Chapter 5
Fundamentals of
Futures Hedging
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Futures Contracts Introduction
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Futures contracts have long been the standard for
price risk management.
In a simple contract, two people decide to trade
something. One agrees to sell and one to buy at a
specific price and time.
Futures contracts are simple contracts.
With the understanding of a few terms and concepts,
anyone can hedge or speculate with futures contracts.
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Futures Contracts
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A futures contract is nothing more than a forward
contract traded on an organized exchange.
It is open to all buyers and sellers.
It is an agreement between the buyer to accept
delivery of a product from the seller with
standardized terms.
The buyer and seller are immediately able to retrade
the contract after the contract is completed.
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Standardization and Leverage
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Figure 5-1 shows the major agricultural commodities
and the specifications on each contract.
Standardization gives futures contracts the ability to
be retraded easily.
The market is also very liquid allowing buyers and
sellers easy entry and exit of the market.
(continued)
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Standardization and Leverage
(continued)
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Leverage
– The full value of a contract generally does not have to be
advanced to get control of the contract.
– Only a portion of the value has to be posted to gain control;
this portion is called the margin.
– The margin is normally roughly 10 percent of the contract
value and is set by each exchange.
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Margin Calls
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If the contract’s value changes, the buyer is
responsible for the additional losses—known as the
margin call.
The margin will have a prespecified value called the
maintenance margin. This value is approximately 75
percent of the value of the initial margin.
The difference between the maintenance margin and
margin level is the amount of money that is allowed to
be lost before additional money is requested.
The trader can also gain paper profits as shown in
Table 5-2.
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Concept of Counterbalance
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Hedging is the process of counterbalance—one action
is offset by another.
Hedging is an attempt to overcome some aspect of risk
with another action; therefore the two actions must be
opposite.
Hedging entails having opposite cash and futures
positions.
The hope is that the losses exactly cover the gains.
Table 5-3 shows the effect of counterbalance in a
hedge.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Two Types of Hedges
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An initial sell position is called a short hedge—used
to protect against declining spot (cash) market values.
An initial buy position in the futures market is
known as a long hedge—used to protect against
increasing spot (cash) market values.
The example in Table 5-3 is a perfect short hedge.
This type of hedge is widely used in agriculture.
Table 5-4 shows a long hedge used by a food
company.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Two Types of Hedges (continued)
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Short hedges are also known as bear hedges or sell
hedges.
Long hedges are also known as bull hedges or buy
hedges.
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Absolute Price Movements
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When the price of an item changes in the cash market,
the price activity is called an absolute price
movement.
Figure 5-2 demonstrates the movements for the corn
market.
These movements are the source of price risk that
producers face.
(continued)
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Absolute Price Movements
(continued)
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Historical price information can be used to calculate
certain statistical values to help analyze the risk of the
movements.
Futures contracts have their own absolute price
movements.
Figure 5-3 exhibits futures price movements for corn.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Relative Price Movements
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Due to the need for counterbalance, cash and futures
absolute price movements exist side by side.
The importance in hedging is how the two prices
relate to each other.
Figure 5-4 shows relative price movements between
cash and futures corn prices.
The risk of relative price movements is known as
basis risk.
Hedging removes the risk of absolute price movements
and replaces it with basis risk.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Basis
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Basis values exist for every cash market.
Basis is the most important aspect of hedging to
understand.
Basis is defined as the difference between the futures
price and the cash price.
Markets that have futures prices that are higher than
cash prices are in contango—positive basis.
Markets that have the cash or spot price higher than
futures prices are in backwardation—negative basis.
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Perfect Hedges
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A perfect hedge eliminates the cash market risk and
has no basis risk effects.
Tables 5-5 and 5-6 reveal the effects of a perfect
hedge with a cash price decrease and increase
respectively.
If the beginning basis remains the same as the
ending basis, then it was a perfect hedge.
Hedgers really want imperfect hedges; in the
examples given, the hedger would have been just as
well off without hedging.
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Imperfect Hedges
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Imperfect hedges have a beginning basis and an
ending basis that are different.
Table 5-7 shows a basis change that results in a net
gain for the hedger.
Price direction is unimportant, only relative
movements between the cash and futures markets—
basis—matters.
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Imperfect Hedges (continued)
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Table 5-8 shows a basis that has deteriorated,
resulting in a net loss for the hedger.
Table 5-9 shows the results of a feed company in a
long hedge with an improving basis on their hedge.
Short hedgers want the basis to narrow, and long
hedgers want the basis to widen.
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Net Hedged Prices
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The net hedged selling price (NHSP) is equal to the final
cash selling price (FCSP) plus the net futures gain/loss
(NF).
The NHSP for Figure 5-8 would be $1.98 per bushel.
The net hedged buying price (NHBP) is equal to the final
cash buying price (FCBP) less the net futures gain/loss
(NF).
Using this formula in Table 5-9 results in a NHBP of
$1.98 per bushel.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Futures in the Grain Market and
Basis Factors
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Traders in grain range from a wheat farm hedger to
complex trading giants like Cargill.
Higher value uses for these major crops necessitate a
higher understanding of price risk management.
A factor that influences basis is the seasonality of
crops.
Seasonal movements create changes in prices and
thus changes in basis.
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Cost of Carry Model
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The cost of carry is the term used to reflect not only
the physical cost of storage but financial costs as
well.
The model is given as the price in next time period
equals the price in time period t plus the cost of carry
from t to the next time period t+1.
See Figure 5-6.
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Basis COC, COT, and
Grain Basis Model
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Basis and the Cost of Carry.
Basis and the Cost of Transportation.
See Figure 5-7.
The basis for grain crops and oilseed is the basis at
time t is equal to the futures price at time t+n less the
cash price at time t.
Estimates of basis value are very important to
hedgers.
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Production Hedge
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Production hedges need futures positions that are
short initially so that a price decrease will yield a gain
in the futures position.
Regardless of the product or time, production price
risk will always be short hedges.
Wheat producer example, Table 5-10.
– This example has the farmer under-hedged by 2,000
bushels.
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If there had been a price increase, then the farmer
would have gained in the cash market and had a loss
in the futures market, as shown in Table 5-11.
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The Decision to Over- or Under-Hedge
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A hedger should under-hedge if he believes there is a
strong probability of cash prices moving in his favor
rather than against him. He should over-hedge if the
chance that cash prices will move against him is
greater than the chance that prices will move in his
favor.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Storage Hedge
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Grain and oilseed crops can be stored for long periods
of time and often are being stored by grain elevators.
Grain elevators run the risk of declining prices after
purchase of the grain or seed.
Storage hedges are short hedges.
Table 5-12 summarizes a grain merchant using a
storage hedge.
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Forward Pricing Hedging
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Grain merchants, food processors, and feed
processors have the opportunity to forward price
grain and oilseeds.
This type of processor must be a long hedger.
Table 5-13 illustrates the hedge by a cereal
manufacturer.
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Basis Traders and Basis Contracts
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Once a hedge is properly placed, all that really
matters is the movement in basis.
Grain traders will make offers at “under” or “off,”
meaning the cash price is below the futures price. If
they offer “on” or “over,” then they are offering
above the futures price.
Table 5-14 illustrates a basis trade with a grain
merchant.
(continued)
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Basis Traders and Basis Contracts
(continued)
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A basis contract must have
– the futures contract.
– a negotiated differential for the cash commodity relative to
the futures price.
– an ending point.
– knowledge of when the title passes and how storage costs
are handled.
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Call Contracts
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A call provision added to a basis contract specifies
that the contract holder must call the broker of the
contract provider to stipulate the day the basis
contract will be exercised. Call contracts allow
certain hedgers to fix both sides of a trade.
An example of this is illustrated in Tables 5-15 and
5-16.
In a seller’s call, the call responsibility lies with the
producer.
In a buyer’s call, the call responsibility lies with the
processor.
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Crush Hedges
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Soybeans go through a crush process that separates
the raw beans into meal and oil.
Crush yields are reported on a regular basis. The
difference between the value of the meal and oil and
the price of the soybeans is called the crush margin.
A processor will enter into a type of hedge called
putting on crush when the crush margin is greater
than the cost of crushing.
The reverse crush hedge is used when the margin is
less than the cost.
See Tables 5-17 and 5-18.
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Using Futures in the
Livestock Industry
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Livestock has a rich history in the futures industry.
Live animals cannot be stored for more than a few
days before the growth and aging process changes
their form.
Live animal futures have a basis that does not follow
the cost of carry model for price differences.
Expectations of future supply and demand are the
basis components of live animal futures.
Traders resort to empirical data to get trends and
patterns. See Figure 5-8.
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Production Hedges
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Live animals go through a growing process that
subjects them to the risk of price decline.
Only slaughter-ready animals can be hedged in the
hog market. Feeder and live animals can be hedged in
the cattle market.
See Table 5-19, Hog Production Hedge
See Table 5-20, Cow-Calf Hedge
– Cross hedge: a hedge whereby the cash and futures
specifications do not match exactly
(continued)
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Production Hedges (continued)
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See Table 5-21, Feedlot Hedge
– Total hedging: the process of a manufacturer that hedges all
available outputs and inputs
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See Table 5-22, Dairy Processor Hedge
– Margin-based hedging: fixing the profit margin in advance
by hedging
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Using Nonagricultural Futures in
Agriculture
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Agribusinesses use large amounts of credit and
therefore have credit risks pertaining to changes in
interest rates.
Also agribusinesses that deal overseas have foreign
exchange risks.
Interest Rate Risk
– Several contracts exist on interest rates (see Figure 5-9).
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These contracts can be used to mitigate certain risks
with interest rates via cross hedging.
– See Table 5-23.
(continued)
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Using Nonagricultural Futures in
Agriculture (continued)
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Foreign Currency Risk
– The dollar changes value in relation to other currencies on a
continuous basis.
– The exchange rates reflect the price of one unit of currency
necessary to buy one unit of another currency.
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Table 5-24 presents an example of a U.S. cotton
merchant dealing with a Mexican mill.
If the dealer forward sells cotton for delivery in two
weeks, he covers his risk.
Proper hedging can counterbalance the currency risk.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Synopsis
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Futures contracts allow agricultural businesses and
producers to manage the risk of price change.
Contracts are simple to use to protect against
increasing or decreasing prices.
The down side is that if the price moves in favor of the
hedger, then the hedge will take the gain away.
To compensate, futures hedgers use basis trades and
speculate on when is the best time to place a hedge,
called selective hedging.
It is critical to understand the fundamentals of future
hedging as it is 90 percent of all price risk management.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation