managing agricultural price risk

Managing Agricultural Price Risk

Types of Price Risk

Year-to-year price cycles

Within year price patterns

Basis risk (local cash price vs. futures)

Iowa Yearly Average Cash Prices

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

Soybeans Corn

Daily Soybean Prices

Daily Corn Prices

Commodity Prices

Cash or spot price: Price received when a commodity is sold locally.

Forward contract price: Price received for selling a commodity locally at a future date.

Futures price: Price at which a contract for a specific commodity and delivery date is sold, on a futures market exchange. Example: Dec. corn or March soybeans @ CBOT

Basis = difference between cash & futures

Basis Risk for Corn--2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

N D J F M A M J J A S O

Futures

Cash

Basis

Pricing Tools

Sell cash

Forward contract

Hedge by selling

a futures contract

Buy PUT options

Sell on the Cash Market

Try to guess when the highest price will occur

Sell when you need the cash Sell a little bit throughout the year Sell when price reaches a target,

or by a certain date

Forward Contracts

• Fixed price contract for a set delivery location, date, quantity and quality•Example: sell 3100 bu. yellow soybeans at

$6.20 for delivery to Roland Co-op by November 1

• Contracts can be:•Preharvest (production unknown)•Post-harvest (production known)

• Local elevator resells on the futures mkt.

Forward Contract Advantages

Lock in a sure price (but give up a gain if the prices increases later)

No broker or feesCan contract any number of bushels

Sell with a Futures Contract(Hedge)

1. Sell with a futures contract through a commodity exchange

2. When you are ready to sell the commodity, buy back the contract

3. Sell on the local cash mkt. 4. Change in the cash market

is offset by the change in the futures market

$2.00

$2.20

$2.40

$2.60

$2.80

$3.00

$3.20

$3.40 Cash

Futures

Example (price declines)* Sell corn futures contract in June @

$3.60 per bushel 4 months later, market has declined Buy back futures contract at $3.30

for a gain of $.25 Sell for cash price of $3.00 Net price is $3.00 + .25 = $3.25

Example (price increases)

* Sell futures contract for $3.60 4 months later, market has risenBuy back futures contract at $4.00 for a loss of $.40

Sell for cash price of $3.70Net price is $3.70 - .45 = $3.25

Hedging Advantages

Give up a gain if the market rises in order to avoid a loss if the market declines

Hedges can be lifted early (unlike a forward contract)

Grain can be sold anywhere on any dateHowever, futures contracts are for a

fixed quantity (5000 bu. on CBOT)

Basis Risk

Basis is the difference between the futures price and the cash price

Futures and cash trend together, but not exactly

Gain or loss on futures contract may not exactly offset the fall or rise of the cash price

Basis will vary (basis risk) less than the cash price varies, though

Hedging vs. Speculation

Hedging is owning both the actual commodity and a futures contract

Speculation is owning only a futures contract

Storing unpriced grain is also speculation

PUT Options

Right to sell a futures contract at a set price (strike price)

Cost of buying a PUT is the premiumIf the futures market moves up or

down, the PUT premium will move in the opposite directly

Premium cannot go below zero

Futures Price and PUTs

$0.00$0.25$0.50$0.75$1.00$1.25$1.50$1.75$2.00$2.25$2.50$2.75$3.00$3.25$3.50$3.75$4.00

PUT

Using a PUT Option to set a minimum price

1. Buy a PUT option

2. Later-sell the cash commodity, sell the PUT

3. If the market moves down, the value of the PUT moves up by about the same value

4. If the market moves up, the value of the PUT moves down, but can’t go below $.00

5. Losses are limited, gains are not.

Example: Buy a PUT

Cash price is at $2.80 (corn)Futures market is at $3.20 Buy a PUT for a $3.50 for a

premium of $.30

Example: PUT Options

Futures declines $.60 to $2.60, cash to $2.20

PUT value goes up by $.60 to $.90.

Net price is:Cash price $2.20+PUT value .90- orig.premium .30=net price $2.80

Futures increases $.50 to $3.70 and cash to $3.30

PUT value goes down, but only to $.00

Net price is:Cash price $3.30+PUT value .00- orig.premium .30= net price $3.00

PUT OptionsEstablish a minimum price (except for

basis variation)Can still benefit from higher pricesMay lose the original premium (at most)

CALL Options

Right to buy a futures contractPremiums for CALLS move in the

same direction as the futures price

Protects the buyer of a commodity against a price increase

Remember!

PUTs move opposite the market.

CALLs move with the market.

USDA Commodity Programs

All major farm crops (and milk)Administered by the Farm Service

Agency (FSA)Combination of subsidy and price risk

protection

Direct Payments

Based on historical acres and yields, not current production.

Paid twice a year.About $15 - 30 per acre in

Iowa

Loan Deficiency Payments (LDPs)

Each county has a Loan Rate, which is fixed by the USDA, for each grain

Each county has a Posted County Price (PCP), which varies daily. It is roughly equal to the local cash price

When the PCP is below the loan rate, the LDP is equal to the difference

Paid on bushels actually produced

LDP Example

A farmer in Adair Co. raises 15,000 bu. of soybeans

The Loan Rate is $5.13The PCP on Nov. 1 is $4.80Farmer can receive a payment of

$.33/bu ($5.13 - $4.80) x 15,000 = $12,450

Can request payment anytime after harvest, until grain is sold (or May 31)

USDA Marketing Loan

Farmer can take out a marketing loan instead of applying for an LDP

Loan = county loan rate x bushels storedIf the market price is lower than the loan

rate, repay market price x bushels storedFarmer keeps the difference between the

loan rate and the market price

Counter Cyclical Payment--CCP

If the national average selling price for a crop for 12 months after harvest is below the trigger price, a CCP is paid.

Trigger prices: corn $2.35soybeans $5.36

wheat $3.40Paid on 85% of historical production,

not current bushels.No decisions to make.

Dairy LDP

If monthly milk price is below the target price ($16 in Boston), farmer is paid 40% of the difference.

Revenue Insurance for Livestock(Livestock Risk Protection—LRP)

Available for hogs, feeder cattle and fed cattle

Based on futures prices on the Chicago Mercantile Exchange (CME)

Can buy guarantees of 70% to 95% of the futures price each day

Specify no. to sell, weight and date

LRP

“Actual” revenue is based on quantity insured and closing futures price on projected date of sale.

If actual revenue is below the guarantee a payment is made for the difference.

Another product called LGM also includes feed prices (corn and soybean meal)

LRP

Advantages vs. PUT options: Can insure any quantity No broker’s fees

Disadvantages May not sell on the specified date Local price may not match futures price No. and weight sold may not match plan Do not insure production risks