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Studies in Agriculture

Studies in Agriculture. SAB – 103 Wednesday: 7.00 pm – 8.40 pm Fall 2016 Instructor: Sankalp Sharma Email: ssharma3@unl.edu. Who am I?. A word on my teaching philosophy. About this class In class expectation Out of class expectation Homework Grading. In-class Expectation.

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Studies in Agriculture

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  1. Studies in Agriculture SAB – 103 Wednesday: 7.00 pm – 8.40 pm Fall 2016 Instructor: Sankalp Sharma Email: ssharma3@unl.edu

  2. Who am I?

  3. A word on my teaching philosophy

  4. About this class • In class expectation • Out of class expectation • Homework • Grading

  5. In-class Expectation • Key to learning: interaction • Review previous class’ notes before class (same file will be updated) • Attend all classes (cannot emphasize enough) Ask questions… But don’t be a troll! No cellphones or laptops during the class !!

  6. Out-of-class Expectation • No gains without practice. • Reading not enough, you must practice problems. • Form groups to practice. • Understand concept, memorization won’t help you.

  7. Homework • Frequently assigned. • Usually only one question. • A random student will be asked to solve the HW on the board.

  8. Grading • Exams will be long and difficult. • Everything taught in class is fair game. • But grading will be easy. • 40% midterm, 40% final, 20% HW, (bonus: 20% class interaction)

  9. Questions?

  10. The Road Map Ahead • Understanding the nature of risk • What is risk management • Introduction to agricultural futures and forwards markets • Hedging Risk using Futures Markets • Introduction to Basis • Hedging with Basis • Discussion on Options

  11. Understanding the nature of risk • What is risk? • What is uncertainty? • What is the difference between the two? • Types of risk • What is risk management? - Types of risk management strategies.

  12. What is risk management? • Strategies available to negate risk: • Good on-farm practices • Foward Contracts • Futures Contracts • Options • Hedging

  13. Introduction to agricultural futures and forwards markets • What is a forward contract? • What is a futures contract? • What is the difference between the two? • Brief History of Futures market. • Mechanics • Futures prices • Futures market participation • Price risk

  14. Hedging Risk Using Futures Markets - Understanding the core concept - Margins - Local vs Futures Market - Hedging Local Market Price Risk - Offsetting price risk

  15. Basis • Introduction • What do we mean by “basis” • Basis risk

  16. Options • Types of options • Options positions • Underlying assets • Trading • Margins

  17. But today let’s begin with…

  18. Risk - So what do we mean by “risk” in agriculture?

  19. How is risk different from Uncertainty?

  20. How is risk different from Uncertainty? - You can assign a “probability”, there is prior information - Uncertainty, no prior information.

  21. For our purposes, we will focus only on risk

  22. Types of risk - Poor on-farm practices - Limited market information - Yield risk through weather (drought, hail, excess rainfall) - Price risk (including input price risk)

  23. What can be done to mitigate said “risk”? “Mitigate” risk  Also defined as risk management. - Crop insurance - Market options (hedging, futures and forward market) - Government programs (such as the Conservation Reserve Program)

  24. What causes people to manage risk? - Because people are reluctant to take gambles - People care about “losses” more than they care about “winning”. - This behavior is known as “risk aversion”.

  25. Introduction to Agricultural Futures Markets • Futures markets for commodities have been an important method for agricultural producers to hedge revenue risk, which can be very high. Reasons to hedge: • They may have to face fluctuations in demand for their goods. • Risky events that can substantially affect their output. • Both of the above can affect output prices. • By allowing producers to “lock in” a price far in advance, futures markets can be used to remove the risk of fluctuating and unknown sale prices.

  26. Basic Intuition: Futures markets • You are a commodity producer, which you will harvest in the future. • Long-story-short, you don’t want to lose money on it. • Find somebody with whom you can lock in “contract”. • Somebody with whom you can agree upon a price and quantity.

  27. Brief history of agricultural futures markets A futures market is a designated location used to assist agribusiness and farmers discover prospective prices for a commodity. Agricultural markets appeared in mid 1800s. • Chicago Board of Trade – 1848 • Chicago Mercantile Exchange (1874). Formally, known as the “Chicago Egg and Butter Board”. • First Corn futures contract written in 1851.

  28. Why did markets come about? • Transportation distances increased, causing higher price volatility followed. • No central information source. • No standardized trading rules and methods.

  29. Futures Markets • They are used to create and trade futures contracts between a buyer and seller of a commodity. • Futures contract are a statement signifying a promise between a seller and a buyer (two sides are required to trade).

  30. What does a futures contract look like? • An obligation of the seller to deliver a commodity to a specified point-of-delivery at a future time. • An obligation of the buyer to pay a fixed price and pick up the commodity at the pre-specified point-of-delivery. • An expiration date (time of delivery). • Remember, futures contracts can be traded by a trader who has no position in the actual physical or cash commodity.

  31. Examples: Commodities Examples include: - Corn - Wheat - Cocoa - Live cattle - Feeder Cattle

  32. Examples: General • Natural Gas • US Dollars • US Treasury Bond

  33. Commodity futures markets – contract price info: Chicago Board of Trade http://www.cmegroup.com/trading/commodities/ Minneapolis Grain Exchange (dark northern spring wheat) http://www.mgex.com/ Kansas City Board of Trade (hard red winter wheat) http://www.kcbt.com/ Wall Street Journal - Market Data http://online.wsj.com/mdc/public/page/marketsdata.html

  34. Futures Contracts • Futures contract provide a very structured and standardized method for buyers and sellers to determine the terms of an exchange. • Each futures contract is exactly the same except for the price of exchange established by the buyer and seller.

  35. Futures Contracts: The following describe the standardizations that exist in each futures contract: • Measures: - 5000 bushels: Corn, Wheat, Soybeans, etc. - 40,000 lbs live cattle. - 50,000 lbs feeder cattle.

  36. Futures Contracts 2) Quality: (say for Wheat) #2 Soft Red Winter (SRW) – CBOT #2 Hard Red Winter (HRW) – KCBT (Kansas City Board of Trade) #2 Hard Red Spring (HRS) – MGX (Minnesota Grain Exchange) 3) Delivery Location: For Example: Chicago and Burns Harbor, Indiana

  37. Futures Contracts 4) Contract end date: - 15th day in the contract month. - Last day of the contract month  Live cattle - Last Thursday of the contract month  Feeder cattle 5) Pricing units - Cents per bushel (tick: 0.25 cents) - Cents per pound (tick: 0.0025 cents per pound)

  38. Brief tangent to understand the difference between: Futures and Forward Contract • A futures contract is standardized. • A forward contract works exactly the same way, except it is not standardized. • It is a privately negotiated contract for a transaction that occurs in the future.

  39. Sample Futures Contract: Commodity Commodity: Crop Quantity: 5000 bushels Quality: #2 Yellow at contract price Delivery Location: Lockport-Seneca.

  40. Sample Futures Contract: Cattle Cattle: Live Quantity: 40,000 pounds Quality: 55% choice, 45% select, Yield grade 3 live steers. Delivery Location: - Approved slaughter plant corresponding to the stockyards, the cattle are at. - Approved slaughter plant within 200 miles of the feedlot from which the cattle originate.

  41. But what is a Cash-Market? - Prices offered or received via private negotiations between two parties, may be an elevator, grain merchandiser, etc.

  42. A word on Prices • Prices in the futures markets, unlike cash (spot) markets, are limited as to the daily price movements. • Price movement limits attempt to prevent panicked trading and lessen the likelihood of a market crash • Price movements also include minimum price movements, referred to as a “tick” - A tick is the smallest price change allowed by the exchange that may occur from one price to another - For example, the minimum tick for Chicago corn is ¼ cent per bushel - So, if corn last traded at $2.32 / bushel, the minimum price change that may be traded is 2.32 ¼ or 2.31 ¾

  43. Purchasing a Futures Contract. (Extremely important that you understand this!) Every contract requires two parties: A seller and a buyer

  44. Who is a Seller? • A party that promises to deliver the designated quantity of a commodity. Selling a contract is known as taking a short position. If the delivery date comes and the seller can’t deliver, they are short of the commodity.

  45. Who is a Buyer? • A party that promises to take delivery of a specified quantity of commodity. • In exchange, they will pay a fixed price. Buying a contract is known as taking a long position. If delivery date comes and the buyer has a commodity they may not want (or too much of it), they are long in the commodity.

  46. Offsetting Contracts • Typically, only few contracts have sellers and buyers who can actually deliver or take on a commodity. • Instead of delivering or taking on a commodity, a party can offset a short or long position by purchasing an opposite contract. Short position  offset by buying a contract (long position). Long position  offset by selling a contract (short position).

  47. Offsetting Contracts • Offsetting releases an individual from the responsibility of either buying or selling a contract. • The only obligation that the individual is required to meet is any difference in the price of the two contracts. • For example, if one contract was bought at $5.00/bu and another was sold at $4.50/bu, the individual would be responsible to pay $0.50/bu (more on this later).

  48. Homework 1 - Emperor Palpatine has 3 futures contract for the following commodities. His positions at the beginning of the contract were: 1) He sold 1 Corn Futures contract at $4.00/bu 2) He sold 1 SR Wheat Futures contract at $5.60/bu 3) He bought 1 HR Wheat Futures contract at $4.70/bu

  49. Homework 1: Continued - Tell me, how should he should offset his positions for each of the contracts above, given that the price now of corn and SR wheat futures contract is $5.00/bu and the price of HR Wheat futures is $5.50/bu?

  50. Next class….

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