basis & Basis Risk 9

10 ex) Wheat producer short hedge Imperfect Conservative Hedge There is basis error. Example of weak basis. Date Cash Futures Basis 10/1 Forward Price = Futures + Basis $5.04 = (-0.46) JUL $5.50/bu. Sell expected 7/1 Sell cash $3.34/bu. JUL $4.00/bu. Buy Gain/Loss = +$1.50/bu actual Net Price = = $4.84/bu. < Forward Price AREC 412 Lec E Basis & Basis Risk 10

11 Imperfect Hedge (continued) There is basis error. Example of strong basis. Date Cash Futures Basis 10/1 Forward Price = Futures + Basis $5.04 = (-0.46) JUL $5.50/bu. Sell expected 7/1 Sell cash $7.34/bu. JUL $7.50/bu. Buy Gain/Loss = -$2.00/bu actual Net Price = = $5.34/bu. > Forward Price (A good study technique is to work the falling price example with strong basis instead of weak basis and work the rising price example with weak basis instead of strong basis.) AREC 412 Lec E Basis & Basis Risk 11

12 ex) Feeder cattle long hedge Date Cash Futures Basis 1/15 FP = F + B $155 = Buy APR $145/cwt expected 4/1 Buy $ Sell APR $130/cwt actual 4/1 Buy $ Sell APR $130/cwt actual AREC 412 Lec E Basis & Basis Risk 12

13 ex) Feeder cattle long hedge Date Cash Futures Basis 1/15 FP = F + B $155 = Buy APR $145/cwt expected 4/1 Buy $130/cwt. Sell APR $130/cwt actual NP = ($130) - $15 = ($145)/cwt. Or -$10 basis error. 4/1 Buy $145.cwt. Sell APR $130/cwt actual NP = ($145) - $15 = ($160)/cwt. Or +$5 basis error. AREC 412 Lec E Basis & Basis Risk 13

14 Basis Outcomes Weak Basis: NP < FP (bad outcome for short good for long) Strong Basis: NP > FP (good outcome for short bad for long) Hedger trades price risk for basis risk. If basis risk is smaller, then hedging is risk reducing. AREC 412 Lec E Basis & Basis Risk 14

15 Hedging and Basis Hedging involves using a futures market transaction as a temporary substitute for a cash market transaction. Choosing a futures contract month for hedging. 1. Use a contract that will not expire prior to marketing the physical commodity. (Stay out of the delivery month first week is okay.) 2. Use a contract (and thus a basis level) which gives a favorable forward price. However, recognize the potential for basis error. Recognize the tradeoff between hedging coverage and basis error. Be reasonable. How do you know what calendar month to choose on the basis table? Choose the calendar month when you make the cash transaction. AREC 412 Lec E Basis & Basis Risk 15

16 ex) forward prices for CO cash wheat in July KC wheat futures 9/15/2017 Futures + Basis = Forward Price Risk? DEC MAR18 MAY JUL SEP DEC... JUL You should be able to: 1) use futures prices and basis to construct a cash market price, and 2) choose a futures contract that results in a best forward price. AREC 412 Lec E Basis & Basis Risk 16

17 ex) forward prices for CO cash wheat in July KC wheat futures 9/16/2016 Futures + Basis = Forward Price Risk? DEC MAR18 MAY JUL SEP DEC... JUL DEC, MAR, and MAY will expire before July. SEP18 might offer a forward price higher than JUL18 but has higher basis risk. (?) DEC offers... You should be able to: 1) use futures prices and basis to construct a cash market price, and 2) choose a futures contract that results in a best forward price. AREC 412 Lec E Basis & Basis Risk 17

18 Hedging works because losses in one market are offset by gains in the other market and because basis is predictable but not perfectly... Realizing the forward price is important because the forward price was chosen by the hedger. This price can be incorporated into farm and agribusiness planning and budgeting. Basis error is one factor which prevents the net price from equaling the forward price. Through forward pricing, the hedger trades price risk for basis risk. Basis risk is usually much smaller than price risk. AREC 412 Lec E Basis & Basis Risk 18

19 Illustrating price risk versus basis risk. f r e q u e n c y price received AREC 412 Lec E Basis & Basis Risk 19

20 Illustrating price risk versus basis risk. f r e q u e n c y price received AREC 412 Lec E Basis & Basis Risk 20

21 Research shows: 1) Basis risk/variability is less than price risk/variability. ex) grains +4 less livestock 2 less 2) Average net price from a routine and conservative hedging strategy is less than the average cash market price. Sometimes it is a lot less. ex) grains 5-15 /bu. feeder cattle $1.25/cwt. fed cattle $1.00/cwt. hogs $0.75/cwt. Why? Futures market commissions. Interest on margin calls. Nature of agricultural prices price distributions are skewed. Risk premium hedgers generally lose money over time. AREC 412 Lec E Basis & Basis Risk 21

22 More Recent & Examples for Study Basis Contract Quote Basis Contract & Hedge Assume $5.00/bu. Use basis of as historical with 0.40 for risk. (This is a reasonable recent price ) Flat Price Contract Quote $4.10/bu. What s the implied basis? (-0.90.) Is the quote a good deal? If not, then at what price does it become a good deal? Work each of these 3 examples alternative contracts using a price decrease, a price increase, and steady price examples. Compare results to a hedge with weak and strong basis outcomes. And compare results to using the cash market. AREC 412 Lec E Basis & Basis Risk 22

23 ex) Wheat producer: 1) cash, 2) flat price contract, 3) futures hedge, 4) basis contract, and 5) hedge & basis contract Falling prices Date Cash Futures Basis 10/1 Forward Price = Futures + Basis $4.50 = (-0.50) JUL $5.00/bu. Sell expected 7/1 Sell cash $3.25/bu. JUL $4.00/bu. Buy Gain/Loss = +$1.00/bu actual Net Price = = $4.25/bu. AREC 412 Lec E Basis & Basis Risk 23

24 (You do the same work with ) Rising prices Date Cash Futures Basis 10/1 Forward Price = Futures + Basis $4.50 = (-0.50) JUL $5.00/bu. Sell expected 7/1 Sell cash $6.20/bu. JUL $6.50/bu. Buy Gain/Loss = -$1.50/bu actual Net Price = = $4.70/bu. AREC 412 Lec E Basis & Basis Risk 24

25 Marketing Method Price Scenario Cash Flat Price Contract Futures Hedge Basis Contract Hedge & Basis K Falling Rising Steady AREC 412 Lec E Basis & Basis Risk 25

26 Marketing Method ($/bu.) Price Scenario Cash Flat Price Contract Futures Hedge Basis Contract Hedge & Basis K Falling $3.25 $4.10 $4.25 $3.35 $4.35 Rising $6.20 $4.10 $4.70 $5.85 $4.35 Steady $4.50 $4.10 $4.50 $4.35 $4.35 There are two kinds of market price risk: 1) the overall market price risk (call it price risk )and 2) the local market relative to the overall market price risk (call it basis risk ). Cash: manages neither. Flat Price Contract: manages both at same time but the contract writer gets paid for 1) & 2). Futures Hedge: manages 1). Basis Contract: manages 2). Hedge & Basis Contract: manages both at separate times and contract writer gets paid for 2). AREC 412 Lec E Basis & Basis Risk 26