Chad Hart Associate Professor chart@iastate 515-294-9911

1. ECON 337: Agricultural Marketing Chad Hart Associate Professor chart@iastate.edu 515-294-9911 Lee Schulz Assistant Professor lschulz@iastate.edu 515-294-3356

2. Sources of economic risk… • Livestock prices (feeder and finished) • Feed prices • Interest rates • Equipment/facilities • Capacity utilization • Labor • Health/performance • Other??? • How are these risks managed? • (and which are most important)

3. Managing price risk is essential… • Volatility over the past 5 years has increased to unprecedented levels. Overriding factors: • Domestic and foreign political policy • Domestic and foreign economic policy • Changing global supply and demand balance • Weather/natural occurrences affecting supply and logistics • The equity and working capital necessary to operate the same volume of business has nearly doubled • MORE IS AT STAKE: Greater potential for profit, greater potential for substantial loss

4. Methods of managing price risk… • Cash sales (purchases) • Forward contract • Hedge with futures contract, i.e., sell (buy) futures • Buy put (call) option • Other option marketing strategies • Livestock Risk Protection (LRP) • Livestock Gross Margin (LGM) • Price risk management → Coordinated and economical application of strategies to minimize, monitor, and control the probability of adverse price movements

5. Cash sales (purchases)… • Characteristics - • easy to understand • retain price and basis* risk • no quantity or quality obligations (within reason) • no futures broker or margin calls • financial risk (i.e., risk of not getting paid) depends on financial strength/integrity of buyer • * basis = cash price – futures price

6. Forward contract… • Characteristics - • locks in a “fixed” price • basis risk is eliminated • pay a premium for transferring basis risk • no margin account or maintenance required • may or may not involve broker / brokerage commission • contract specifications and size flexible (within reason) • obligated to deliver • low quality cattle might be excluded/refused • weight price slide risk • risk of other party not honoring contract • not always available • prices are not very transparent

7. Formula Most common contract Price tied to another market, typically spot (cash) Examples: 3-Day rolling average of Iowa/SoMinnesota weighted average +$1.50 Last week’s average excluding the high and low 92% of the previous day cutout value Buyer does not share risk Types of Contracts

8. Types of Contracts Fixed window Formula tied to cash price Predetermined upper and lower bounds Share pain and gain outside window Example: $50 and split 50/50 above and below Floating window Formula tied to cash price Boundaries move with feed prices Do not share outside of window Buyer shares risk

9. Types of Contracts Cost-Plus Price direct function of feed prices Fixed amount for non-feed costs + known margin Buyer assumes all price risk Ledger Floor price is fixed or based on feed prices Producer is “loaned” the difference between floor and lower cash prices Loan is repaid at higher cash prices Buyer provides line of credit but not risk share

10. Hedge with futures contract… • Characteristics - • locks in a “fixed” price (CME futures price) • subject to basis risk • fixed contract specifications and size • deal with broker / brokerage commission • margin account and maintenance required • easy to enter and liquidate • transparent price quotes • no risk of other party “backing out” • feeder cattle futures is cash settled contract • No delivery ability / obligation • No risk of low quality cattle being “refused”

11. Buy put (call) option contract… • Characteristics - • locks in a “floor” price (ceiling for call) (strike price) • subject to basis risk • fixed contract specifications and size • deal with broker / brokerage commission • pay premium for option • no margin calls (unless option is exercised) • easy to enter and liquidate • transparent price quotes • no risk of other party “backing out” • cash settled contract (no delivery ability / obligation)

12. Other options strategies… • Characteristics - • anything goes… • buy / sell puts(s), call(s), sell futures, forward contract… • selling options requires margin account and maintenance • make sure you know what you are doing • Several of the more common option strategies • Synthetic put – hedge (sell futures) or forward contract and buy call option (works similar to buying put option) • Window / fence – establish minimum (floor) and maximum (ceiling) prices by buying a put option and selling a call option(s)

14. Risk management using futures… Hedging defined… Use of the futures market as a temporary substitute for an intended transaction in the cash market which will occur at a later date

15. Relationship Between Cash & Futures Prices is Critical for Risk Management • Basis = Cash Price – Futures Price • Rearranging formula gives • Basis + Futures Price = Cash Price

16. Decomposing a Cash Price • Cash Price = Basis + Futures Price • Recall definition of hedging • Hedging effectively “locks in” the Futures Price when the hedger sells (for a short hedger) the futures contract • Hedging does not lock in the Basis • Therefore the Cash Price is not locked in and the hedger is still exposed to basis risk

17. Evaluating a Hedge • At the time the hedge is placed, we can estimate the Expected Selling Price(i.e., what the hedger expects to receive for the commodity net any gains or losses in the futures, minus the brokerage commission) • Futures Price at which futures contract is sold • + Expected Basis • Brokerage commission • Expected Selling Price

18. Futures Hedge Example • Assume JUN LC are $124.57/cwt when hedge is initiated (Nov 22) • Expect June basis to be +$1.00/cwt(for 1250 lb steer) • Assume brokerage commission = $60/ round turn or $0.15/cwt • What is the Expected Selling Price? • Futures Price at which hedge is initiated $124.57 • + Expected Basis + 1.00 • Brokerage commission - 0.15 • Expected Selling Price $125.42/cwt

19. Basis… • Generally, basis is more predictable than cash or futures prices due to: • Convergence • Futures and cash prices move together • (same fundamental conditions generally affect both markets) • Year-to-year stability implies the ability to rely upon historical data for predictions • Sources of basis information • Ag Decision Maker (www.extension.iastate.edu/agdm/) • Beef Basis – feeder cattle (www.beefbasis.com)

20. Basis… • Strong • Weak • Narrow • Wide • Over • Under

21. At Hedge’s Conclusion • Calculate Actual Sale Price • Price received in the cash market • + Net on futures transaction • Brokerage commission • Actual Sale Price

22. Futures Hedge Example • Assume JUN LC are $127.07/cwt on 6/15 when hedge is concluded • Assume cash 1250 lb steer price = $128.07/cwt when hedge concludes • What is your net gain on the futures trade? • Sold JUN LC futures @ $124.57 • Offset (buy) JUN LC futures @ - 127.07 • Net gain on futures transaction - 2.50

23. Futures Hedge Example So, if JUN LC are $127.07/cwt on 6/15 when hedge concludes And cash 1250 lb steer price = $128.07/cwt when hedge concludes What is the Actual Sale Price? Price received in cash market $128.07 + Net on futures transaction - 2.50 - Brokerage commission - 0.15 Actual Sale Price $125.42/cwt Expected = Actual Why? Because Expected Basis = Actual Basis

24. $128.070 $125.420

25. Option Hedging Strategies • Buying a PUT (CALL) gives the option buyer the right but not the obligation to SELL (BUY) a futures contract at a specified price known as the “strike price” • So, we can use the purchase price of the PUT (CALL) in place of selling (buying) a futures contract • Therefore, a producer can buy a PUT option to establish a Minimum Expected Selling Price • Similarly, buying a CALL option will establish a • Maximum Expected Purchase Price

26. Minimum Expected Selling Price Buy a Put • start with a put option strike price • subtract the put option premium • This creates a “futures equivalent” • then add basis forecast • subtract brokerage commission • remember that many brokers charge once to buy an option and once to sell an option • have to account for possibility of “double” brokerage commission in calculations

27. Minimum Expected Selling Price Buy a Put • Example: Buy CME $124.00 JUN Live Cattle PUT • (when JUN LC futures are @ $124.57) • Put option premium = $3.85/cwt • Mid June basis forecast = +$1.00/cwt(1250 lb steer) • Assume brokerage commission is $30 ($0.075/cwt) to buy an option contract and $30 ($0.075/cwt) to sell an option contract • For the buyer of a $124.00 JUN LC Put • What is the Minimum Expected Selling Price?

28. Minimum Expected Selling Price Buy a Put $124.00 Option Strike Price - 3.85 Put Premium $120.15/cwt Futures equivalent + 1.00 Expected mid June basis - 0.15 Maximum possible commission $121.00/cwt Minimum Expected Selling Price

29. Actual Sale Price • start with price received in cash market • add the “net” from the option trade • subtract actual brokerage commission • -- Sell cash cattle in mid June for $128.07/cwt • -- JUN live cattle futures are $127.07/cwt • -- What is the value of $124.00 put option?

30. Actual Sale Price (for buyer of CME Put Option) $128.070 Cash Market Price - 3.850 + Net on Option Trade - 0.075 - Brokerage Commission $124.145 Actual Net Sale Price Actual > Expected Minimum Why? Prices went up after Put Option purchase and the Put Option buyer retained the right to benefit from future price increases

31. $128.070 $125.420 $124.145

32. Comparing pricing alternatives… Cash vs. Hedging vs. Options… Because the various risk management tools have different characteristics (e.g., flat price vs. minimum price), it is useful to compare them under alternative price outcomes

33. Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/Spring2015/