Risk management tools by cory g walters university of kentucky cgwalters@uky edu 859 257 2996
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Risk Management Tools by Cory G. Walters University of Kentucky [email protected] (859) 257-2996. Agricultural Economics. Importance of Grain Marketing. Goal of Producer: Raise and market grain at a profitable price Profit uncertainty arises from:

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Risk management tools by cory g walters university of kentucky cgwalters@uky edu 859 257 2996

Risk Management Toolsby Cory G. WaltersUniversity of [email protected](859) 257-2996

Agricultural Economics


Importance of grain marketing

Importance of Grain Marketing

  • Goal of Producer: Raise and market grain at a profitable price

    • Profit uncertainty arises from:

      • Fluctuations in cost of per bushel production

        • i.e. yield variability

      • Price fluctuations

  • Can alleviate yield variability by:

    • Crop rotation

    • Planting several hybrids

    • Crop Insurance

Agricultural Economics


Why grain marketing is important

Why Grain Marketing is Important

  • Because

    • We cant control:

      • Oil Price

        • Renewable fuel (Ethanol)

      • Exports – Cheap U.S. dollar

      • Index Funds

      • Large crop

  • Outcomes

    • Corn, Soybean, and Wheat prices have displayed historic prices and volatility

  • The crystal ball does not exist

Agricultural Economics


Prices

Prices

  • Prices are established in two separate markets

    • Cash market

    • Futures market

  • Futures Market

    • Trades contracts for future delivery

      • Everything except price is known in a contract

        • Time (delivery month), location, crop type, grade, and quantity.

  • Cash Market

    • Where “physical” grain in handled

Agricultural Economics


Futures market

Futures Market

  • Chicago Board of Trade was founded in 1848

  • Futures contract

    • Is a commitment to make (or take) delivery of a specific quantity and quality at a predetermined price in the future

  • Contracts are settled through liquidation by offsetting sales with purchases (or vice versa) or by delivery of the commodity

Agricultural Economics


Futures market1

Futures Market

  • Primary function of a futures exchange for price risk management and price discovery

    • This is done by brining buyers and sellers together

    • Trading is done in an open and competitive environment

  • Futures price represents a price prediction that is determined by both buyer’s and seller’s for the time of delivery

    • Maybe its not a price prediction because the price is subject to continuous change

Agricultural Economics


Futures market2

Futures Market

  • Two types of people participate in the market

    • Hedgers

    • Speculators

  • What is the definition of a hedge?

Agricultural Economics


Futures market3

Futures Market

  • The definition of a hedge is to

    • “Try to avoid or lessen a loss by making a counterbalancing investment…”

  • A hedge is a counterbalancing investment involving a position in the futures market that is the opposite one’s position in the cash market.

    • If futures and cash market move up and down together then any loss in one market will be a gain in the other

Agricultural Economics


Prices1

Prices

  • Difference between cash market and futures price is called basis

    • Basis can be different at different elevators

  • Cash market represents two components

    • Futures price

    • Basis

  • Example: $4.00 Cash corn, $4.20 futures, results in a ?? basis

Agricultural Economics


Grain marketing

Grain Marketing

  • Can alleviate price uncertainty by

    • Hedging

      • Involves selling futures contracts in one market as a substitute (temporary) for selling in the local cash market.

        • Temporary because the commodity will eventually be sold in the cash market

Agricultural Economics


Hedging

Hedging

  • An example

    • Producer has 5000 bushels of corn in storage.

      • Sells one futures contract (a futures contract is 5000 bushels)

      • Can use “mini” contracts- 1000 bushels a contract

      • Producer is in a hedged position

      • They own 5000 bushels of corn and sold 5000 bushels of corn futures.

  • Since the producer has sold futures, price has been established on the major component of the local cash price

    • What is the other component?

Agricultural Economics


Hedging1

Hedging

  • The hedge position is removed when the producer is ready to sell corn in the cash market.

    • Two steps ( done immediately)

      • Sell corn in local cash market

      • Buy back futures

  • The buying of futures offsets the selling futures position

  • Selling in the local cash market converts corn into cash

Agricultural Economics


Basis

Basis

  • Basis = Cash - Futures or

    • Cash = Basis + Futures

  • Futures hedge leaves the basis un-priced.

    • Local cash price is still subject to basis fluctuations

      • Typically basis fluctuations is less than futures price fluctuations

      • What about for wheat this past year?

  • Agricultural Economics


    Hedging2

    Hedging

    • Place Hedge

      • $4.00 futures price (sell)

      • $3.75 cash price

        • Basis = $-.25

    • Lift Hedge

      • $5.00 futures price (buy)

      • $4.75 cash price

        • Basis = $-.25

    • Result

      • $4.75 cash sale minus $1.00 futures equals $3.75 price.

    Agricultural Economics


    Hedging3

    Hedging

    • Place Hedge

      • $4.00 futures price (sell)

      • $3.75 cash price

        • Basis = $-.25

    • Lift Hedge

      • $3.00 futures price (buy)

      • $2.75 cash price

        • Basis = $-.25

    • Result

      • $2.75 cash sale plus $1.00 futures equals $3.75 price.

    Agricultural Economics


    Hedging4

    Hedging

    • Margin money

      • Used to maintain position in the futures market

        • Insure futures commitment

        • More funds may be needed

      • Margin calls

        • Not a “LOSS” but a cost for insuring against price decline.

        • Remember, “LOSSES” on futures are offset by gains from local cash market

      • Money is fully collateralized

      • Returned when position is closed out

        • Less brokerage fees

    Agricultural Economics


    Grain contracts

    Grain Contracts

    • Exist a number of tools to help producers manage increasing risk

      • Need more information to effectively use available marketing tools

    • Common types of contracts

      • Forward cash

      • Basis

      • Minimum price

      • Hedge-to-arrive

    Agricultural Economics


    Grain contracts1

    Grain Contracts

    • Each type of contract manages a source or sources of price risk (local cash price)

      • What are the two sources of price risk?

    • Other types of risk

      • Production risk

        • Pricing grain before it is planted exposes themselves to production risk

          • How to manage production risk?

    Agricultural Economics


    Grain contracting requires business principles

    Grain Contracting REQUIRES Business Principles

    • Know everything about a contract before you sign

    • Get assistance before you sign if you don’t understand something

    • Know who your signing the contract with

      • Can they come through on their end of the deal

    • Understand all possible price outcomes of the contract

      • Analyze outcomes of extreme price outcomes

    • Understand what happens if you cant produce the required amount of production

    • Talk with the party throughout the period of the contract

    Agricultural Economics


    Grain contracts2

    Grain Contracts

    • EVERYTHING is determined EXCEPT for price

      • Quality

      • Price adjustments if quality is not met

      • Date of delivery

      • Location of delivery

      • Quantity being contracted

      • And yours’ and other parties signature

    Agricultural Economics


    Choice of contract

    Choice of Contract

    • Depends upon your risk management (level of risk you want to take), marketing objectives, and market conditions.

      • Market conditions

        • Whether you think prices will

          • Increase

          • decrease

        • Whether you think basis will

          • Increase

          • decrease

    Agricultural Economics


    Choice of contract1

    Choice of Contract

    • With two market condition variables we can create four different market scenarios. Each has its own set of contracts that work well for its market condition

    • Price increase and basis increase

    • Price increase and basis decrease

    • Price decrease and basis increase

    • Price decrease and basis decrease

    Agricultural Economics


    Choice of contract2

    Choice of Contract

    • Price increase and basis increase

      • Potential contracts

        • Storage (don’t price)

        • Delayed price contract

          • Manages no risk, provides off-farm storage

        • Minimum price contract

    Agricultural Economics


    Choice of contract3

    Choice of Contract

    • Price increase and basis decrease

      • Potential contracts

        • Basis Contract

        • Sell cash and buy futures

          • Speculating

          • Almost the same as holding un-priced grain in bin, what is the difference?

        • Sell cash and buy an option

        • Minimum price contract

    Agricultural Economics


    Minimum price contract

    Minimum Price Contract

    • Similar to forward price contract

      • EXCEPT that price is not fixed.

        • Price is guaranteed to be no lower than a predetermined price

          • Leaves price upside open.

      • Protects both types of risk

    • Weaknesses

      • Premiums may be expensive

        • Depends upon length of contract and price volatility

    Agricultural Economics


    Choice of contract4

    Choice of Contract

    • Price decrease and basis increase

      • Potential contracts

        • Hedge

        • Hedge-to-arrive

        • Buy put option

    Agricultural Economics


    Choice of contract5

    Choice of Contract

    • Price decrease and basis decrease

      • Potential contracts

        • Sell crop (local cash)

        • Forward contract

    Agricultural Economics


    Now what

    Now what?

    • Marketing decisions based completely upon your current reading of the market are often wrong

      • Leading to frustration

    • Which way is the market moving?

      • Attend outlook talk(s)

      • Read farm magazines

      • Look at the “carry”!!!

    Agricultural Economics


    What is the carry

    What is the “Carry”?

    • The “carry” is the difference between two different futures contracts for the same commodity.

    • The “carry” can be

      • Positive

      • Negative (also called inverted)

    Agricultural Economics


    What does the carry tell us

    What does the “carry” tell us?

    • The “carry” tells us about the size of the crop

      • Large “carry” indicates traders think the crop will be large and they want you to store the crop for future delivery

      • Small “carry” indicates traders think the crop will be small and they want the crop now (i.e., at harvest)

    Agricultural Economics


    What s going on in the corn market

    What’s Going on in the Corn Market?

    • Dec 09 corn is trading around $3.63 per bushel

    • July 10 corn is trading around $3.86 per bushel

    • A difference of +$0.23 per bushel

      • Traders are expecting a “large” corn crop

        • Large relative to use

    • Current basis of -$0.15

      • Almost equal to average basis in July

    Agricultural Economics


    What s going on in the corn market1

    What’s Going on in the Corn Market?

    • Does it pay to speculate against a strong positive “carry” ?

      • On average, NO

    • Does the $0.23 per bushel benefit to storage cover costs of storage?

      • Maybe

      • Could add (subtract) to the $0.23 return if basis improves (decreases) over average

    Agricultural Economics


    The corn market is telling us

    The Corn Market is telling Us

    • To not speculate on higher futures prices

      • Do not hold un-priced corn in the bin

    • To sell the “carry”

      • If benefit is greater than the cost

    • Or to sell corn off the combine for cash

    Agricultural Economics


    What s going on in the soybean market

    What’s Going on in the Soybean Market?

    • Dec 09 corn is

    Agricultural Economics


    What s going on in the soybean market1

    What’s Going on in the Soybean Market?

    • Nov 09 soybean is trading around $9.12 per bushel

    • May 10 soybean is trading around $9.16 per bushel

    • A difference of +$0.04 per bushel

      • Traders are expecting a “small” soybean crop

        • Small relative to use

    • Current basis of +$0.03

      • +$0.33 better than the average May basis

    Agricultural Economics


    What s going on in the soybean market2

    What’s Going on in the Soybean Market?

    • Does it pay to speculate against a very small “carry” ?

      • On average, Maybe

    • Does the -$0.29 per bushel benefit to storage cover costs of storage?

      • NO!

    Agricultural Economics


    The soybean market is telling us

    The Soybean Market is telling Us

    • To sell soybeans off the combine for cash

      • This is recommended since soybean price is high relative to long term average

      • Maybe re-own with options

    • To maybe speculate on higher futures prices

      • Hold un-priced corn in the bin

    • To not sell the “carry”

    Agricultural Economics


    Crop insurance

    Crop Insurance

    • Use to protect a percentage of production

      • Purchase revenue insurance to protect price

        • Buying a put

          • Protects against lower prices

            • Base price > Harvest price

        • Buying a call

          • Protects against higher prices

            • Base price < Harvest price

    Agricultural Economics


    Average crop revenue election acre program

    Average Crop Revenue Election (ACRE) Program

    • A very cheap state insurance program

      • Pays upon revenue losses at the state yield

        • Uses average KY yields and national prices

        • Pays when KY revenue (state yield * national price) is less than revenue risk management level (average state yield * average national price * .9)

    Agricultural Economics


    Questions

    Questions?

    Agricultural Economics


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