Hedging Not to Make Money But Cut Risk

By Jane Fyksen, Crops Editor
Thursday, March 22, 2007 1:27 PM CDT

Third in series

Like relying on car insurance to "hedge" potential costs of a car accident, producers can use futures markets to hedge potential costs of commodity price volatility.

The primary objective of hedging is not to make money but to minimize price risk and potential losses.

University of Missouri ag economists Joe Parcell and Vern Pierce provide this overview of hedging.

"Arbitrage" is a fancy word for a commodity simultaneously being bought and sold in two separate markets to take advantage of a price discrepancy between the two. A commodity futures exchange acts as a market place for people engaged in arbitrage. Suppose there's a shortage of corn in North Carolina to feed livestock. If you think you can profit from buying corn in Wisconsin, paying shipping costs and selling corn in North Carolina, you're apt to continue to do so until the supply and demand for corn are equal in North Carolina; thus the Wisconsin corn price plus shipping costs equal the North Carolina corn price.

For the futures market, arbitrage is carried out through the exchange of paper promissory notes to sell or buy a commodity at an agreed upon price at a future date. As people with different perceptions of where supply and demand are currently and how supply and demand will change in the future interact, commodity prices are driven to equilibrium. As new information enters the market, people's perceptions change and the process of arbitraging begins again.

For example, let's say you believe fall production of corn has been underestimated in mid-summer, and your neighbor thinks it's been overestimated. Since you think corn prices will drop, you sell a futures contract, and your neighbor buys a futures contract because he believes the price is going to go higher. Assume you execute contracts for the same price and they're held by each other, and in three months, you must buy back your contract and your neighbor must sell back his contract. By both of you ending up with no obligations, this clears the market. Furthermore, the contract price is allowed to freely change in value during the three months depending on the change in supply and demand for the underlying commodity, say Parcell and Pierce.

Now, depending on what happens to prices over the following few months, either the contract will not change in value or it'll appreciate or depreciate. If the value doesn't change, neither benefits. If the value appreciates, your neighbor earns a profit by selling back his contract at the new higher price and you would lose money by buying your contract back at the new higher price. If the value depreciates, the neighbor loses money by selling back his contract at the new lower price and you profit by buying back his contract at the new lower price.

Is it really that simple? "In some ways 'yes,'" say these experts, adding that the rules of trading allow for the buying and selling of the contract at any time. There's no minimum time you must hold a contract.

"However, as you might suspect... arbitrage through the futures is in some ways a gamble, like buying insurance. Sometimes it pays for itself and sometimes it doesn't," they note.

Further, what you and your neighbor were doing is "speculating." That is, neither of you has actual ownership of a commodity, but believe you can "out-guess" the market. ("Hedging" is where you own the commodity and use the commodity futures markets to transfer risk.)

In a marketplace like the Chicago Board of Trade (CBOT), no specific buyer and seller are obligated to each other. Therefore, you can sell a contract or buy one at any time within the trading specifications for the exchange. As contract months change, the market enters a contract expiration month in which everybody end up with zero contracts for that trading period. That is, if you sell (or buy) one contract, you must buy (or sell) back one prior to contract expiration. However, the physical delivery of commodities allows for substituting the commodity for the contract.

Price risk occurs for a number of reasons - drought, near-record production, an increase in demand like the one ethanol is currently fueling, decreased international production and so on. The commodity futures markets provide a means to transfer risk between producers and others holding physical commodity (i.e. hedgers) and other hedgers or speculators in the market.

According to Parcell and Pierce, futures exchanges exist and are successful based on the principle that hedgers may forgo some profit potential in exchange for less risk and speculators will have access to increased profit potential from assuming this risk.

For example, suppose a person works on commission and receives $2,000, $8,000, $5,000 and $13,000 in salary for four consecutive months for an average salary of $7,000 per month over the period. Now suppose he could accept a salaried position for a known $6,000 per month. If he's after less income variability, he would "pay" for the decreased variability and accept the, on average, $1,000 a month pay cut. Alternatively, the employer would require the $1,000 per month to off-set the risk he now assumes from the new hire not being motivated to sell more.

This same concept applies to hedging in which hedgers might be willing to give up some revenue for a known price, and speculators would require the opportunity for more revenue by assuming the price risk.

For example, suppose that in late April, you plant 500 acres of corn. At that time, you notice you he can forward price a portion of your corn production through the futures market at $3.80 per bushel. Knowing that your cost of production is $3.45 per bushel, you're willing to price a third of your anticipated production at $3.80. That is, hedging by a farmer generally involves selling the commodity at the commodity exchange market because a producer wants to lock in a price floor (a minimum price he'll receive).

You sell a futures contract for your corn, speculators or hedgers (entities such as grain elevators looking to lock in a price ceiling for the grain they're forward contracting) simultaneously are buying contracts. What can happen? Parcell and Pierce offer the following examples, holding basis constant.

Here's the scenario if the futures price goes higher: Assume the fall futures and cash price of corn goes up to $4 a bushel when you're ready to harvest. You lose 20 cents bushel in the futures market, but gain this back in the cash market through the simultaneous cash price increase with the futures price. (What happens to basis - the difference between the cash and futures market - during this time will determine how much you makes in the cash market) At worst, you receive $3.80 per bushel for your hedged grain. (This pair notes that commissions are not used for this example; they'd lower the price received by a small amount.)

What if the futures price goes lower? The fall futures and cash price of corn goes down to $3.50 per bushel when you're ready to harvest. You gain 30 cents a bushel in the futures market, but lose in the cash market through the simultaneous price decrease with the futures price. (Again, what happens to basis during this time will determine how much you make in the cash market.) At worst, you receive $3.80 for your hedged grain, less commissions.

Let's say the futures price doesn't change. The fall futures and cash price of corn stay at $3.80 when you're ready to harvest. You don't gain in either the futures or cash market except for potential basis gain or loss. At worst, you receive $3.80 for your hedged grain, less commissions.

These experts query: What do all of these scenarios have in common?

They say you generally knew what price you'd receive for the portion of your hedged corn. Why is that important? You don't need to worry about a price decline that would affect revenue. You know approximately how much of a revenue stream you'll have for cash flow analysis.

They note, however, that there are some production risks that can't be covered through futures, such natural catastrophes like drought. Crop insurance cover such production short-falls.

Also, as noted, they really didn't get into the basis component of hedging; a change in basis can boost or cut a net price decrease or increase from hedging.

When might you hedge? By knowing cost of production, you can determine at what prices you might consider forward pricing portions of a crop. Parcell and Pierce maintain it's "imperative that a producer knows his cost of production when hedging a commodity." You might consider forward pricing a portion of your crop through the futures market when the futures price lets you cover your cost of production.

"It is important that producers determine a target profit margin, because people have a tendency to always want to price at the market high," they stress, noting that while it's nice to be able to say you received more on your crop than your neighbor, it's "even better to say you retired a farmer by making wise choices instead of risky choices."

While the costs of hedging are straightforward, these expenses can become substantial over time, they continue. Commissions are paid to a broker for administrative costs, futures exchange operation, and futures exchange regulation. Costs are on a per-order basis, an order being either a buy or sell order. Therefore, to enter and exit the market total costs can add up.

Margin money is only paid on futures positions and not options positions. Margin money refers to earnest money placed in a brokerage account to cover potential losses. The initial margin is needed to start trading. Typically, a futures position will require the initial cost of between 3 to10 percent of the actual cost of the contract being traded. (A 5,000-bushel corn contract may require an initial margin of $750 per contract). The exact percentage is determined by the commodity broker. The maintenance margin is used to step up the initial margin account. For instance, suppose the maintenance margin on the corn contract is $500 per contract. Thus, whenever the initial margin account drops to $500 because of "paper" losses in the futures market, the account must be added to so the balance in the account returns to the brokerage set minimums. There's no maximum number of times a margin call can occur, note Parcell and Pierce.

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