Fundamentals of Futures Contracts and Hedging. Overview of discussion. Fundamentals of the hedge 10/6/2016

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1 Fundamentals of Futures Contracts and Hedging Scott Clawson NE Area Ag Economics Specialist Overview of discussion Fundamentals of the hedge Who are the players in a hedge? Basics of the hedge What is basis? What are the functions of the margin account? Review of available materials Fundamentals of the hedge Hedging is a method of managing price risk For this discussion we are wanting to protect against declining cattle prices In short, we are taking opposite positions in the cash and futures market to lock in a price in the future Can be very beneficial for both parties: lender and producer 1

2 Basic hedge example Cash Market Futures Market February August BUY 60 head of 500 lb. steers. SELL 60 head of 815 lb. $127/cwt. SELL 1 Feeder Cattle $140/cwt. BUY 1 Feeder Cattle $130/cwt. Cattle sold for $127/cwt. Producer had a gain of $10/cwt on the futures contract Cattle marketed locally by producer via method of their choice. In this situation, there was a price decline, the hedge protected the producers final hedge price. Why is it $137, why 60 head, why August? Net proceeds: $127 (cash mkt) + $10 (futures) = $137/cwt. Why 60 head? The exchange for trading feeder cattle contracts is the CME Group (Chicago Mercantile Exchange) It is traded on 50,000 lb contracts Estimated Finish Weight 815 lb/hd Number of Head 60 Total Pounds 48,900 In the field, we will never end up hitting our target on this number. Variations in ADG, death loss, etc will never be pinpoint. It s generally better to have more cattle than contracts Are there more contract specs? In the past, physical delivery of the cattle was an option. Today, they are settled strictly financially using the CME Feeder Cattle index as a benchmark Open contracts at the end of the contract time period are settle using the index. What is the index? Weighted average of cash prices over a 12 state area lbs. Medium Large frame score Muscle score of a #1-2 Steers CO, IA, KS, MO, MT, NE, NM, ND, OK, SD, TX, WY 2

3 Why August? Not all months are available for feeder cattle contracts January March April May August September October November So, which do we select if we are planning to market in a month that there is no formal contract? We want to select the contract that is the closest to our planned marketing date. If that falls in a month with no contract, then we would select the contract that expires after, not before our marketing date. Why $137/cwt.? In our initial example, our contract was sold at $140/cwt. So why was our net price received only $137/cwt.? Basis is the difference between the cash and futures price Basis = Cash Price - Futures Price $127/cwt. - $130/cwt. = -$3/cwt More on basis Several factors can impact our basis on a load of cattle Location Cattle quality Sex Weight Any cash market discounts Basis will also vary with the markets from year to year. 3

4 More on basis How do we predict basis? Many producers that hedge cattle on a consistent basis will have a general idea We can also look historically as to what it has been. The Livestock Marketing Information Center (LMIC) helps calculate basis across the country. Contact your local OSU County Extension Office to gather some basis history for Oklahoma Basis history in OK Basis Risk? Data Source: AMS LS214 and CME and Data Compiled by LMIC Detailed hedge example Cash Market Futures Market Basis Feb. BUY 60 head of 500 lb. steers. Expected sales price of $136/cwt. SELL 1 Feeder Cattle $140/cwt. Expected $4 Aug. SELL 60 head of 815 lb. $125/cwt. BUY 1 Feeder Cattle $130/cwt. Actual $5 Cattle sold for $125/cwt. Producer had a gain of $10/cwt on the futures contract. Cattle marketed locally by producer via method of their choice. In this situation, there was a price decline, the hedge protected the producers final hedge price. What about a price increase? Net proceeds: $125 (cash mkt) + $10 (futures) = $135/cwt. 4

5 Price increase example Cash Market Futures Market Basis Feb. BUY 60 head of 500 lb. steers. Expected sales price of $136/cwt. SELL 1 Feeder Cattle $140/cwt. Expected $4 Aug. SELL 60 head of 815 lb. $155/cwt. BUY 1 Feeder Cattle $160/cwt. Actual $5 Cattle sold for $155/cwt. Producer had a loss of $20/cwt on the futures contract. Cattle marketed locally by producer via method of their choice. Net proceeds: $155 (cash mkt) + ( $20) (futures) = $135/cwt. Margin account One of the significant barriers to using hedging is the concern around the margin account. Similar to other types of accounting, futures contracts mark to market everyday. The margin account is the vehicle to funding those changes in value. Margin account details The fees to enter into a futures position are relatively small. Yet, that is not the only money that moves in the process. 1. Margin Deposit A good faith deposit made by you with the brokerage house and deposited with the futures exchange. It is held to insure against losses on the futures contract. 2. Margin Call A notice that additional margin money is required to keep equity in your futures or options position. Margin calls may result from loss in the futures or options position or from increased exchange requirements resulting from a higher price level or unusual market volatility. Definitions from: KSU Definitions of Marketing Terms 5

6 Margin account details This assumes we are in a traditional (short) hedge to protect against falling calf prices. Cattle Prices Climbing The live cattle are increasing in value. The futures contract is losing value, to settle or mark the contract to market, a margin call would be made when the balance of the margin account is below the required level. The live cattle are decreasing in value. The futures contract is gaining value. This means that the balance in the margin account is increasing, offsetting the value of the cattle in the field. What is the impact on our collateral position if financed? Cattle Prices Falling Finding information Then select Agriculture Wrap up Utilizing a hedge is a foundation for price risk management Easy to migrate to speculating Understanding the pricing and movement of cash helps with the understanding of margin accounts Basis risk vs. Market risk Other resources linked at the homepage 6

7 Thank you! Scott Clawson NE Area Ag Econ Specialist