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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Presentation Transcript
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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