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ECON 339 X: Agricultural Marketing Chad Hart Assistant Professor chart@iastate. edu 515 -294 -9911 ECON 339 X: Agricultural Marketing Chad Hart Assistant Professor [email protected] edu 515 -294 -9911 Econ 339 X, Spring 2011 John Lawrence Professor [email protected] edu 515 -294 -7801

Margin Accounts A margin account is an account that traders maintain in the market Margin Accounts A margin account is an account that traders maintain in the market to ensure contract performance. There are minimum limits on the size of the account. Crop Corn Soybeans Trader Type Hedger Speculator Initial $1, 500 $2, 025 $3, 250 $4, 388 Maintenance $1, 500 $3, 250 To trade, you must create a margin account with at least the “Initial” amount and maintain at least the “Maintenance” amount in the account at the end of each trading day. Econ 339 X, Spring 2011

Margin Calls ØMargin accounts are rebalanced each day ØDepending on the value of futures Margin Calls ØMargin accounts are rebalanced each day ØDepending on the value of futures ØIf your futures are losing value, money is taken out of the margin account to cover the loss ØIf the account value falls below the “Maintenance” level, you receive a margin call (a call to put additional money in your margin account) ØIf your futures position is gaining value, money is put into your margin account Econ 339 X, Spring 2011

Margin Example ØEarlier, I went long on Dec. 2011 corn Ø$5. 48/bushel on 1/11/11 Margin Example ØEarlier, I went long on Dec. 2011 corn Ø$5. 48/bushel on 1/11/11 ØLet’s say I’m a farmer, so I am considered a hedger ØAlong with buying a corn futures contract, I have to establish a margin account and deposit $1, 500 in it ØOn 1/12/11, the Dec. 2011 corn futures price moved to $5. 60/bushel ØSince I’ll be selling the futures contract later, this price move is in my favor Econ 339 X, Spring 2011

Margin Example ØI gained 12 cents per bushel and since the contract is for Margin Example ØI gained 12 cents per bushel and since the contract is for 5, 000 bushels, that’s a gain of $600 ØAt the end of the day (1/12/11), $600 is deposited into my margin account, raising the account balance to $2, 100 ØSince $2, 100 is greater than the “Maintenance” level, I will not receive a margin call Econ 339 X, Spring 2011

Margin Example #2 ØEarlier, I also went short on Nov. 2011 soybeans Ø$12. 73/bushel Margin Example #2 ØEarlier, I also went short on Nov. 2011 soybeans Ø$12. 73/bushel on 1/11/11 ØAlong with selling a soybean futures contract, I have to establish a margin account and deposit $3, 250 in it ØOn 1/12/11, the Nov. 2011 soybean futures price moved to $13. 08/bushel ØSince I’ll be buying back the futures contract later, this price move is not in my favor Econ 339 X, Spring 2011

Margin Example #2 ØI lost 35 cents per bushel and since the contract is Margin Example #2 ØI lost 35 cents per bushel and since the contract is for 5, 000 bushels, that’s a loss of $1, 750 ØAt the end of the day (1/12/11), $1, 750 is be taken from my margin account, lowering the account balance to $1, 500 ØSince $1, 500 is less than the “Maintenance” level, I will receive a margin call and be asked to deposit $1, 750 more into the account or to close out the futures position ØThe $1, 750 brings the account balance back up to the initial requirement Econ 339 X, Spring 2011

Margin Example #2 Date Price Gain Margin Call Account Balance $3, 250 $1, 750 Margin Example #2 Date Price Gain Margin Call Account Balance $3, 250 $1, 750 $3, 250 1/11/11 $12. 73 1/12/11 $13. 08 -$1, 750 1/13/11 $13. 00 +$400 $3, 650 1/14/11 $13. 05 -$250 $3, 400 1/18/11 $13. 10 -$250 Econ 339 X, Spring 2011 $100 $3, 250

Market Participants Ø Hedgers are willing to make or take physical delivery because they Market Participants Ø Hedgers are willing to make or take physical delivery because they are producers or users of the commodity ØUse futures to protect against a price movement ØCash and futures prices are highly correlated ØHold counterbalancing positions in the two markets to manage the risk of price movement Econ 339 X, Spring 2011

Hedgers Ø Farmers, livestock producers Ø Merchandisers, elevators Ø Food processors, feed manufacturers Ø Hedgers Ø Farmers, livestock producers Ø Merchandisers, elevators Ø Food processors, feed manufacturers Ø Exporters Ø Importers What happens if futures market is restricted to only hedgers? Econ 339 X, Spring 2011

Market Participants Ø Speculators have no use for the physical commodity ØThey buy or Market Participants Ø Speculators have no use for the physical commodity ØThey buy or sell in an attempt to profit from price movements ØAdd liquidity to the market Ø May be part of the general public, professional traders or investment managers ØShort-term – “day traders” ØLong-term – buy or sell and hold Econ 339 X, Spring 2011

Market Participants Ø Brokers exercise trade for traders and are paid a flat fee Market Participants Ø Brokers exercise trade for traders and are paid a flat fee called a commission Ø Futures are a “zero sum game” ØLosers pay winners ØBrokers always get paid commission Econ 339 X, Spring 2011

Hedging Ø Holding equal and opposite positions in the cash and futures markets Ø Hedging Ø Holding equal and opposite positions in the cash and futures markets Ø The substitution of a futures contract for a later cash-market transaction Ø Who can hedge? ØFarmers, merchandisers, elevators, processors, exporter/importers Econ 339 X, Spring 2011

Cash vs. Futures Prices Iowa Corn in 2010 Econ 339 X, Spring 2011 Cash vs. Futures Prices Iowa Corn in 2010 Econ 339 X, Spring 2011

Short Hedgers Ø Producers with a commodity to sell at some point in the Short Hedgers Ø Producers with a commodity to sell at some point in the future ØAre hurt by a price decline Ø Sell the futures contract initially Ø Buy the futures contract (offset) when they sell the physical commodity Econ 339 X, Spring 2011

Short Hedge Example Ø A soybean producer will have 25, 000 bushels to sell Short Hedge Example Ø A soybean producer will have 25, 000 bushels to sell in November Ø The short hedge is to protect the producer from falling prices between now and November Ø Since the farmer is producing the soybeans, they are considered long in soybeans Econ 339 X, Spring 2011

Short Hedge Example Ø To create an equal and opposite position, the producer would Short Hedge Example Ø To create an equal and opposite position, the producer would sell 5 November soybean futures contracts Ø Each contract is for 5, 000 bushels Ø The farmer would short the futures, opposite their long from production Ø As prices increase (decline), the futures position loses (gains) value Econ 339 X, Spring 2011

Short Hedge Example Ø As of Tuesday, Nov. 2011 soybean futures Historical basis for Short Hedge Example Ø As of Tuesday, Nov. 2011 soybean futures Historical basis for Nov. Rough commission on trade Expected local hedged price ($ per bushel) 12. 73 -0. 25 -0. 01 12. 47 Ø Come November, the producer is ready to sell soybeans Ø Prices could be higher or lower Ø Basis could be narrower or wider than the historical average Econ 339 X, Spring 2011

Prices Went Up, Hist. Basis Ø In November, buy back futures at $14. 00 Prices Went Up, Hist. Basis Ø In November, buy back futures at $14. 00 per bushel Nov. 2011 soybean futures Actual basis for Nov. Local cash price Net value from futures ($ per bushel) 14. 00 -0. 25 13. 75 -1. 28 ($12. 73 - $14. 00 - $0. 01) Net price Econ 339 X, Spring 2011 12. 47

Prices Went Down, Hist. Basis Ø In November, buy back futures at $10. 00 Prices Went Down, Hist. Basis Ø In November, buy back futures at $10. 00 per bushel Nov. 2011 soybean futures Actual basis for Nov. Local cash price Net value from futures ($ per bushel) 10. 00 -0. 25 9. 75 +2. 72 ($12. 73 - $10. 00 - $0. 01) Net price Econ 339 X, Spring 2011 12. 47

Short Hedge Graph Hedging Nov. 2011 Soybeans @ $12. 73 Econ 339 X, Spring Short Hedge Graph Hedging Nov. 2011 Soybeans @ $12. 73 Econ 339 X, Spring 2011

Prices Went Down, Basis Change Ø In November, buy back futures at $10. 00 Prices Went Down, Basis Change Ø In November, buy back futures at $10. 00 per bushel Nov. 2011 soybean futures Actual basis for Nov. Local cash price Net value from futures ($ per bushel) 10. 00 -0. 10 9. 90 +2. 72 ($12. 73 - $10. 00 - $0. 01) Net price Ø Basis narrowed, net price improved Econ 339 X, Spring 2011 12. 62

Long Hedgers Ø Processors or feeders that plan to buy a commodity in the Long Hedgers Ø Processors or feeders that plan to buy a commodity in the future ØAre hurt by a price increase Ø Buy the futures initially Ø Sell the futures contract (offset) when they buy the physical commodity Econ 339 X, Spring 2011

Long Hedge Example Ø An ethanol plant will buy 50, 000 bushels of corn Long Hedge Example Ø An ethanol plant will buy 50, 000 bushels of corn in December Ø The long hedge is to protect the ethanol plant from rising corn prices between now and December Ø Since the plant is using the corn, they are considered short in corn Econ 339 X, Spring 2011

Long Hedge Example Ø To create an equal and opposite position, the plant manager Long Hedge Example Ø To create an equal and opposite position, the plant manager would buy 10 December corn futures contracts Ø Each contract is for 5, 000 bushels Ø The plant manager would long the futures, opposite their short from usage Ø As prices increase (decline), the futures position gains (loses) value Econ 339 X, Spring 2011

Long Hedge Example Ø As of Tuesday, Dec. 2011 corn futures Historical basis for Long Hedge Example Ø As of Tuesday, Dec. 2011 corn futures Historical basis for Dec. Rough commission on trade Expected local net price ($ per bushel) 5. 48 -0. 25 +0. 01 5. 24 Ø Come December, the plant manager is ready to buy corn to process into ethanol Ø Prices could be higher or lower Ø Basis could be narrower or wider than the historical average Econ 339 X, Spring 2011

Prices Went Up, Hist. Basis Ø In December, sell back futures at $6. 00 Prices Went Up, Hist. Basis Ø In December, sell back futures at $6. 00 per bushel Dec. 2011 corn futures Actual basis for Nov. Local cash price Less net value from futures -($6. 00 - $5. 48 - $0. 01) Net cost of corn ($ per bushel) 6. 00 -0. 25 5. 75 -0. 51 5. 24 Ø Futures gained in value, reducing net cost of corn to the plant Econ 339 X, Spring 2011

Prices Went Down, Hist. Basis Ø In December, sell back futures at $4. 00 Prices Went Down, Hist. Basis Ø In December, sell back futures at $4. 00 per bushel Dec. 2011 corn futures Actual basis for Nov. Local cash price Less net value from futures -($4. 00 - $5. 48 - $0. 01) Net cost of corn ($ per bushel) 4. 00 -0. 25 3. 75 +1. 49 5. 24 Ø Futures lost value, increasing net cost of corn Econ 339 X, Spring 2011

Long Hedge Graph Hedging Dec. 2011 Corn @ $5. 48 Econ 339 X, Spring Long Hedge Graph Hedging Dec. 2011 Corn @ $5. 48 Econ 339 X, Spring 2011

Prices Went Down, Basis Change Ø In December, sell back futures at $4. 00 Prices Went Down, Basis Change Ø In December, sell back futures at $4. 00 per bushel Dec. 2011 corn futures Actual basis for Dec. Local cash price Less net value from futures -($4. 00 - $5. 48 - $0. 01) Net cost of corn ($ per bushel) 4. 00 -0. 10 3. 90 +1. 49 5. 39 Ø Basis narrowed, net cost of corn increased Econ 339 X, Spring 2011

Hedging Results Ø In a hedge the net price will differ from expected price Hedging Results Ø In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis. Ø So basis estimation is critical to successful hedging. Ø Narrowing basis, good for short hedgers, bad for long hedgers Ø Widening basis, bad for short hedgers, good for long hedgers Econ 339 X, Spring 2011

Class web site: http: //www. econ. iastate. edu/~chart/Classes/econ 339/ Spring 2011/ Econ 339 X, Class web site: http: //www. econ. iastate. edu/~chart/Classes/econ 339/ Spring 2011/ Econ 339 X, Spring 2011