Compare Three Risk Management Alternatives for Corn Crop - Hedging Part 3

This is the third article in a series about using hedging as part of a risk management strategy for agriculture producers. Part 1 provided an overview and explanation of hedging; part 2 discussed the different hedging tools that are available and this article, part 3, outlines a real life example.

Example Situation

Imagine you’re a producer wanting to compare three price risk management alternatives for your recently planted corn crop. Your primary goal is to lock in a price that can reasonably cover your cost of production plus provide some additional profit margin.

You already have purchased Revenue Protection (RP) crop insurance at the 80 percent coverage level. Your actual production history (APH) yield is 156 bushels per acre; therefore, the crop insurance coverage yield (at 80 percent coverage) is 125 bushels per acre with 1,600 acres currently planted. The RP insurance effectively gives you replacement coverage for any yield shortfall below 125 bushels per acre.

The following pages illustrate several potential hedging alternatives and outcomes.

Hedging alternatives

You want to lock in a price on the 200,000 bushels (yield of 125 bushels per acre multiplied by 1,600 acres planted to corn) covered by the Revenue Protection crop insurance policy. The December (new crop) corn futures price is currently trading at $5.00 per bushel. You’re concerned about the potential negative impact on the markets of recent news reports regarding improving corn production in Argentina and Brazil along with declining domestic livestock feed demand. You have three alternatives available to protect the price of your growing crop:

FORWARD

Enter into a forward contract from the local grain cooperative elevator, which offers a fixed cash delivery price of $4.25 per bushel (implies a forward basis of 75 cents under futures)

• You enter into contract directly with the local elevator.


• You know the delivery price with certainty ($4.25 per bushel), as both the futures and basis components of the price are fixed in the contract.


• No margin deposit is required up front.


• You are contractually obligated to deliver 200,000 bushels of corn to the local elevator. If you harvest less than that, you must either purchase the remaining corn balance in the cash market for delivery or buy out the balance at the current local cash price.

FUTURES

Sell corn futures contracts listed on the CME

• You sell 40 contracts (5,000 bushels per contract) in the December delivery (new crop) contract at the current futures price of $5.00 per bushel. The local forward contract price of $4.25 mentioned at left implies a forward local basis of -$0.75 per bushel (forward contract price minus futures price).


• You place your order locally either through an independently owned Introducing Broker or an Associated Person employed with a Futures Commission Merchant firm. The order is either routed to the trading floor to be filled in the futures pit or placed electronically via CME’s electronic GLOBEX marketplace.


• The broker charges a round-turn brokerage fee, which is generally deducted from your brokerage account when the futures position has been offset. In this example, assume a brokerage fee of $50 per contract or $0.01 per bushel.


• You are required to deposit initial margin (typically between 5 to 10 percent of the total contract value for each contract) with the broker. If the December corn futures price moves above $5.00 per bushel, you would be required to make up any mark-to-market losses through additional deposits called margin calls.


• You are responsible for financing both initial margin and any additional margin calls through use of cash reserves and lines of credit, incurring some interest costs.


• You are not contractually tied to a particular physical delivery market for your crop.


• You effectively remove the futures portion of your cash price risk but still face the risk of adverse movements in the generally less volatile basis.

SWAP

Enter into a pay variable, receive fixed swap contact that uses the CME December corn futures as the variable index price (“futures lookalike swap”)

• You enter into enough swaps to cover the 200,000 bushel cash exposure.


• You place your order either directly or indirectly (via electronic platform) with a firm that is registered as a designated Swap Dealer (SD) by the Commodity Futures Trading Commission.


• Fixed price equals the current December futures price of $5.00 per bushel.


• As a derivative contract, the swap includes all the standardized terms of the CME corn futures contract.


• The swap is marked-to-market on a daily basis through the netting of the swap cash flows. The producer will either run an accumulated credit or deficit with the Swap Dealer firm. Cash deposits will be required by the producer if the account has an accumulated deficit (in a similar manner to margin calls on a futures position). However, some lenders offer producers a price risk management tool that combines a standard loan with a commodity swap product. Any potential account deficit is covered through the tool, and only mark-to-market adjustments are settled to your account at expiration of the swap when the final financial settlement is made. Rather than the brokerage fee and uncertain interest expenses affiliated with a futures position, the cost of the swap is covered by a one-time fee (which is deducted from the swap fixed price). In this example, suppose the fee is 7 cents per bushel, so the net fixed swap price is $4.93 per bushel after deducting from the current $5.00 market price.


• As with futures, you are not tied to a particular physical delivery market.


• You still have basis risk equivalent to the basis on a similar futures hedge since the swap inherits the standardized characteristics of the underlying futures contract.

Hedging outcomes

Suppose the following November, you harvest a good crop (256,000 bushels), as your yield (160 bushels per acre) was 4 bushels higher than your APH yield. However, as you feared, the CME December futures price has dropped to $4.00 per bushel in the midst of an excellent crop nationwide and a large crop coming out of South America and the Ukraine. Depending upon which hedging strategy you initially chose, the outcomes would be as follows:

FORWARD

• You deliver 200,000 bushels of harvested corn to the local elevator and receive payment equal to the originally agreed fixed price of $4.25 per bushel.


• You can either sell the remaining 56,000 bushels on the current spot market or put into storage in hopes of receiving a higher price that more than compensates for the additional costs of storage. As the crop has technically become what is known as old crop, you could also store and then hedge it using either the futures (could use any of the remaining delivery months within the current marketing year) or a futures lookalike swap. The difference between the deferred month futures price and the current Chicago futures contract price represents the amount that the marketplace is offering you to store your crop and deliver in the deferred month.


• After shopping around, you find a local ethanol plant offering a very favorable basis of 30 cents under the December futures, or $3.70 per bushel ($4.00 futures - $0.30 basis) for spot delivery. You decide to deliver the remaining corn to the ethanol plant.


• You calculate your total revenue received and net price for your crop as follows:

i. Forward contract: 200,000 bushels x $4.25 / bu = $850,000

ii. Ethanol plant spot sale: 56,000 bushels x $3.70 / bu = $207,200

iii. Total (i + ii) = $850,000 + $207,200 = $1,057,200

iv. Price per bushel (iii / 256,000) = $4.13 per bushel (rounded to the nearest cent)

FUTURES

• You can deliver all or any portion of your harvested corn to the market outlet of your choice and decide to take the favorable basis offered by the local ethanol plant and deliver all 256,000 bushels for the spot price of $3.70 per bushel.


• For the futures hedged portion (200,000 bushels), the favorable basis move (went from a forward bid of -$0.75 at planting to the current -$0.30 per bushel) results in a basis gain of $0.45 above the forward contract price of $4.25 for a net price of $4.70 per bushel for the hedged grain (200,000 bushels). This basis gain will be reflected in the addition of the profits from the futures position to the revenue from the spot sale to the ethanol plant.


• You offset the 40 CME December corn futures contracts that you originally sold at $5.00 per bushel by buying back the 40 contracts at the current December futures price of $4.00. This results in a gross futures profit of $1.00 per bushel. You had total interest costs equal to ½ cent per bushel due to the need for outside financing of the initial margin deposit, so accounting for the brokerage fee of $0.01 per bushel results in a total cost of $0.015 per bushel on the hedged corn. This reduces the effective net futures profit to $0.985 per bushel. You receive this net credit to your brokerage account.


• You calculate your total revenue received and net price for your crop as follows:

i. Ethanol plant spot sale: 256,000 bushels x $3.70 / bu = $947,200

ii. Futures net profit: 200,000 bushels x $0.985 / bu = $197,000

iii. Total (i + ii) = $947,200 + $197,000 = $1,144,200

iv. Price per bushel (iii / 256,000) = $4.47 per bushel (rounded to the nearest cent)

 SWAP

• As with futures, you can choose the best market to deliver your harvested corn. You take the favorable basis bid offered by the local ethanol plant and deliver all 256,000 bushels at the $3.70 spot price.


• On the swap, the accumulation of the daily exchange of cash flows (paying variable CME December corn futures price / receiving net fixed price of $4.93 after deducting $0.07 per bushel service fee) results in a net settlement mark-to-market profit of $0.93 per bushel since you receive $4.93 from the Swap Dealer and pay the current floating price of $4.00 per bushel. As with futures, you offset the swap to get out of the position by placing an opposite position order to the one initially placed (for the 200,000 bushels). You owe no other interest or brokerage costs, since the service fee covered all daily mark-to-market adjustments without the need for you to post your own or borrowed funds to assure financial performance on the swap position.


• As with the futures hedge, you benefit from an improvement in the futures basis of $0.45 per bushel before removal of the $0.07 service fee for a net basis gain of $0.38 per bushel.


• You calculate your total revenue received and net price for your crop as follows:

 i. Ethanol plant spot sale: 256,000 bushels x $3.70 / bu = $947,200

ii. Swap net profit: 200,000 bushels x $0.93 / bu = $186,000

iii. Total (i and ii) = $947,200 + $186,000 = $1,133,200

iv. Price per bushel (iii / 256,000) = $4.43 per bushel (rounded to the nearest cent)

The futures lookalike swap provides the convenience of no margin deposits / calls (as with the forward contract) with the flexibility of delivering your physical crop to the market outlet of your choice (as with the futures contract). The net price of the no margin convenience is essentially $0.055 ($0.07 swap service fee minus $0.015 brokerage fee for futures hedge) per bushel relative to the futures hedge.

Many university extension programs have very good guides and programs on developing a strong marketing plan, including risk management. Following are several links to resources from the University of Minnesota Center for Farm Financial Management.

Introduction to Risk Management guide: http://agrisk.umn.edu/Library/Display.aspx?RecID=6639

National Ag Risk and Farm Management Library: http://www.agrisk.umn.edu/

Winning the Game marketing workshops: http://www.cffm.umn.edu/wtg/

Visit the hedging glossary for a list of definitions used in this article.

Information in this post was provided by AgriBank. AgriBank is FCS Financial’s funding source. It is one of the largest banks within the national Farm Credit System, with more than $80 billion in total assets. Under the Farm Credit System’s cooperative structure, AgriBank is owned by 17 affiliated Farm Credit Associations. The AgriBank District covers America’s Midwest, a 15-state area from Wyoming to Ohio and Minnesota to Arkansas. More than half of the nation’s cropland is located within the AgriBank District, providing the Bank and its Association owners with exceptional expertise in production agriculture. For more information, visit www.AgriBank.com.