This is part two in a three part series about using hedging as part of your marketing toolbox. Part 1 explains what hedging is and how it assists producers.
FUTURES. These are standardized (all specifications are fixed except for price) forward contracts that trade via open outcry (pit) or electronic auction at one of the commodity futures exchanges such as the Chicago Mercantile Exchange (CME). Producers can protect against a decline in their future sale price by placing a short hedge — selling futures as a placeholder for the future cash sale. When the cash sale does occur, the futures contract is usually offset (bought back), and the financial gain (if prices fall) or loss (if prices rise) is added to the revenue from the cash sale. Since cash prices will typically not move totally in lockstep with the futures (due to differences in time, location and quality), the futures hedger will be subject to basis risk, which is the fluctuation in the difference between the local cash and standardized futures prices.
OPTIONS. Like futures, these are standardized contracts that trade on the futures exchanges in a similar manner. Unlike futures, options allow producers to set a floor (put options) on their sale price with the advantage of participating in favorable price moves to the upside. In exchange for this flexibility, the producer must pay a premium that represents the lone negotiable item on the contract. Producers can choose from various levels of price coverage (deductibles) by choosing from a list of available strike prices on the option. If prices fall below the strike price, the producer will receive a payout equal to the difference between the strike price and the lower futures price. This payout is usually embedded in the option's market premium (called intrinsic value), which the producer can recover by reselling the purchased put option at the market premium to offset the option position (or they can exercise the option but they give up any time value that may still be embedded in the premium). Producers may also set a ceiling on the price of a future commodity input purchase (such as a cattle feedlot operation) by purchasing a call option.
SWAPS. In terms of the financial payout, these contracts are very similar to futures; however, they typically have a higher level of customization and flexibility. These contracts are available either on the futures exchanges (such as the CME's Clearport electronic marketplace) or outside the exchanges in what is known as the over-the-counter (OTC) marketplace. A swap is simply a contract that calls for the exchange of cash flows between two parties that are based upon a particular market price or index value. The most common kind of swap used in commodities is the fixed-floating swap, where one party pays a predetermined fixed price and the other party pays a market-determined floating price. For hedging a future cash sale, a producer will take the float side of the swap. As prices go below the fixed price, the producer will be credited with the price difference (receives the higher fixed price, pays the lower floating). As prices go above the fixed price, the producer will be debited equal to the price difference (pays the higher floating, receives the lower fixed). Therefore, as a hedge, the swap will perform in a similar manner to a futures hedge. Producers who hedge a future commodity input purchase would take the opposite (pay fixed, receive floating) side of the swap transaction.
CASH FORWARD CONTRACTS. These contracts are between the producer and a local buyer (elevator, ethanol plant, processor, etc.) and unlike the previous three categories, are always settled by physical delivery of the commodity. A fixed price forward contract requires the producer to deliver the contracted quantity in the future for a fixed cash price payment. Under this contract, both the futures and basis components of the selling price are fixed. A basis contract fixes the basis on a future delivery but leaves the futures price component open. The producer can fix the futures component at a later time either through exercising a provision in the cash contract or by selling futures against the contract. A hedged-to-arrive contract fixes the futures component of the selling price and usually allows the producer to fix the basis component at a later date. A minimum price contract specifies future delivery at a minimum cash price with a premium either paid directly by the producer or deducted from the sale price. All of these cash contracts essentially obligate the producer to deliver the contracted amount of the commodity to a predetermined cash market outlet.
Producers may wish to consult an accountant, broker, lender and/or other experts to help choose the hedging strategies right for them.
Visit the hedging glossary for definitions of the terms 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.
Commonly used hedging tools for producers include:
FUTURES. These are standardized (all specifications are fixed except for price) forward contracts that trade via open outcry (pit) or electronic auction at one of the commodity futures exchanges such as the Chicago Mercantile Exchange (CME). Producers can protect against a decline in their future sale price by placing a short hedge — selling futures as a placeholder for the future cash sale. When the cash sale does occur, the futures contract is usually offset (bought back), and the financial gain (if prices fall) or loss (if prices rise) is added to the revenue from the cash sale. Since cash prices will typically not move totally in lockstep with the futures (due to differences in time, location and quality), the futures hedger will be subject to basis risk, which is the fluctuation in the difference between the local cash and standardized futures prices.
OPTIONS. Like futures, these are standardized contracts that trade on the futures exchanges in a similar manner. Unlike futures, options allow producers to set a floor (put options) on their sale price with the advantage of participating in favorable price moves to the upside. In exchange for this flexibility, the producer must pay a premium that represents the lone negotiable item on the contract. Producers can choose from various levels of price coverage (deductibles) by choosing from a list of available strike prices on the option. If prices fall below the strike price, the producer will receive a payout equal to the difference between the strike price and the lower futures price. This payout is usually embedded in the option's market premium (called intrinsic value), which the producer can recover by reselling the purchased put option at the market premium to offset the option position (or they can exercise the option but they give up any time value that may still be embedded in the premium). Producers may also set a ceiling on the price of a future commodity input purchase (such as a cattle feedlot operation) by purchasing a call option.
SWAPS. In terms of the financial payout, these contracts are very similar to futures; however, they typically have a higher level of customization and flexibility. These contracts are available either on the futures exchanges (such as the CME's Clearport electronic marketplace) or outside the exchanges in what is known as the over-the-counter (OTC) marketplace. A swap is simply a contract that calls for the exchange of cash flows between two parties that are based upon a particular market price or index value. The most common kind of swap used in commodities is the fixed-floating swap, where one party pays a predetermined fixed price and the other party pays a market-determined floating price. For hedging a future cash sale, a producer will take the float side of the swap. As prices go below the fixed price, the producer will be credited with the price difference (receives the higher fixed price, pays the lower floating). As prices go above the fixed price, the producer will be debited equal to the price difference (pays the higher floating, receives the lower fixed). Therefore, as a hedge, the swap will perform in a similar manner to a futures hedge. Producers who hedge a future commodity input purchase would take the opposite (pay fixed, receive floating) side of the swap transaction.
CASH FORWARD CONTRACTS. These contracts are between the producer and a local buyer (elevator, ethanol plant, processor, etc.) and unlike the previous three categories, are always settled by physical delivery of the commodity. A fixed price forward contract requires the producer to deliver the contracted quantity in the future for a fixed cash price payment. Under this contract, both the futures and basis components of the selling price are fixed. A basis contract fixes the basis on a future delivery but leaves the futures price component open. The producer can fix the futures component at a later time either through exercising a provision in the cash contract or by selling futures against the contract. A hedged-to-arrive contract fixes the futures component of the selling price and usually allows the producer to fix the basis component at a later date. A minimum price contract specifies future delivery at a minimum cash price with a premium either paid directly by the producer or deducted from the sale price. All of these cash contracts essentially obligate the producer to deliver the contracted amount of the commodity to a predetermined cash market outlet.
In selecting the appropriate hedging tool, producers should consider:
- What buyer, price and tools are reasonably available for my particular commodity and local cash market venues?
- What tools are appropriate given the knowledge level and expertise that I currently possess (or are present in my management team)?
- What tools are appropriate given my financial ability to take on risk and my personal risk tolerance?
Producers may wish to consult an accountant, broker, lender and/or other experts to help choose the hedging strategies right for them.
Visit the hedging glossary for definitions of the terms 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.
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