Answer each of the following questions by circling True or False (2 points each).

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1 Name: Econ 337 Agricultural Marketing, Spring 2019 Exam I; March 28, 2019 Answer each of the following questions by circling True or False (2 points each). 1. True False Some risk transfer premium is appropriate in basis contracting between feeders and packers because packers assume basis risk from feeders. 2. True False A call is in-the-money when the market price of the underlying commodity futures contract is above the strike price. 3. True False A futures trader s margin account is only settled when the account is offset or closed. 4. True False Shrink must be considered when selling livestock on a carcass weight basis. 5. True False The futures market is a zero sum game ; gains = losses before commissions are paid. 6. True False Finding a market for lower end cuts (e.g., flank, skirt, top blade, ground, etc.) can be a challenge when direct marketing meat. 7. True False Speculators have no use for the physical commodity and are attempting to profit from price movements. 8. True False Hedgers are willing to make or take physical delivery because they are producers or users of the commodity. 9. True False Livestock price seasonality refers to multi-year trends in prices that result from patterns in inventory changes while livestock price cycles refer to price trends within a year. 10. True False Pork packers use USDA quality grades to determine the value of the hogs they buy. 11. True False Demand refers to a schedule of quantities consumers would purchase over a range of prices. 12. True False In technical analysis, or charting, a resistance level is a price level where the market seems to hit and bounce up. 13. True False An option fence can be executed by buying a put option and selling a call option. 1

2 Multiple Choice: Circle the appropriate response for each statement or question (2 points each). 14. The profit maximizing weight to produce is a. the point where the input price equals marginal cost. b. the point where the cost of the last unit (e.g., pound) produced is equal to its price. c. the point where average variable cost equals marginal cost. d. as long as the input price is less than the price of the output. 15. Buying a put option will always be a second best choice because a. a futures hedge pays better if prices fall b. the cash market pays better if prices rise c. buying a put option pays better at both low and high prices d. both a and b 16. If you sell a call option and receive $0.30/bushel for the premium, what is the most you can lose? a. $0.30/bushel b. $0.30/bushel plus commission c. Your losses are unlimited. d. The amount in your initial margin account. 17. The difference between futures contracts and other contract arrangements is that futures contracts a. are standardized, negotiable, and traded on an organized exchange like the CME. b. are offered at any local grain elevator. c. are available only for lean hogs. d. none of these. 18. A hog packer could buy a put option to a. protect against a basis change b. protect against higher hog prices c. protect against lower hog prices d. A hog packer would be more likely to buy a call option. 2

3 19. Basis a. will determine the outcome of the hedge position when a futures position is liquidated. b. is the difference between a futures contract price and the local cash price for the commodity. c. being less volatile and more predictable than cash prices is an underlying assumption in any recommendation to hedge. d. all of the above. e. none of the above. 20. The amount of the basis a. is most critical as the contract approaches maturity or the futures position is liquidated. b. is affected by local conditions, such as packer demand and local supply. c. is the same for all producers. d. a and c e. a and b 21. The characteristic of a futures market and cash market price relationship that makes hedging feasible is a. their tendency to converge as the contract approaches maturity. b. basis is always constant throughout the life of the contract. c. losses in the cash market are offset by losses in the futures market. d. all of the above. 22. A difference in using options for price protection compared with hedging or cash contracting is a. an option position establishes a minimum selling price or maximum purchase price, but leaves the buyer in a position to benefit from favorable price changes. b. hedging and cash contracting set an approximate selling price, regardless of later price changes. c. there is no cost in using options unlike hedging or cash contracting. d. a and b. e. b and c. 3

4 23. Some of the major advantages of centralized pricing (e.g., auction markets) are: a. full and immediate information, competitive bidding, transaction costs b. full and immediate information, competitive bidding, equalization of market power c. competitive bidding, equalization in market power, physical movement of product d. full and immediate information, transaction costs, physical movement of product 24. What is an advantage to decentralized pricing (e.g., direct sales)? a. More skills and information needed b. No assembly function c. Higher search costs d. None of these e. All of these 25. What kind of estimates are included in USDA s quarterly Hogs and Pigs Reports? a. Hog inventories broken down by breeding stock and market hogs, and with market hogs reported by weight groupings. b. Sows farrowing, pigs per litter, and pig crop by quarters for prior months. c. Estimates of sow farrowing intentions for the next six-month period. d. All of the above. Short answer: Provide a complete answer to 4 out of the following 7 questions. Questions 26, 27, 28, 29, 30, 31, 32. If you answer more than 4 questions, you will only be graded on the first (5 points) Match each cattle pricing method with the appropriate statement. Cattle pricing methods may be used more than once. a. Live weight pricing b. Carcass weight pricing c. Value-based pricing (grid) c Each animal is priced individually. a Pricing location is at the feedlot and adjusted for shrink. b Meat yield is based on the carcass weight. c Potential for large discounts. a Buyer pays the transportation costs. 4

5 27. (5 points) Feeders and packers can lock in a basis with a basis contract. This assures the transaction price will move in lock-step with futures prices. Describe 2 advantages for feeders and 2 advantages for packers of basis contracts. Also, describe 1 disadvantage for feeders, packers, or the industry of basis contracts. Advantages for feeders: Locks in a buyer. Reduces any further costs of marketing. Locks in a basis or cash-futures price difference. Can concentrate on futures prices to identify a price to lock in. Attractive if prices are expected to increase. May receive favorable financing terms. Advantages for packers: Securing cattle in advance of slaughter needs. Attractive if anticipate needing cattle during times of reduced supplies. Locks in a basis or cash-futures price difference. Known quality of cattle can reduce further procurement costs. Disadvantages: Both feeders and packers are still vulnerable to price level changes. Hedging with futures or option would need to be used to eliminate price level risk. Basis contracts are typically for a specific set of cattle quality specifications. If actual cattle quality is lower than the contract specifications, cattle feeders can be penalized. Do not move the industry toward value-based pricing, in and of themselves. If all cattle are sold at the same price, no consideration is given to within-pen quality differences. Poorer cattle receive a higher price than they deserve and better cattle are unnecessarily discounted. 28. (5 points) List 5 factors that influence an options premium and explain clearly how a decrease in each of the factors (before expiration) affects the premium of a put option. 1. Underlying futures price [futures price decreases, option premium for a put increases) 2. Strike price [strike price decreases, option premium for a put decreases) 3. Time to expiration [time to expiration decreases, option premium for a put decreases) 4. Volatility [volatility decreases, option premium for a put decreases) 5. Interest rate [interest rate decreases, option premium for a put increases) 5

6 29. (5 points) List 8 steps in developing a marketing plan. What is the biggest reason for failure to repeatedly use a marketing plan? 1. Describe your current operation 2. Specify goals 3. Know your costs of production and break-even 4. Utilize sound market information 5. Set target prices 6. Evaluate pricing alternatives and actions 7. Execute when target prices are hit 8. Review and evaluate results Biggest reason for failure to repeatedly use a marketing plan is that performance is compared to what might have been, i.e., typically the highest price alternative which is probably an unrealistic goal. 30. (5 points) What are 3 responsibilities of a producer in a production contract poultry arrangement? Give 2 reasons producers are attracted to this type of arrangement? Producer responsibilities: Operate like independent contractors Facilities land, builds, and maintains houses, equipment, etc. Operating costs utilities, supplies, labor Monitoring and controlling health Biosecurity who gets in Record keeping Manure management Attractive to producer because: No market (price) risk Steady income Access to manure 6

7 31. (5 points) Cattle cycles occur in large part because of the biological nature of production. Explain why cattle prices often rise in the short-run and decrease in the long-run during the expansion phase. Also, in addition to biology and time lags of animal production, explain 1 other reason why cattle cycles exist. During expansion: Holding of more heifers for breeding purposes leads to fewer weaned calves sold. This leads to short-term decreases in marketings as expansion begins, and prices usually rise. Over time, the larger breeding herd leads to more calves being sold and prices decrease in long-run. Why cattle cycles exist: Production levels change in response to profitability Producers tend to be small and unable to individually affect the market 32. (5 points) Identify and provide a brief description of 2 alternative marketing arrangements to the cash (negotiated) market for hogs and discuss 2 factors that have driven the increased use of alternative marketing arrangements. Alternative Marketing Arrangements: NEGOTIATED FORMULA - Swine or pork market formula determined by negotiation on a lot-by-lot basis and scheduled for delivery not later than 14 days after the date on which the formula is negotiated and swine are committed. OTHER MARKET FORMULA Pricing mechanism is a formula price based on one or more futures or options contracts. SWINE OR PORK MARKET FORMULA Pricing mechanism is a formula price based on a market for swine, pork, or a pork product, other than a future or option for swine, pork, or a pork product. OTHER PURCHASE AGREEMENT Not a negotiated purchase, swine or pork market formula purchase, negotiated formula purchase, or other market formula purchase; and does not involve packer-owned swine. Includes window or ledger contracts and cost of production contracts. Increased use of AMAs have been driven by: Large risk of profit margins. Price can be connected to quality and yield information sending a stronger price signal through the supply chain than buying on the average. Improved efficiencies through planning supply movements that translates into reduced costs for both the feeder and the packer. Economics drive packer and feeder decisions to use one marketing arrangement over another. 7

8 Calculations and Short Answer: Provide a complete answer to each of the following questions. 33. (5 points) Calculate a seasonal index price projection for June 2019 cull sows, given a February 2019 price of $31.86 per cwt. Seasonal Price Index -- Cull Sows, National, Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual Average Price % of Annual Price (Index) P Feb19 I Jun I Feb = P Jun19 = $ = $33.55/cwt 34. (10 points) You are a hedger that went short on August 2019 lean hogs on March 1, 2019 at $ per cwt. The initial margin requirement is $1,200. The maintenance margin is $1,200. Fill out your margin account for one futures contract. Date Futures Price Gain/Loss Margin Call Account Balance 3/1/2019 $ X X $1, /4/2019 $ $80.00 ($0.200 * 400) X or leave blank $1, /5/2019 $ $ (-$0.925 * 400) $290 $1, /6/2019 $ $ ($0.325 * 400) X or leave blank $1, /7/2019 $ $50.00 (-$0.125 * 400) X or leave blank $1, /8/2019 $ $ (-$1.850 * 400) $660 $1,

9 35. (8 points) A packer buyer is looking at a pen of cattle that they believe will grade 90% Choice, 10% Prime, 0% Select, and 100% CAB. They also think there are 25% yield grade 4, 10% yield grade 1 or 2, and 10% will have carcasses that are over 1,050 pounds. They have the following information (all in $/cwt of carcass weight). Base: Choice Yield Grade 3 = $205 Yield Grade 4 = -$10.00 Prime = $10.00 Yield Grade 1 & 2 = $4.00 Select = -$9.00 Carcasses > 1,050 pounds = -$25.00 CAB = $4.50 The farmer wants a flat in-the-meat bid. How much should the packer buyer bid for the cattle? Show your work. % Premium/ Discount Price Calculation Base Price = $ Prime 10% X $10.00 = $1.00 Choice 90% X $0.00 = $0.00 Select 0% X -$9.00 = $0.00 CAB 100% X $4.50 = $4.50 Yield 4 25% X -$10.00 = -$2.50 Yield 1& 2 10% X $4.00 = $0.40 Carcasses >1,050 10% X -$25.00 = -$2.50 Sum = $ The packer buyer should not bid any more than $205.90/cwt for the cattle because the packer stands the grading risk. 9

10 36. (7 points) For the following question use a Dec lean hog futures price of $80.00 per cwt. Assume historical expected basis of -$1.00 per cwt and a commission of $0.15 per cwt. A producer does a short hedge on Dec lean hog futures. What is the hedgers expected price with the short hedge in place? If the Dec lean hog futures price rises to $90.00 per cwt, what is the hedger s net price? Show the math and draw and label the graph on the next page. Expected Price Net Price = Futures Price + Basis Commission = $80.00 $1.00 $0.15 = $78.85 = Cash + Futures Return = (Futures + Basis) + (Old Futures Futures Commission) = ($90.00 $1.00) + ($80.00 $90.00 $0.15) = $89.00 $10.15 = $

11 Return/Net Price Cash $100 $95 $90 $85 $80 Net $75 $10 $5 $0 -$5 -$10 $0 $5 $10 $75 $80 $85 $90 $95 $100 $105 $110 $115 Futures Price Hedge 11