Hedging Using Futures - Price Protection for Cattle Producers
Hedging with futures is one of the marketing tools that can be used to forward price a commodity to protect against a price movement. This article reviews the basics of hedging using a Chicago Mercantile Exchange (CME) live cattle futures contract as a short hedge (selling) for protection against a potential price decline. This discussion only considers the hedging of cattle and not the value of the Canadian dollar versus the American dollar.
A good starting point is to become familiar with some of the common futures trading terms.
- Short - is to sell a futures contract when participating in the futures market
- Long - is to buy a futures contract when participating in the futures market
- Hedge - taking a futures market position that is equal and opposite a cash market position
- Short Hedge - is to sell a futures contract. This is to protect against the risk of a decrease in the commodity price to be sold in the cash market in the future.
- Long Hedge - is to buy a futures contract. This is to protect against the risk of an increase in the commodity price to be purchased in the cash market in the future.
- Offset - is to take the opposite position of the original futures contract for the same delivery month. i.e. a seller of a futures contract (short position) offsets by purchasing (long position) the same number of contracts for the same delivery month
- Basis - the difference between the local cash price and a nearby futures price
- Nearby Futures - is the next delivery month or sometimes called the spot month
- Margin - money deposited by both the sellers and buyers of futures contracts as a performance bond to ensure the terms of the contract are met.
The OMAFRA factsheet, "Managing Commodity Price Risk Using Hedging and Options" provides further explanations.
What is a futures contract?A futures contract is a standardized agreement that states the commodity, quantity, quality, expiry date and whether it is deliverable or cash settled. Futures contracts are traded (sold and purchased) on regulated exchanges (i.e. CME) to establish a price.
A CME live cattle contract is for 40,000 pounds. Therefore the number of head it represents will depend on the live market weight of cattle. For example, for cattle marketed at 1,450 pounds a futures contract would represent approximately 27 head. Contracts are available for the months of February, April, June, August, October, and December. They expire the last business day of the contract month. For example, the December 2011 live cattle contract will expire on December 30, 2011. Live cattle futures contracts are deliverable upon expiry. To remove the obligation to make or take delivery of cattle, the futures contract needs to be offset prior to expiry. In fact, very few futures contracts are delivered upon, they are offset. Generally, the trading in futures contracts is not for the exchange of the physical commodity, but rather it is the trading of obligations. Complete contract specifications for live cattle (and other futures contracts) are provided on the CME Group website (www.cmegroup.com).
Who trades futures contracts?
There are basically two types of traders who participate in the futures market, hedgers and speculators. Hedgers produce or use (i.e. farmers and packers) the physical commodity (i.e. live cattle) and trade futures with the goal to reduce price risk or establish prices for a commodity. Speculators generally do not trade or use the physical commodity. They trade futures to profit from the price movement in the futures market. Remember, for every seller there is a buyer and for every buyer there is a seller.
There are two types of hedgers, a short hedger who wants to protect against a price decline and a long hedger who wants to protect against a price rise. An example of a short hedger would be a cattle producer finishing cattle who wants to protect a future price against a potential decline. To start the hedge they would sell a live cattle futures contract. An example of a long hedger would be a cattle producer who needs corn for feed and who wants to protect a future corn price against a potential increase. To start the hedge he would buy a corn futures contract.
What is hedging with futures?
To hedge is to take a futures position that is equal and opposite to a position held in the cash market. The objective is to manage the risk of an adverse move in prices. Hedging works because futures and cash prices both respond to the underlying forces of supply and demand. This means they both tend to move together and in the same direction over time. Also, the futures contract delivery provision (or threat of delivery) helps to ensure the futures and cash prices eventually move together.
Example of a cattle short hedge
- Cattle were purchased at the end of March 2011 and fed to be marketed the end of September 2011.
- At the end of March the October 2011, live cattle futures were valued at US$125 per cwt. The risk was that cattle prices could fall prior to the cattle being ready to market. Also, a potential profit could be realized at this price level.
- To protect against declining prices, a short hedge was put in place by selling one CME live cattle futures October 2011 contract for US$125 per cwt. The estimated market price was C$111.35 per cwt. This was based on a Canadian dollar being worth $1.03 U.S. and a historical basis of minus C$10 per cwt. for cattle being marketed the end of September (US$125 ÷ 1.03 - $10).
- The cattle were fed and sold to a packer at the end of September for C$106.66 per cwt weighing 1,450 pounds. At the same time the CME live cattle futures October 2011 contract was offset by purchasing one October 2011 contract for US$120 per cwt.
- The futures contract was sold for US$125 and purchased for US$120 for a gain of US$5 per cwt. The value of the Canadian dollar was 97 cents U.S. making a futures contract gain of $5.15 per cwt. Canadian.
- By hedging, a price of C$111.81 per cwt was realized. This was made up of the $106.66 per cwt from the cash market and $5.15 per cwt from the futures. This was based on the futures contract representing approximately 27 head of cattle at 1,450 pounds (i.e. 40,000 pounds per contract ÷ 1450 per head).
- The other costs that need to be accounted for are the brokerage fees (i.e. 12.5 cents per cwt. assuming a $50 fee/contract) and carrying costs (cost to carry the margin account, for this example would have been minimal to zero).
A short hedge provides protection against declining prices. If prices had gone up in the above example, the value realized from the futures hedge would have declined but the cash price should have increased since the two prices generally move in the same direction over time (not necessarily the same amount). The difference between the local cash price and the futures price is the basis.
What is the basis?
- Basis is the difference between the local cash price and the nearby futures price.
- Basis = Local Cash Price C$/cwt - (Nearby month CME live cattle futures price US$/cwt X exchange rate)
- For example, assume the Ontario cattle price is C$106.66 per cwt, the nearby month CME live cattle futures price is US$120 per cwt and the exchange rate is $1.03
- Basis = $106.66 - ($120 X 1.03) = $106.66 - $123.60 = -$16.94/cwt
- Many factors can influence the basis, most notably changes in the local supply and demand and transportation costs.
What is margin?
Futures trading is conducted using a margin account. When a futures trader enters into a futures position they are required to post an initial margin amount as specified by the futures exchange.
- Currently, for CME live cattle futures the initial margin to be posted is US$1,650 per contract. At the end of each trading day, futures positions are "marked to the market".
- If you had sold one live cattle futures contract for $125 and at the end of the day the contract settled at $124, $1 per cwt or $400 per contract would be put in your margin account. (Note you sold the futures contract for $125 and if you were to offset it by purchasing at $124, you would make $1 per cwt. Therefore $1 per cwt increase in the margin account)
- Conversely if the contract settled at $126, $1 per cwt or $400 per contract would be taken out of your margin account. (Note you sold the futures contract for $125 and if you were to offset it by purchasing at $126, you would lose $1 per cwt, therefore the margin account is reduced)
- The margin account is good faith money to honour the changes in the contract values.
- If the amount of money in the margin account falls below a specified maintenance margin, the futures trader gets a "margin call" and has to add money to the margin account. This must be done immediately to avoid losing the futures position.
- Therefore it is important to be aware of the potential cash flow commitments that can result.
- The cost of the margin account for a hedging position is the cost to carry the margin account (i.e. any interest costs that are realized).
In summary, hedging with futures is one of the marketing tools that can used to forward price a commodity to protect against a movement in the price. Basically, you use a futures contract as a temporary substitute for an intended transaction in the cash market that will occur at a later date. This way you extend the marketing window and work on minimizing price risk with a marketing tool that is relatively easy to enter and exit. Keep in mind that margin money needs to be accounted for, the quantity (40,000 pounds) that the contract covers, the basis and exchange rate risk. This article provided a basic overview of using a futures contract as a short hedge to manage price risk. A CME resource with more detailed information, "Self-Study Guide to Hedging with Livestock Futures and Options" is available at www.cmegroup.com.
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|Author:||John Bancroft - Market Strategies Program Lead/OMAFRA|
|Creation Date:||25 October 2011|
|Last Reviewed:||12 February 2016|