Price Risk Management for Cattle
Producers
 Why
worry about price risk
 Futures
 Forward Contract
 Options
 Insurance
Feedlot Profit Factors
Steer feeding profit variation explained (%)
Placement wt
<600
700-800
Fed price
58.07
50.46
Feeder price
2.30
19.31
Corn price
5.29
4.19
Feed/gain
7.22
3.55
ADG
1.36
6.31
Interest rate
1.55
-.38
Total explained
75.79
83.44
Fed Cattle Price Forecast Error, 1995-2004:
Seasonal Index and Basis Adjusted Futures
Quarters
Index
Index Futures Futures
Out
Average Std Dev Average Std Dev
1
2
3
4
-0.26
-0.37
-0.11
0.56
5.24
6.18
6.29
5.89
http://www.econ.iastate.edu/faculty/lawrence/
0.05
0.59
0.95
0.80
3.86
4.97
6.33
6.89
68% of time
16%
SD
SD
16%
Risk Management Tools
 Futures
market
– Hedging cattle, feeders and/or corn
 Options
market
– Buy a Live cattle(LC) Put
– Buy a Corn Call and a Feeder cattle(FC) Call
 Forward
Contract
 Livestock Revenue Insurance
– Livestock Risk Protection (LRP)
– Livestock Gross Margin (LGM)
Futures Market Exchanges
 Chicago
Mercantile Exchange
 Centralized pricing
– Buyers and sellers represented by brokers in
the pits
– All information represented through bids and
offers
 Perfectly
competitive market
– Open out-cry trading
– Electronic trading
The futures contract
A
legally binding contract to make or take
delivery of the commodity
– Trading the promise to do something in the
future
– You can “offset” your promise
 Standardized
contract
– Form (wt, grade, specifications)
– Time (delivery date)
– Place (delivery location)
Standardized contract
 Certain
delivery (contract) months
 Fixed size of contract
– Grains 5,000 bushels
» Corn, Wheat, Soybeans
– Livestock in pounds
» Lean Hogs 40,000 lbs carcass
» Live Cattle 40,000 lbs live
» Feeder Cattle 50,000 lbs live
 Specified
delivery points
– Relatively few delivery points
The futures contract
 No
physical exchange takes place when the
contract is traded.
 Payment is based on the price established
when the contract was initially traded.
 Deliveries are made when the contract
expires (delivery time).
Hedging definition
 Holding
equal and opposite positions in
the cash and futures markets
 The substitution of a futures contract for
a later cash-market transaction
Terms and Definitions
 Basis
– The difference between the spot or cash price
and the futures price of the same or a related
commodity.
 Margin
– The amount of money or collateral deposited
by a client with his or her broker for the
purpose of insuring the broker against loss on
open futures contracts.
Hedging Example
 April
–
–
–
–
1, plan to market cattle in Dec.
December LC futures on 4/1
Expected basis in October
Commission
Expected hedge price
$126.08
-2.26
-.15
$123.67
Hedging Example
 Now
Dec 10 and the cattle are ready to sell.
 Higher prices, Same basis
–
–
–
–
–
–
–
Dec futures on 12/10
Actual basis in Dec
Cash price received for cattle
Offset futures: 126.08-130=
Commission
Futures gain/loss:
Net hedge price:
$130.00
-2.26
$127.74
-3.92
-.15
-4.07
$123.67
Hedging Example
 Now
Dec 10 and the cattle are ready to sell.
 Lower prices, Same basis
–
–
–
–
–
–
–
Dec futures on 12/10
Actual basis in Dec
Cash price received for cattle
Offset futures: 126.08-120=
Commission
Futures gain/loss:
Net hedge price:
$120.00
-2.26
$117.74
6.08
-.15
+5.93
$123.67
Hedging results
 In
a hedge the net price will differ from
expected price only by the amount that the
actual basis differs from the expected basis.
 Basis estimation is critical to successful
hedging
Futures Summary
 Today’s
price for delivery in future
 Standardized contract/promise to make or
take delivery
 Contract/promise can be offset
 Several participants for different positions
 Basis estimation important to hedgers
Forward Contracts
 Contract
for delivery
– Defines time, place, form
 Tied
to the futures market
– Buyer offering the contract must lay off the
market risk elsewhere
– The buyer does the hedging for you
Forward contract advantages
 No
margin account or margin call
 Working with local people
 Flexible sizes
 Known basis
 Tangible
 Simple
Forward contract disadvantage
 Inflexible
– Replace price risk with production risk
– Difficult to offset
– Must deliver commodity
 Buyer
“takes protection”
– The known basis may be wider
Options
Function like “price insurance”
Put option
 Right (no obligation)
to sell at a specified
strike price
 Sets a price floor

Call option
 Right (no obligation)
to buy at a specified
strike price
 Sets a price ceiling

Hedger’s Price Floor
 In
April for cattle to sell in Dec
 Buy Dec Put with strike price=
–
–
–
–
Premium for this strike
Expected basis
Commission
Floor price
$126.00
-$6.83
-$2.26
-$0.15
$116.76
Hedger’s Price Floor
It is now Dec, futures went up
Futures price $130.00
Cash price $130.00futures-2.26basis
$127.74
Value of 126 put
$0
Cost of put $6.83premium +.075commision -$7.91
Net cash price
$119.83
Hedger’s Price Floor
It is now Dec, futures went down
Futures price $120.00
Cash price $120.00futures-2.26basis
$117.74
Value of 126 put
$6.00
Cost of put $6.83premium +.075commision -$7.91
Net cash price
$116.76
Call option example
A
finisher wants to buy corn to feed after harvest.
1) In May, buy a $6.00 Dec Corn Call
Expected basis =
-$0.25
Premium =
$0.20
Commission =
$0.01
Expected maximum price (EMP) or Ceiling =
SP + Basis + Prem + Comm
= $5.96
Call option example Higher
3) At harvest futures prices higher.
Futures =
$7.15
Cash market =
$6.90
Option value = $7.15-6.00 =
$1.15
Net price = Cash - Return + Cost
= $6.90 – 1.15 +0.20 + 0.01 = $5.96
Call option example Lower
2) At harvest futures prices lower.
Futures =
$5.50
Cash market =
$5.25
Option value =
$0
Net price = Cash - Return + Cost
= $5.25 - 0 + 0.20 + 0.01 =
$5.46
Option Summary
 Buyers
have known cost and unlimited
potential
 Sellers have limited potential and
unlimited risk
 Still have basis risk
Livestock Risk Protection
 Guarantees
price level only, not production
 Coverage levels 70% to 100%
 Any number of head…
 Maximum per SCE is 5,000 head; 10,000 head
per crop year (July 1 – June 30)
 Producer selects coverage level and end date
close to when cattle are expected to go to
market
 Weeks out: 13, 17, 21, 25, etc.
Livestock Gross Margin
Insures a “margin” between revenue and
cost of major inputs
Cattle
Value of cattle – feeder cattle and corn
Hogs
Value of hog – corn and SBM costs
Protects against decreases in cattle/hog
prices and increases in input costs
Cattle Livestock Gross Margin




Insurance period is 11 months with no cattle insured in 1st
month
Producer selects number of cattle to be covered during
each month of the insurance period and a deductible off
the expected margin
Producer chooses deductible amount from $0 to $150 per
head in $10 increments off the expected margin
Maximum of 2000 hogs insured in any insurance period;
4000 cattle in a year; no minimum number
Who can benefit from
LRP/LGM?
 Producers
who depend on the daily cash
market or a formula related to it.
 Producers with low cash reserves.
 Producers who do not have the volume to use
futures contracts or put options.
 Producers who prefer insurance to the
futures market. No margin account.
Summary
 Increased
risks = greater wins and losses
 Measure risk tolerance, then set margins
 You can’t insure your way to
profitability