Hedging Hogs by the Farm Manager Introduction Hog prices can vary significantly from year to year and even day to day. With this volatility in the hog market, forward pricing opportunities arise worthy of locking in. This article deals with the specific topic of using the futures market to hedge with the goal of locking in a hog price in advance of delivery. The hedge being done is to lock in the price (preferably a profitable one) regardless of whether the market goes up or down from that point. More information on other ways of forward contracting hogs is available in the module Hog Market Contracting. The Futures Contract A futures contract is a legal and binding agreement to deliver or accept delivery of a specific commodity on or before a specific date in the future. The only North American futures market for hogs trades on the Chicago Mercantile Exchange (CME). CME Lean Hog futures quotes are available at: http://www.cmegroup.com/trading/agricultural/livestock/lean-hogs.html CME Lean Hog Contract Specifications Trading Unit: 40,000 lb. carcass basis hogs Description: Hogs (barrows and gilt) carcasses Daily Price Limit: US$ 3.00/cwt above or below previous day's settlement price; none for expiring contract in last 2 trading days Contract Months: Feb, Apr, May, Jun, Jul, Aug, Oct, Dec Last Day of Trading: the 10th business day of the futures month, 12:00 p.m. Delivery Days: Cash settled to CME LEAN HOG INDEX (weighted average of three area packers). The holder of a futures market sell position may deliver to a participating slaughter plant at this index. An open futures position, either a sell or buy position, is cash settled against the CME LEAN HOG INDEX as of the day of expiry of a month of the lean hog futures contract.
Calculating the Price The lean hog futures contract is based on carcass weight and is priced in US dollars per pound. To convert to a Canadian hog price, some adjustments must be made. First, there are differences in what remains with the carcass of a US hog compared to the carcass of a Canadian hog. The average dressing percentage of a US hog is 74 per cent, (i.e.the average carcass weighs 74 per cent of the live animal weight), while the average dressing percentage in Canada is 80 per cent. An adjustment is therefore made to account for the differences in the average dressing percentage between the US and Canada. To convert from a US dressed price to a Canadian dressed price, first multiply the US price by 0.925. This factor is derived from the respective dressing percentages of 74% divided by 80%. Second, a currency conversion must be done. There can be differences between the spot currency exchange and a forward currency exchange. The exchange rate you need depends on the month of hog futures used. For example, if you are using the December lean hog futures, use the December Canadian dollar futures for the exchange conversion. If the lean hog and currency futures months do not match, use the next exchange rate futures month after the lean hog futures month being converted. Finally, US hogs are priced in pounds and Canadian hogs are priced in kilograms so a weight conversion must also be completed. Multiply by 2.205 to convert from pounds to kilograms. Below is an example of converting a US hog futures price to a Canadian hog price, given the following factors: December US lean hog futures at 87 cents per pound December Canadian dollar futures at 9389 cents US 2.205 pounds = one kilogram Applying the formula: Getting the Hedge in Place To hedge by directly using the futures market, an account with a commodity futures brokerage firm is required. A hog producer would enter into (or open) a sell futures position by using the lean hog futures contract nearest (or immediately after) the date the hogs are expected to be ready for sale. In a true hedge, once the hogs are actually priced on the cash market (usually at the time of delivery), the futures hedge is exited by buying the same number of futures contracts for the same futures month as originally specified in the sell position. If, on a sell hedge, the 2
futures market is lower at the time of exiting (or lifting) the hedge than when the hedge was entered, the futures trade result will be positive. If the basis (described in more detail below) between the US and Canadian hog market at the time of exiting the hedge was at the level estimated when the hedge position was entered, then the profit on exiting the futures trade would offset the lower cash hog selling price. See Using Hedging to Protect Farm Product Prices for more details on the hedging process. Changes in the currency exchange rate affects the Canadian hog price. Therefore, producers may also consider locking the Canadian dollar against the US. The risk is that the value of the Canadian dollar rises against the US dollar, so protection would be taken to offset that possibility. This can be done in several ways: by contracting the exchange rate through a bank, by hedging using a buy position on the Canadian dollar futures market by using the exchange options market by buying a Canadian dollar call. See How Exchange Rates Affect Agricultural Markets for more information on exchange rates. Hedging Factors to Consider Hedging, using the futures market, does not eliminate all price risk, since there is still basis risk. Basis is the difference between the cash price and a futures price. On a futures hedge, the final price received by the producer will be lower if the basis is weaker (or wider). In other words, the difference between the cash and the futures price increases from when the basis was estimated when the futures hedge was opened. Also, using a futures hedge does not address market access issues, since it does not involve the packer. Figure 1 shows the seasonality and range of basis for Alberta hogs. 3
Producers using hedges must be aware of the possibility for a margin call if the futures price moves against a hedge position. A margin call is a requirement to send funds to the broker to cover possible losses in hedge trades. In the case of a short (sell) hog futures hedge, if the futures price rises above the price when the sell order was filled, a margin call could result. However, it is also important to remember that when hog futures prices are rising, the Canadian cash hog market is also likely to be rising. So in a hedge, a margin call from a hedge is not lost money. A hedge is done to lock in the price (preferably a profitable one) regardless of whether the market goes up or down from that point. A Hog Futures Hedge Example 1, below, shows a hog futures hedge. The first and most important step in any marketing plan is to know one s costs of production. With that information, a breakeven price can be calculated. Any price above that breakeven point implies a profit on that hog sale. In Example 1, the cost of the futures trade or brokerage commission was omitted. For a 40,000 pound (18,140 kg) futures contract, approximate total commission would be $125. A cost could also be assigned to the margin money that was tied up while the hedge was in place. If the cost of borrowing was six per cent and a C$1200 margin was needed to secure the hedge position for the six-month period, the interest on that margin would have cost $24 (assuming a 4% interest rate). Some brokerage firms do offer interest on margin money while it is used to secure a trade position. 4
Example 1. Slaughter Hogs Hedge Futures Basis Live Cash Hog Price Date Hedge Placed June 7 th Futures Month: December Sell (Dec) Lean Hog Futures @ US$ 0.82/lb = Expected Basis: C$ 0.30/kg under the futures price Expected Cash Price: $1.69 - $.30 = $1.39/kg. Date Hedge Exited or Lifted December 5 Buy (Dec) Lean Hog Futures @ US$ 0.87 /lb = Actual Basis: C$ 0.30/kg under the futures price Hogs sold December 5 Actual Cash Price: C$ 1.58/kg Futures Gain or Loss: Futures Gain or Loss = Futures Sell Price Futures Buy Price C$1.69/kg C$1.88/kg = C$-0.19/kg LOSS Less: - Broker s Fee = $0.00 - Interest on Margin = $0.00 Profit or Loss on Futures Hedge = C$ 0.19/kg loss = C$ - 0.19/kg 5
Hedge and Cash Sale Net Result: Farm Hog Price = Cash Sell Price ± Futures Gain or Loss C$1.58/kg C$0.19/kg = C$1.39/kg The combined price result of the cash sale and futures would be exactly the price that was targeted when the hedge was initiated. The same combined result would be obtained if the hog futures price had gone down from June to December, as long as the basis at the time of the actual hog sale was equal to that estimated, and the exchange rate was also unchanged. In such a case, the gain on the futures trade would be offset by the lower than targeted cash price received for the hogs. However, in the Example 1, the US dollar got more expensive and hog futures prices increased in December. Thus, the producer lost via futures (C$ 0.19/kg). Also, hog cash price in Dec is higher than expected cash price. Hedging In-Coming Feed Supplies Similarly, a hog producer may be able to lock in some of the costs of production, particularly feed costs. Feed costs can also be forward priced either by using forward cash price contracts or hedging with the futures market. Most of the hog producers go for forward contracting on barley. Because there is no real functioning futures market for barley. However, if the hog producers want to hedge feed costs through the futures market, they could buy go long corn futures as a hedge. Other useful information is that of market outlook, keeping in mind that no market predictions are consistently accurate. In Example 2, a buy position is entered into at US$ 4.81/bushel (C$ 198.94/tonne) for March corn on the Chicago Board of Trade in, say, early September. Subject to a change in basis from the $108/tonne estimate, the cash price for Corn in early March will be locked in at $306.94/tonne regardless of whether the March futures price for corn goes up or down. If, at the end of February, the physical corn is purchased at a price of $210/tonne, the buy hedge position is no longer needed and is removed by selling the March corn futures position via the broker. If the March corn futures price is at US$ 4.68/bushel (C$ 203.86/tonne) when the hedge is removed (the March futures is sold or offset) the futures trade will have resulted in a futures profit of C$ 4.92/tonne, again not considering broker commission. When the $4.92/tonne futures profit is subtracted from the $210/tonne purchase price of the physical corn, the net cost of the corn is $205.08/tonne. 6
Example 2: Hedging In-coming Corn Supplies Futures Basis Cash corn Price Date: September 6, 2013 Buy: March Chicago Board of Trade Futures @ US$ 4.81/bushel Expected March basis: C$ 108/tonne Expected Cash Price: C$ 306.94/tonne Date: March 14, 2014 Sell: March Western corn Futures @ US$ 4.685/bushel Actual March basis: C$ 210 - C$ 203.86 = C$ 6.14/tonne Actual Cash Price: C$ 210/tonne Futures Position: PROFIT Net Cash Corn Position: In this example, a weaker basis than originally estimated, would result in a lower net cost of the corn. A stronger basis at the time of physical corn purchase would result in a higher net cost of the corn. Hedging doesn t protect against a stronger than expected basis. See Basis How Cash Grain Prices are established for more details on basis and grain markets. Summary This module has provided an overview of hedging hogs via the futures market. Using the futures market to hedge the hog price can be a very useful alternative to cash contracting under certain circumstances. If, for example, a producer believed that the basis level offered under available cash contracts was weaker than the cash market would offer when the hogs go to market, yet wanted to protect against price downside risk on the futures component of the price, then the futures hedge would be appropriate to consider. The sell lean hog futures position would lock in the futures price while leaving the basis open. 7
Some factors that need to be considered before entering into a hedge are exchange rate risk, basis risk and the possibility of margin calls. Producers considering the futures hedge strategy are advised to complete a few hedges on paper before actually entering into one. A hedge using the futures or options market should only be entered with the assistance of a respected broker and support of the lender if margin financing is required. Various strategies also exist for use of options on futures to provide price risk protection. For more information about the content of this document, contact Jason Wood. This document is maintained by Magda Beranek. This information published to the web on September 8, 2004. Last Reviewed/Revised on January 8, 2015. 8