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Using Futures Commodity Marketing Activity Chapter #4 Using Futures Commodity Marketing Activity Chapter #4

What is a Futures Contract? n n n Standardized agreement to buy or sell What is a Futures Contract? n n n Standardized agreement to buy or sell a commodity at a date in the future Commodity to be delivered Quantity Quality Delivery Point Delivery Date

Futures n n As the delivery month approaches, futures price tend to fall in Futures n n As the delivery month approaches, futures price tend to fall in line with cash market prices Anyone may buy or sell futures through brokers Obligation to take delivery on a purchased contract is removed by sell before delivery (Offsetting) Visa Versa

Hedging n n Buying or selling futures contracts as protection against the risk of Hedging n n Buying or selling futures contracts as protection against the risk of loss due to changing prices in cash market Protection against falling wheat market or rising feed cost Short Hedge: plan to sell a commodity Long Hedge: plan to buy a commodity

What is Basis? n n Relationship between local cash market and futures market price What is Basis? n n Relationship between local cash market and futures market price Basis = cash $ - futures $ a negative number is under a positive number is over

Short Hedge n n n Corn Dec. Forward cash market is $2. 30 Dec. Short Hedge n n n Corn Dec. Forward cash market is $2. 30 Dec. Future price is $2. 55 Basis is 25 cents under Sell Dec. Corn Future In Dec. Corn market price is $2. 00, Futures price is $2. 25 (25 cents under) buy back futures contract at $2. 25, sell corn for $2. 00

Short Hedge n n n Sell Future Buy Future Profit = $2. 55 $2. Short Hedge n n n Sell Future Buy Future Profit = $2. 55 $2. 25 $0. 30 n n Dec Forward Dec Cash Loss = $2. 30 $2. 00 $0. 30 You get $2. 00 on cash market plus $. 30 from futures = $2. 30

What if prices go up? n n n Sell Future Buy Future Loss = What if prices go up? n n n Sell Future Buy Future Loss = $2. 55 $2. 90 $0. 35 n n Dec Forward Dec Cash Profit = $2. 30 $2. 65 $0. 35 You get $2. 65 on cash market minus $. 35 from futures = $2. 30

Hedges If Basis strengthens: Cash=2. 30 Fut=2. 55 Basis Future $ Cash $ Fut Hedges If Basis strengthens: Cash=2. 30 Fut=2. 55 Basis Future $ Cash $ Fut Gn Net -. 15 2. 25 2. 10. 30 2. 40 -. 10 2. 25 2. 15. 30 2. 45 -. 15 2. 90 2. 75 -. 35 2. 40 -. 10 2. 90 2. 80 -. 35 2. 45 n Protected when price fell, didn’t see the profit when prices went up n

Long Hedge n n n Same as short hedge for buying inputs Protection against Long Hedge n n n Same as short hedge for buying inputs Protection against prices rising Can’t take advantage of a price decline

Margin n n Exchange clearing house requires you make a deposit to guarantee possible Margin n n Exchange clearing house requires you make a deposit to guarantee possible losses If prices change significantly, you may have to deposit more money Contract obligation is Offset when you buy or sell back Commission charged by brokers for trading contracts

Short Hedge Example: n n n Sept. you plant winter wheat and expect a Short Hedge Example: n n n Sept. you plant winter wheat and expect a 20, 000 bu crop you feel that prices are headed down $500 per contract margin deposit and commission won’t cause you a problem you sell 4 wheat futures contracts What price can you expect?

Short Hedge Example: n n n July futures price is $3. 60, forward cash Short Hedge Example: n n n July futures price is $3. 60, forward cash price is $3. 33 (27 cents under) based on experience, you expect basis to be about 16 cents under In July, futures price falls to $3. 35, cash price to $3. 20 (15 cents under) you buy back 4 futures contracts at $3. 35 (25 cent gain) sell wheat at $3. 20 and get $3. 45

Short Hedge Example: n n Overall gain is 20, 000 bu. X’s. 25 cents Short Hedge Example: n n Overall gain is 20, 000 bu. X’s. 25 cents = $5, 000 better than cash price Pay commission of $80/contract

Long Hedge Example: n n n You plant to buy 120 head of feeder Long Hedge Example: n n n You plant to buy 120 head of feeder cattle in March In Dec. indications are that prices will rise You buy 2 feeder cattle futures (88, 000#) at $66/cwt Futures price goes up to $68. 90 in Mar. , and cash price is $67 You sell back futures contracts @ $68. 90 Price you pay is $67 minus $2. 90 gain in futures market = $64. 10

Long Hedge Example: n n You have reduced your cost by $2, 552 from Long Hedge Example: n n You have reduced your cost by $2, 552 from the cash price minus commission of $75 /contract should have a definite plan should have a target price