Risk Management Tools by Cory G. Walters University of Kentucky cgwalters@uky.edu (859) 257-2996

1. Risk Management Toolsby Cory G. WaltersUniversity of Kentuckycgwalters@uky.edu(859) 257-2996 Agricultural Economics

2. 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

3. 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

4. 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

5. 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

6. 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

7. Futures Market • Two types of people participate in the market • Hedgers • Speculators • What is the definition of a hedge? Agricultural Economics

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. Choice of Contract • Price decrease and basis increase • Potential contracts • Hedge • Hedge-to-arrive • Buy put option Agricultural Economics

27. Choice of Contract • Price decrease and basis decrease • Potential contracts • Sell crop (local cash) • Forward contract Agricultural Economics

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. What’s Going on in the Soybean Market? • Dec 09 corn is Agricultural Economics

35. 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

36. 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

37. 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

38. 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

39. 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

40. Questions? Agricultural Economics