Facilitator’s Notes – Hedging
AgVentures
Grain Marketing
Facilitator’s Notes
Hedging in the Futures Market
TIME ALLOWED: 45-50 minutes.
INTRODUCTION:
The given power point presentation is long. You should be able to remove some extra examples
and certain portions of the presentation that are given in the power point slides depending upon
your anticipated knowledge of the audience with regard to futures markets in order to meet the
time limit stated. In conjunction with the power point slides the following script will enable the
facilitator to give basic understanding about hedging to the seminar or workshop participants.
OBJECTIVE(S):
1. Understand how to use the futures contracts in grain price risk management.
2. Understand the mechanics of hedging using few examples: Especially short hedges such
as pre-harvest and storage hedges.
3. Provide thorough understanding of why hedging works.
INSTRUCTIONS:
The following are some suggestions that can aid the facilitator in presenting the material well.
1. Read the document on Hedging that is given in the grains curriculum.
2. Order the following publications directly from the CBT (Chicago Board of Trade) web
site to share with the seminar participants. These publications can be downloaded from
the web site or ordered by following the directions provided. (3-5 days needed to receive
the printed materials from the exchange. 25 copies or below can be supplied at free of
cost).
a. Web address: www.cbot.com
b. From the main page: go to the knowledge center and click on education.
c. Follow the directions from here.
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Facilitator’s Notes – Hedging
3. The following publications are recommended.
a. A Home Study Course: Agricultural Options and Futures. (Needs to order)
b. Any other publications that you want to share with the audience should be
downloaded or ordered.
Slide 1:
Start by asking what are the various risks that producers experience in their business?
Ask the participants whether they have used futures markets to manage price risk or not?
Assume the audience had basic understanding about the futures markets.
Slide 2:
Say that the farmers have two kinds of risk while marketing their products. One is economic risk
(due to changes in the prices that makes the value of the inventories to fluctuate) and other one is
physical product risk such as product destruction in quality while in storage.
Risk management is a marketing function – facilitative function. A facilitative function is one
that makes the marketing of grain without much friction. When you transfer the price risk to
someone else using the futures markets, these markets are helping or facilitating in transfer of the
risk and are aiding in better marketing of grain.
High risk and high return; Low risk and low return. We often hear these statements that are true.
For a producer risk is a business cost where as for someone else, for a speculator, risk taking is
for a profit.
As a producer you have unavoidable risk – price risk. You do not have control over the prices
because producers are price takers in the market place. For you risk transfer is desirable and
doing so will lead to profits.
Slide 3:
This slide provides some examples of risk management strategies that each one of us are familiar
with in our normal life.
Slide 4:
Grain farmers experience two risks such as production risk and price risk. Here are typical cases.
Production risk can be controlled by crop insurance but how about price risk? Let us see few
marketing tools that are available to the farmers to manage price risk.
Slide 5:
Here, read the list the things on the slide. Most of the producers know about cash sales. But
selling in the cash market does not result in profits because the prices tend to be low. Other
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Facilitator’s Notes – Hedging
marketing tools such as forward cash and basis contracts, minimum price contracts can be used
besides hedging using the futures and options markets.
Mention that the focus of this session is on using futures markets to hedge. Participants can know
more about the forward contracts, minimum price contracts and options in later sessions or by
reading through the grain curriculum.
Slide 6:
Ask the participants about the futures exchanges such as to name couple of exchanges, what
kinds of products are traded there? Etc.,
Ask the participants what is futures contract is and what is meant by futures price? What is the
difference between cash price and futures price?
Explain a little bit about how the futures markets will work (you should read through the hedging
module). This may be new material for some producers but most of them already know the
mechanics or operations of futures exchanges (the materials that you downloaded or ordered
from the CBT exchange should be distributed to aid in learning of the markets). If many of them
do not know how margin accounts work you can use the next set of slides to explain the
situations.
Slide 7 & 8:
Explain how the margining process works.
Here, assume that your broker requires you to put an initial margin of $500 to trade one corn
contract and specifies that the maintenance margin is $350. If the account value falls below the
maintenance margin you receive a margin call and need to bring back the account value to the
initial margin. Every day following your initial action (buy or sell), as the prices of corn change,
your account balance will be adjusted (marked to the margin – gains will be deposited and losses
will be taken away on a daily basis from your account).
Let us see the first example: On 17th January you sold a July corn contract when the futures are
trading at $2.50. You had deposited $500 as initial margin into your margin account. Next day,
i.e. 18th January the price of the futures contract went up by two cents to $2.52. This means you
have lost 2 cents for every bushel you have sold through a futures contract i.e. you had a loss of
$100 (5000 bushels in a contract times two cents). You account balance will be adjusted to $400.
Like wise if the price has gone up to $254 on 19th January, you experienced another $100 loss.
After adjusting your account balance is at $300 that is below the maintenance margin. Hence you
receive a margin call to the amount of $200 to bring back your account value to initial margin.
You can follow the example further and explain when the account values goes up above $500 the
account holder is free to withdraw the money.
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Show using the two examples, one starting with selling the contract first and another with buying
the contract, the facilitator should show the audience when the margin calls will be issued and
when an account holder can withdraw the money.
Slide 9:
Explain about the two broad groups of futures market participants, speculators and hedgers, and
their motivations to participate in the markets. Emphasis should be placed on the role that the
speculators play in these markets.
Slide 10:
Hedge definition should be given here. Explain that the hedges work because that loss in one
market will be offset by gain in another market. Remind the audience that the futures and cash
prices move together because both are influenced by the same fundamental factors. As we loose
on one side of the transaction we will make gains on the other side and that is what the hedging
is all about.
Slide 11:
Before a producer attempt to hedge he should ask the set of questions given on this slide. Here
knowing the costs of production and knowing the timing of sale are important.
Slide 12:
This slide provides few hedging guidelines.
Slide 13:
This shows the production and marketing periods for a crop and shows the price risk that a
producer experiences. These price risks can be managed by using futures hedge. Now let us look
at an example to understand how the hedges work.
Slide 14:
Go over the corn example.
Here this is a perfect hedge situation in corn, when the prices fell from November to December
the basis remained constant.
Make sure that the audience will understand by hedging the return to hedge was above the cash
price due to gain from futures transactions.
Slide 15:
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In a perfect hedge situation the basis risk is zero. But in the real world there will be basis risk
that will be shown in other examples that follow shortly.
Slide 16:
Let us consider the case where the prices improve from the time we placed the hedge and
removed it. Go over the example.
Make sure that the audience will understand by hedging the return to hedge was below the cash
price due to loss from futures transactions. So hedging prevents from taking advantage of rising
cash prices.
Slide 17:
This example will show the effect of changing basis on the final outcome. This hedge is an
imperfect hedge because the change in the cash price is ten cents where as futures price differ
only by five cents from selling price to that of buying price. As the basis weakened by 5 cents
from 50 cents to 55 cents the net return on hedge was only $1.95 rather than target price of
$2.00.
Here it is vital to understand how the changes in basis will affect the hedge results.
Slide 18:
A successful hedger will be able to predict the basis patterns. He uses the markets to avoid the
price risk. By taking equal and opposite positions in the cash and futures markets losses will be
offset by gains from other. There will be no tears or regrets with the outcome of the results as he
was able to manage the price risk by initiating hedge positions.
Slide 19:
There are three different kinds of hedges: Short hedge, Long hedge and Texas ‘hedge’. A short
hedger is one who is having cash grain (bought condition) and like to control the price risk by
selling futures contract first (short: selling futures first to initiate a hedge), before he sells the
grain later and lifts the hedge. Opposite to short hedger is long hedger situation. A long hedger
buys the futures contracts first, when initiating the hedge.
Texas ‘hedge’ is not a hedge. It is extreme form of speculation where the producer takes similar
positions in both the markets. It should be avoided at all costs.
Slide 20:
Again, here are three kinds of hedges that farmers place. A perfect hedge is a case normally
presented in a text book. In real world there is always the basis risk. Most of the hedges that
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farmers place are short hedges. They sell the futures contracts first to protect the falling prices
for the grain they are going to sell in the future.
Slide 21 & 22:
Let us look at an example of storage hedge. A storage hedge is a short hedge. Narrowing or
strengthening basis will help the final outcome.
From the example given on slide 22 show that the basis has narrowed or strengthened by 40
cents. This strengthening basis has led to the storage return.
Slide 23 & 24:
The storage return is equal to change in the basis over the storage period. A strengthening basis
will help the hedger. So in hedging the basis determines the success of a hedge.
Slide 25:
Here is another example of corn storage hedge with different time periods and prices. Here the
facilitator should show how the forward price and storage profits were calculated.
Slide 26 & 27:
These sets of slides will provide what is pre-harvest hedge with an example. In the example
given on the slide-27 explain that basis forecast or estimated basis was used to set the spring
target price. When the final basis happens to be the same as estimated basis the hedger was able
to attain the spring target price as the final price.
Slide 28:
This pre-harvest hedge example will show how to lock in a profit if a producer knows his
production costs and able to anticipate the basis.
Slide 29:
On this slide calculation of return to a hedge was shown in a template form using a different set
of numbers. You should remind the audience that the commission or brokerage fee is not taken
into consideration in calculating the final price because these amounts to very small in value
(0.01 cent or less).
Slide 30:
This is another example of short hedge showing a much longer time period including pre-harvest
and storage times.
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Slide 31:
The following are some of the reasons for most of the farmers not using futures hedges. The
most important thing is lack of knowledge or having false knowledge (heard bad stories) about
these markets. These are all due to lack of understanding and disciplined approach towards grain
marketing. The futures markets are here to fulfill several economic functions of which price risk
transfer is one.
Slide 32:
There are several other marketing tools that enable a producer to become a better marketer. You
will learn about these in subsequent sessions or read in the grain curriculum.
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Exercises
Exercise 1: Futures Contract



Develop an understanding of the mechanics of futures contracts
Learn how the futures and cash markets interact
Discover how selling below and above the futures contract price effects the net price
a) During March, 2002 you sell a December futures contract for soybeans at $5.10. You close
out the contract in December and sell cash beans at the Grainville Elevator in the same month.
The CBOT price at the time is $4.80. The local December basis is $0.30. Calculate your net
price on the soybeans.
Answer:
From the futures market transaction:
Sell December futures during March, 2002 at $ 5.10
Later Buy the December futures at the close of hedge at $4.80
Therefore, gain from the futures market is $5.10-$4.80 = $0.30
In the cash market:
Sell the beans in Cash market where the cash price equals the December futures price minus
local basis for that month. The cash price received = $ 4.50 ($4.80 - $0.30).
To arrive at the final net selling price we should add or deduct any profit or loss coming from the
futures market transactions. Here we made a profit of $0.30 which we will add to the cash price
to arrive at the final net selling price of $4.80.
Note: This is the example of a short hedge or selling hedge. The producer initiated the hedge by
selling the futures contract first because he feared that in future the prices will go down. In fact
when the market declined he received a net selling price of $4.80 which is far better than the
cash price of $4.50 at the time of actual sale. He should be glad that he went into the futures
market that gave him profit when the prices went down.
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Facilitator’s Notes – Hedging
b) Calculate the net price received for the beans if the CBOT price is $5.40 at the time you close
the contract and sell the beans.
From the futures market transaction:
Sell December futures during March, 2002 at $ 5.10
Later Buy the December futures at the close of hedge at $5.40
Therefore, loss from the futures market is $5.40-$5.10 = - $0.30
In the cash market:
Sell the beans in Cash market where the cash price equals the December futures price minus
local basis for that month. The cash price received = $ 5.10 ($5.40 - $0.30).
To arrive at the final net selling price we should add or deduct any profit or loss coming from the
futures market transactions. Here we made a loss of $0.30 that we should deduct to the cash price
to arrive at the final net selling price of $4.80.
Note: In this case the prices went up since the selling of the futures contract. In fact when the
market increased he received a net selling price of $4.80 that is worse than the cash price of
$5.10 at the time of actual sale. He should be unhappy that he went into the futures market that
gave him loss when the prices went up. He must be thinking that he should have stayed back in
the cash market without hedging i.e. speculate that the prices will go up in the future.
From this problem, You all should understand that hedging not only allow you protection from
falling prices but also prevents you from taking advantage of the rising prices.
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Exercise 2: Futures Contracts


Learn how futures contracts and local basis interact to create marketing opportunities
Learn how to calculate net selling price
Assume that in August when his crop looks quite favorable, a farmer observes that the futures
market is offering $3.25 per bushel for December delivery of corn. He knows from the historical
basis records that he kept the basis is 10 cents under the December futures contract. He lifts the
hedge November when the December futures are trading at $3.10.
Question:
By hedging in the December futures at what price he can lock in if there is no basis
risk?
Answer:
By hedging in the December futures he can lock in a price of $3.15 for his corn if
there is no basis risk. The estimated selling price = futures price – estimated basis i.e.
$3.15 ($3.25 – $0.10).
Had the farmer not used the futures market to establish a selling price he would have
received only the local harvesting cash price of $3.00 per bushel and also the basis
did not change from that of anticipated.
Question:
What is the final net selling price if the basis at the time of actual sale is minus 20
cents?
Answer:
The basis weakened from minus 10 to minus 20. A weakening of 10 cents in the
basis level. The net selling price is $3.05.
Cash price at the time of sale will be $2.90 ($3.10-$0.20)
Profit from futures transactions will be $0.15 ($3.25 - $3.10)
Final net selling price $3.05 ($2.90 + $ 0.15)
Had the farmer not used the futures market to establish a selling price he would have
received only the local harvesting cash price of $2.90 per bushel and also the basis
weakened by 10 cents from that of anticipated giving a net selling price of $3.05.
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Exercise 3: Futures Contracts

Discover the risks that are incurred when cash sales are disconnected from the
corresponding futures positions
A) You have 3,000 bushels of soybeans to market. You sell a futures contract for March beans
(see CBOT price data sheet). You close the contract and sell cash beans in late February at
Grainville Elevator. The CBOT price at the time is $5.41. Using the Grainville basis calculated
in Exercise 1, what price did you net on the beans?
Answer:
Initial action: Sell March futures contract for beans at $5.28 (taken from the CBOT price data
sheet).
Later action:
Buy the March futures contract at $5.41 to offset the futures position. So the loss from the
futures market is $0.13
In February the historical basis is minus $0.22 in the local market. Using the historical basis to
be the actual basis the cash price will be $5.19 that is the difference between $5.41 and $0.22.
So the net selling price is $5.06 that is the cash selling price minus the loss coming from the
futures transactions.
B) The market looks very strong in February when you close out your futures position ($5.41).
You decide to hold onto the beans. You end up selling them to Grainville Elevator in June when
the CBOT price is $5.02. What price did you net on your beans?
Initial action: Sell March futures contract for beans at $5.28 (taken from the CBOT price data
sheet).
Later action:
Buy the March futures contract at $5.41 to offset the futures position. So the loss from the
futures market is $0.13.
In June the local basis is minus $0.42 and the CBOT futures price is $5.02. From these two we
can calculate the cash price he sold the beans in June and that is $4.60 ($5.02-$0.42).
He had a loss of $0.13 from the futures transactions which we should deduct from the cash price
he sold the beans during June to arrive at the final net selling price of $4.47.
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Note: Closed the hedge in February and started speculating on the price by holding on to the
beans. Even though the cash prices went up during the hedged period, the prices dropped
considerably since lifting the hedge that led to very low cash price. For period that he hedged, in
the futures markets he made a loss due to price increase. All these contributed to the poor results.
He needs have discipline and be very careful not to mix hedging with speculation whose goals
were different.
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