Securing Forward Profit Margins
The Margin Management Policy
1
Margin Management Policy
What is a Margin Management Policy?
A Margin Management Policy states the company’s views regarding
transactions in cash (physical) contracts, futures contracts and option
contracts to protect profitability in a forward time period.
Benefits of a Margin Management Policy include:
•
Promotes discipline throughout the organization
•
Allows for Executive Management oversight and review
•
Delegates administrative duties and management decisions
•
Defines responsibilities and accountabilities
•
Provides direction to everyone involved in margin management
Margin Management Policy
The Margin Management Committee
The committee may consist of one or two individuals, it may involve
several individuals depending on the size/structure of the company.
Their function includes:
• Writing, implementing, and periodically reviewing the Margin
Management Policy
Who should or could be included?
• Executive Management
•
Finance/Treasury
•
Accounting
•
Purchasing (Feed/Input Expenses, Marketing (Livestock/Crop Sales)
Basic Components of a Margin Management Policy
1. Approve the specific commodities and quantities to be hedged
example: Hogs, Cattle (# of head), Milk (lbs. of production), Soy meal
(tons consumed), Corn (bushels consumed or produced), etc…
2. Identify Margin Risk in conjunction with time
example: We will monitor margin risk looking forward 4 quarters or one
crop year beyond the current period.
3. Determine responsibilities
example: Identify who or what team is responsible for each step of the
process and list those responsibilities and authorities.
4. List approved types of Margin Management Strategies
example: Flat Price, Basis, Forward, Futures, Options…Identifying
limits in conjunction with time.
Basic Components of a Margin Management Policy
5. Identify forms of strategy execution
example: Identify who or what team can execute approved strategies
and what entities the strategies can be executed with…address
counter-party risk
6. Establish Internal Reporting Procedures
Who should be informed and kept informed; How should they be
informed?
7. Establish on-going review procedures
Daily review, weekly review, monthly review.
8. Establish accounting procedures
Follow accepted practices.
5
Margin Management Policy – Sample Hog Farm
Mission Statement:
Our objective is to actively monitor and manage forward profit margins in an effort
to reduce or eliminate the effect of adverse commodity prices on our hog
farm’s profitability.
Overall Goal:
To identify an acceptable range of margin or margin percentiles to either
protect above-average historical margins, and/or reduce the effect of adverse
market conditions.
Approved Commodities:
Corn, Soybean Meal, Hogs
Identification of Range of Margin and/or Margin Percentiles:
The margin management team will utilize several resources to identify margin
opportunities including internal staff and outside advisors. A margin model will
be employed to project and rank forward profit margin opportunities from a
historical perspective. These historical margin percentiles will form the basis of
our plan to establish coverage levels based upon an acceptable range.
Sample Margin Management Plan
Historical Margin
Percentile
Incremental
Coverage
Cumulative
Coverage
70
10%
10%
75
15%
25%
80
15%
40%
85
15%
55%
90
15%
70%
95
15%
85%
100
10%
95%
Margin Management Policy – Sample
Responsible Parties:
The Margin Management Team is responsible for
monitoring forward profit margins and has the authority to
make margin management commitments for up to 100% of
purchases/sales in the current quarter, 75% in the next
quarter, 50% in the following quarter, and 25% in any
deferred quarter. The team will report and recommend price
management strategies to the owners and report positions
to the accounting department and lender if required.
8
Margin Management Policy – Sample
Internal Reporting Procedures:
The Margin Management Team will maintain a position record reflecting
the net long and short positions of the company. The position report will reflect
both feed purchases and hog sales in the cash market as well as any open
derivative positions on the exchange. The report will be forwarded to the
owners upon completion. The MM Team will notify the owners if a margin
management decision is executed. The MM Team will provide the owners with
recommendations for margin management strategies for time periods and
volumes beyond the MM Team’s authority for their consideration. The Team
will also make sure to notify the accounting department (and/or lender) of all
transactions (if required).
Accounting Procedures
We will follow commonly accepted practices of accounting including: the
allocation of futures and options gains or losses to the appropriate physical
market transactions. Company auditors will be asked to provide guidelines.
Margin Management Best Practices and Notes
 Execute a Margin Management Policy – determine contracting
alternatives to use in both the cash and futures market, time horizon,
budget, and responsibilities across the organization.
 Establish a plan to both execute and offset positions – initiate protection
based on margin percentile, net return, etc. as well as remove positions
against physical marketings or transactions in the cash market.
 Determine in advance potential adjustments to initial hedge positions, and
under what circumstances strategies should be modified (margin calls,
exhausting range of protection, change in market conditions, etc…)
 Schedule a periodic reconciliation timetable (monthly, quarterly, etc.) to
recapitalize operating line with hedge gains or hedge line with revenue
from cash sales against losses on hedging transactions.
 Periodically review practices to measure effectiveness of margin
management program and to make sure that all available tools are being
used appropriately to protect profitability of operation.
Practical Applications
Hedging Hogs:
A Margin Management Case Study
Using Futures Contracts
11
Practical Applications
A hog producer in Southern Minnesota is planning on marketing 22,248
hogs for 3rd quarter 2012 or roughly 4,620,000 pounds of pork.
The producer’s open market margin for 3rd quarter 2012 marketings on
September 16, 2011 is $8.18/cwt. (assuming zero basis), just at the 70th
percentile over the last 10 years and decides to execute hedges to lock
in that level on 25% of production, keeping with his policy.
The producer decides to execute three hedges:
1. A long futures position representing 60,000 bushels in September
2012 corn to protect the risk of prices rising between now and the
time when the corn is purchased from the feed mill.
2. A long futures position representing 400 tons in September 2012
soybean meal to protect the risk of prices rising between now and
the time when the meal is purchased.
3. A short futures position in July Lean Hog futures, August Lean Hog
futures, and October Lean Hog futures to protect the risk of prices
declining between now and the time when the hogs are sold to the
packer.
12
Practical Applications
On September 16, 2011 September 2012 Corn Futures are trading
at $6.63/bushel. The operation executes its hedge and buys 12
September 2012 Corn futures which represents 60,000 bushels.
On September 16, 2011 March Soybean Meal Futures are trading
at $354.10/ton and the operation executes its hedge and buys 4
September 2012 Meal futures which represents 400 tons.
On September 16, 2011 July Lean Hog futures are trading at
$97.35/cwt, August Lean Hog futures are trading at $96.40/cwt,
and October Lean Hog futures are trading at $86.25/cwt. The
operation executes its hedge and sells 5 July Lean Hog futures, 10
August Lean Hog futures and 14 October Lean Hog Futures which
represents 5,562 animals or 25% of total 3rd quarter production.
Upon execution of these hedges, the operation locks in a positive
margin of $8.177/cwt (assuming a zero basis for the period).
13
Practical Applications
14
Practical Applications
On September 16, 2011
September 2012 Corn Futures
@ $6.63
15
Practical Applications
On September 16, 2011
September 2012 Soybean Meal Futures
@ $354.10
16
Practical Applications
On September 16, 2011
July 2012 Lean Hog Futures
@ $97.35
17
Practical Applications
On September 16, 2011
August 2012 Lean Hog Futures
@ $96.40
18
Practical Applications
On September 16, 2011
October 2012 Lean Hog Futures
@ $86.25
19
Practical Applications
Margin Reconciliation:
Corn:
$6.63/bu x 60,000 bu.
Meal:
$354.10/ton x 400 tons
Other Feed Cost:
Non-Feed Cost:
Total Expense:
-$
-$
-$
-$
-$
July Hogs:
August Hogs:
October Hogs:
Total Revenue:
$ 194,700.00
$ 385,600.00
$ 483,000.00
$1,063,300.00
$97.35/cwt x 200,000 lbs.
$96.40/cwt x 400,000 lbs.
$86.25/cwt x 560,000 lbs.
397,800.00
141,640.00
100,000.00
331,579.00
971,019.00
25% of 3rd Quarter Marketing:
$ 92,281.00
Profit Per Animal:
$ 16.59
Profit Margin:
$ 8.177/cwt
20
Practical Applications
The producer’s open market margin for 3rd quarter 2012 marketings on
September 23, 2011 is $10.49/cwt. (assuming zero basis), just at the
80th percentile over the last 10 years and decides to execute hedges to
lock in that level on 25% of production, keeping with his policy.
The producer decides to execute three hedges:
1. A long futures position representing 60,000 bushels in September
2012 corn to protect the risk of prices rising between now and the
time when the corn is purchased from the feed mill.
2. A long futures position representing 400 tons in September 2012
soybean meal to protect the risk of prices rising between now and
the time when the meal is purchased.
3. A short futures position in July Lean Hog futures, August Lean Hog
futures, and October Lean Hog futures to protect the risk of prices
declining between now and the time when the hogs are sold to the
packer.
21
Practical Applications
On September 23, 2011 September 2012 Corn Futures are trading at
$6.08 ½/bushel. The operation executes its hedge and buys 12
September 2012 Corn futures which represents 60,000 bushels.
On September 23, 2011 March Soybean Meal Futures are trading at
$334.80/ton and the operation executes its hedge and buys 4 September
2012 Meal futures which represents 400 tons.
On September 23, 2011 July Lean Hog futures are trading at $96.90/cwt,
August Lean Hog futures are trading at $95.45/cwt, and October Lean
Hog futures are trading at $84.62/cwt. The operation executes its hedge
and sells 5 July Lean Hog futures, 10 August Lean Hog futures and 14
October Lean Hog Futures which represents 5,562 animals or 25% of total
3rd quarter production.
Upon execution of these hedges, the operation locks in a positive margin
of $10.49/cwt (assuming a zero basis for the period).
22
Practical Applications
23
Practical Applications
Margin Reconciliation:
Corn:
$6.08 ½/bu x 60,000 bu.
Meal:
$334.80/ton x 400 tons
Other Feed Cost:
Non-Feed Cost:
Total Expense:
-$
-$
-$
-$
-$
July Hogs:
August Hogs:
October Hogs:
Total Revenue:
$ 193,800.00
$ 381,800.00
$ 473,900.00
$1,049,500.00
$96.90/cwt x 200,000 lbs.
$95.45/cwt x 400,000 lbs.
$84.62/cwt x 560,000 lbs.
25% of 3rd Quarter Marketing:
365,100.00
133,920.00
100,000.00
331,579.00
930,599.00
$ 118,901.00
Profit Per Animal:
$ 21.38
Profit Margin:
$ 10.532/cwt
24
Practical Applications
The producer’s open market margin for 3rd quarter 2012 marketings on
November 18, 2011 is $13.33/cwt. (assuming zero basis), just at the 90th
percentile over the last 10 years and decides to execute hedges to lock
in that level on 25% of production, keeping with his hedge policy.
The producer decides to execute three hedges:
1. A long futures position representing 60,000 bushels in September
2012 corn to protect the risk of prices rising between now and the
time when the corn is purchased from the feed mill.
2. A long futures position representing 400 tons in September 2012
soybean meal to protect the risk of prices rising between now and
the time when the meal is purchased.
3. A short futures position in July Lean Hog futures, August Lean Hog
futures, and October Lean Hog futures to protect the risk of prices
declining between now and the time when the hogs are sold to the
packer.
25
Practical Applications
On November 18, 2011 September 2012 Corn Futures are trading at
$5.83/bushel. The operation executes its hedge and buys 12 September
2012 Corn futures which represents 60,000 bushels.
On November 18, 2011 March Soybean Meal Futures are trading at
$311.60/ton and the operation executes its hedge and buys 4 September
2012 Meal futures which represents 400 tons.
On November 18, 2011 July Lean Hog futures are trading at $98.90/cwt,
August Lean Hog futures are trading at $97.45/cwt, and October Lean
Hog futures are trading at $85.80/cwt. The operation executes its hedge
and sells 5 July Lean Hog futures, 10 August Lean Hog futures and 14
October Lean Hog Futures which represents 5,562 animals or 25% of total
3rd quarter production.
Upon execution of these hedges, the operation locks in a positive margin
of $13.33/cwt (assuming a zero basis for the period).
26
Practical Applications
27
Practical Applications
Margin Reconciliation:
Corn:
$5.83/bu x 60,000 bu.
Meal:
$311.60/ton x 400 tons
Other Feed Cost:
Non-Feed Cost:
Total Expense:
-$
-$
-$
-$
-$
July Hogs:
August Hogs:
October Hogs:
Total Revenue:
$ 197,800.00
$ 389,800.00
$ 480,480.00
$1,068,080.00
$98.90/cwt x 200,000 lbs.
$97.45/cwt x 400,000 lbs.
$85.80/cwt x 560,000 lbs.
25% of 3rd Quarter Marketing:
349,800.00
124,640.00
100,000.00
331,579.00
906,019.00
$ 162,061.00
Profit Per Animal:
$ 27.15
Profit Margin:
$ 13.337/cwt
28
Practical Applications
The producer’s open market margin for 3rd quarter 2012 marketings on
November 21, 2011 is $15.58/cwt. (assuming zero basis), at the 95th
percentile over the last 10 years and decides to execute hedges to lock
in that level on the remaining 25% of production, keeping with his hedge
policy.
The producer decides to execute three hedges:
1. A long futures position representing 60,000 bushels in September
2012 corn to protect the risk of prices rising between now and the
time when the corn is purchased from the feed mill.
2. A long futures position representing 400 tons in September 2012
soybean meal to protect the risk of prices rising between now and
the time when the meal is purchased.
3. A short futures position in July Lean Hog futures, August Lean Hog
futures, and October Lean Hog futures to protect the risk of prices
declining between now and the time when the hogs are sold to the
packer.
29
Practical Applications
On November 21, 2011 September 2012 Corn Futures are trading at
$5.69/bushel. The operation executes its hedge and buys 12 September
2012 Corn futures which represents 60,000 bushels.
On November 21, 2011 September Soybean Meal Futures are trading at
$302.70/ton and the operation executes its hedge and buys 4 September
2012 Meal futures which represents 400 tons.
On November 21, 2011 July Lean Hog futures are trading at $99.30/cwt,
August Lean Hog futures are trading at $97.92/cwt, and October Lean
Hog futures are trading at $86.00/cwt. The operation executes its hedge
and sells 5 July Lean Hog futures, 10 August Lean Hog futures and 14
October Lean Hog Futures which represents 5,562 animals or 25% of total
3rd quarter production.
Upon execution of these hedges, the operation locks in a positive margin
of $15.58/cwt (assuming a zero basis for the period).
30
Practical Applications
31
Practical Applications
Margin Reconciliation:
Corn:
$5.69/bu x 60,000 bu.
Meal:
$302.70/ton x 400 tons
Other Feed Cost:
Non-Feed Cost:
Total Expense:
-$
-$
-$
-$
-$
July Hogs:
August Hogs:
October Hogs:
Total Revenue:
$ 198,600.00
$ 391,700.00
$ 481,600.00
$1,071,900.00
$99.30/cwt x 200,000 lbs.
$97.92/cwt x 400,000 lbs.
$86.00/cwt x 560,000 lbs.
25% of 3rd Quarter Marketing:
341,400.00
121,080.00
100,000.00
331,579.00
894,059.00
$ 177,841.00
Profit Per Animal:
$ 31.97
Profit Margin:
$ 15.331/cwt
32
Practical Applications
FUTURES PERFORMANCE BOND CORN ($5.69/bu on November 21, 2011):
September 16: Bought 12 CU $6.63
September 23: Bought 12 CU $6.085
November 18:
Bought 12 CU $5.83
November 21:
Bought 12 CU $5.69
Total Futures Maintenance Requirement:
Total Futures Initial Requirement:
$ (56,400.00)
$ (23,700.00)
$ (8,400.00)
$
0.00
$ (88,500.00)
$ (96,000.00)
FUTURES PERFORMANCE BOND MEAL ($302.70/ton on November 21, 2011):
September 16: Bought 4 SMU $354.10
September 23: Bought 4 SMU $334.80
November 18:
Bought 4 SMU $311.60
November 21:
Bought 4 SMU $302.70
Total Futures Maintenance Requirement:
Total Futures Initial Requirement:
$ (20,560.00)
$ (12,840.00)
$ (3,560.00)
$
0.00
$ (36,960.00)
$ (32,000.00)
Total Performance Bond Requirement on Feed:
$ (253,460.00)
33
Practical Applications
Futures Performance Bond July Hogs ($99.30/cwt. on November 21, 2011):
September 16:
Sold 5 LHN $97.35
September 23:
Sold 5 LHN $96.90
November 18:
Sold 5 LHN $98.90
November 21:
Sold 5 LHN $99.30
Total Futures Maintenance Requirement:
$ (3,900.00)
$ (4,800.00)
$ (800.00)
$
0.00
$ (9,500.00)
Futures Performance Bond August Hogs ($97.925/cwt. on November 21, 2011):
September 16:
Sold 10 LHQ $96.40
$ (6,100.00)
September 23:
Sold 10 LHQ $95.45
$ (9,900.00)
November 18:
Sold 10 LHQ $97.45
$ (1,900.00)
November 21:
Sold 10 LHQ $97.92
$
0.00
Total Futures Maintenance Requirement:
$ (17,900.00)
Futures Performance Bond October Hogs ($86.00/cwt. on November 21, 2011):
September 16:
Sold 14 LHV $86.25
$ 1,400.00
September 23:
Sold 14 LHV $84.62
$ (7,700.00)
November 18:
Sold 14 LHV $85.80
$ (1,120.00)
November 21:
Sold 14 LHV $86.00
$
0.00
Total Futures Maintenance Requirement:
$ (7,420.00)
Total Maintenance Requirement:
Total Initial Requirement:
$ (34,820.00)
$ (121,800.00)
34
Practical Applications
Total Performance Bond Requirement Corn:
Total Performance Bond Requirement Meal:
Total Performance Bond Requirement Hogs:
$ (184,500.00)
$ (68,960.00)
$ (156,620.00)
Total Performance Bond Requirement:
$ (410,080.00)
Performance Bond Requirement per Animal:
(22,248 head)
Performance Bond Requirement per cwt:
(4,620,000 lbs.)
$ 18.43
$ 8.88/cwt.
Performance Bond Maintenance Requirement: $ (160,280.00)
Maintenance Requirement per cwt:
$ 3.47/cwt.
(Current Open Market Margin @ $15.33/cwt. minus Performance Bond
Requirement @ $3.47/cwt. = Net Profit Margin @ $11.86/cwt.)
35
Practical Applications
 Reconciling Net Margins
 Reconciling Open Market Margin
 Reconciling Futures’ Hedges
36
Practical Applications
NET MARGIN RECONCILIATION:
September 16 Margin:
September 23 Margin:
November 18 Margin:
November 21 Margin:
Net Profit Margin:
$8.177/cwt
$10.532/cwt
$13.337/cwt
$15.331/cwt
$ 92,281.00
$ 118,901.00
$ 162,061.00
$ 177,841.00
$ 551,084.00
Profit Per Animal:
$ 24.77
Profit Margin:
$ 11.84/cwt
37
Practical Applications
38
Practical Applications
On August 16, 2012
September 2012 Corn Futures
@ $7.97 ¾
39
Practical Applications
On August 16, 2012
September 2012 Soybean Meal Futures
@ $516.50
40
Practical Applications
July 2012 Lean Hog Futures
Expire @ $97.07
41
Practical Applications
August 2012 Lean Hog
Futures Expire @ $91.80
42
Practical Applications
On August 16, 2012
October 2012 Lean Hog Futures
@ $75.62
43
Practical Applications
OPEN MARKET MARGIN RECONCILIATION:
Corn:
$7.98/bu x 241,552 bu.
Meal:
$515.50/ton x 1600 tons
Other Feed Cost:
Non-Feed Cost:
Total Expense:
July Hogs:
August Hogs:
October Hogs:
Total Revenue:
$97.07/cwt x 800,000 lbs.
$91.80/cwt x 1,600,000 lbs.
$75.62/cwt x 2,240,000 lbs.
3rd Quarter Marketing:
-$1,927,585.00
-$ 824,800.00
-$ 400,000.00
-$1,326,315.00
-$4,478,700.00
$ 776,600.00
$1,468,800.00
$1,694,000.00
$3,939,400.00
-$ 539,300.00
Profit Per Animal:
-$ 24.24
Profit Margin:
-$ 11.537/cwt
44
Practical Applications
FUTURES RECONCILIATION CORN ($7.98/bu on August 16, 2012):
September 16:
September 23:
November 18:
November 21:
Hedge Gain:
Bought 12 CU $6.63
Bought 12 CU $6.085
Bought 12 CU $5.83
Bought 12 CU $5.69
$ 81,000.00
$ 113,700.00
$ 129,000.00
$ 137,400.00
$ 461,100.00
FUTURES RECONCILIATION MEAL ($515.50/ton on August 16, 2012):
September 16:
September 23:
November 18:
November 21:
Hedge Gain:
Bought 4 SMU $354.10
Bought 4 SMU $334.80
Bought 4 SMU $311.60
Bought 4 SMU $302.70
Hedge Gain on Feed:
$ 64,560.00
$ 72,280.00
$ 81,560.00
$ 85,120.00
$303,520.00
$764,620.00
45
Practical Applications
Futures Reconciliation July Hogs (Settled @ $97.07):
September 16:
September 23:
November 18:
November 21:
Hedge Loss:
Sold 5 LHN $97.35
Sold 5 LHN $96.90
Sold 5 LHN $98.90
Sold 5 LHN $99.30
$
-$
$
$
$
550.00
350.00
3,650.00
4,450.00
8,300.00
Futures Reconciliation August Hogs (Settled @ $91.80):
September 16:
Sold 10 LHQ $96.40
$ 18,400.00
September 23:
Sold 10 LHQ $95.45
$ 14,600.00
November 18:
Sold 10 LHQ $97.45
$ 22,600.00
November 21:
Sold 10 LHQ $97.92
$ 24,500.00
Hedge Gain:
$ 80,100.00
Futures Reconciliation October Hogs (Last @ $75.62):
September 16:
Sold 14 LHV $86.25
$ 59,500.00
September 23:
Sold 14 LHV $84.62
$ 50,400.00
November 18:
Sold 14 LHV $85.80
$ 56,980.00
November 21:
Sold 14 LHV $86.00
$ 58,100.00
Hedge Gain:
$224,980.00
Hedge Gain on Hogs:
$313,380.00
46
Practical Applications
Open Market Margin:
Corn Hedge Gain:
Meal Hedge Gain:
Hog Hedge Gain:
Realized Net Margin:
-$ 539,300.00
$ 461,100.00
$ 303,520.00
$ 313,380.00
$ 538,700.00
Profit per Animal:
(22,248 head)
Profit per cwt
(4,620,000 lbs.)
$ 24.21
$ 11.57/cwt
47
Commodity & Ingredient Hedging, LLC
Adding insight, innovation and
strategic value to your price
management decisions
175 W. Jackson Blvd. Suite. 1760
Chicago, IL 60604
Telephone: 312-596-7755
Email: mail@cihedging.com
Internet: www.cihedging.com
The information contained in this publication is taken from sources believed to be reliable, but is not
guaranteed by Commodity & Ingredient Hedging, LLC as to accuracy or completeness, and is intended for
purposes of information and education only. Nothing therein should be considered as a trading
recommendation by Commodity & Ingredient Hedging, LLC. The rules and regulations of the individual
exchanges should be consulted as the authoritative source on all contract specifications and regulations.
There is a risk of loss in all futures and options trading.