2008 K-State Risk Assessed Marketing

Workshops

Grain Marketing Basics: Cash Grain Basis, Forward Contracts, Futures & Options

Dr. Daniel M. O’Brien

Extension Agricultural Economist

K-State Research and Extension

Price Trend EffectsOn Cash Sales & Forward Contracts

Pricing Alternatives

Falling Futures

Rising Futures

Wider Basis

Narrower Basis

Cash Market Sales ( ) () ( ) ()

Forward Cash Contract None None None None

Basis Contract ( ) () None None

Hedge-to-Arrive (HTA) None None ( ) ()

Minimum Price Contract None () None None

Price Later Contract ( ) () ( ) ()

Price Trend EffectsOn Futures, Options & Marketing Loans

Pricing Alternatives

Falling Futures

Rising Futures

Wider Basis

Narrower Basis

Short Futures Hedge None None ( ) ()

Buy Put Options None () ( ) ()

Sell Cash & Buy Calls None () None None

Marketing Loans None () ( ) ()

Risk Exposure of Marketing ToolsA. Options Volatility Risk

Risk that option premiums will not change 1-for-1 with cash/futures as the price level changes

B. Production Risk if Pre-harvest Pricing Risk of being unable to deliver grain to fulfill a contract

C. Counter Party Risk Risk that a buyer wont fulfill their contract obligations

D. Control Risk Risk of market actions getting “out of control” before

corrective actions can be taken by the seller

?

Areas of Risk ExposureFor Cash Sales & Forward Contracts

Pricing Alternatives

Options Volatility

Prodn. Risk if

Prehvst.

Counter Party Risk

Control

Risk Cash Market Sales --- --- --- Yes

Forward Cash Contract --- Yes Yes ---

Basis Contract --- Yes Yes Yes

Hedge-to-Arrive (HTA) --- Yes Yes Yes

Minimum Price Contract Yes Yes Yes Yes

Price Later Contract --- --- Yes Yes

Areas of Risk ExposureFor Futures, Options & Marketing Loans

Pricing Alternatives

Options Volatility

Prodn. Risk if

Prehvst.

Counter Party Risk

Control

Risk Short Futures Hedge --- Yes --- Yes

Buy Put Options Yes Yes --- Yes

Sell Cash & Buy Calls Yes --- --- Yes

Marketing Loans --- --- --- Yes

Hedging With Futures

Price Hedges on Grain Production

1) (Prehedge) Analyze hedging opportunity Futures less Basis less Brokers’ fees

2) (Placing the Hedge) Sell futures contract(s) nearest to the grain delivery period In a “Short” or “sell” futures position

3) (Closing Out the Hedge Position)

Buy back futures contract(s)

Sell cash grain (optional)

Grain Forward Pricing Decisions How Much to Forward Contract or Hedge?

For Pre-Harvest Pricing: Max of 50%-75% of expected production (average yields)

If have a short crop, use Crop Insurance Coverage revenues to help fill Forward Contract obligations

Recommended: A disciplined grain marketing plan

What Time Period to Set Grain Delivery In? Examine Harvest vs Post Harvest Basis, Storage

Returns, and Grain Delivery Opportunities Timing of cash flow needs

Forward Contract Vs Futures Hedge If Basis Projection is Accurate, then..

Forward Contract $ = Futures Hedge $

Who Carries the Futures Account? FC: Elevator contacts broker & pays any margin calls Hedge: Producer works w. broker, pays margin calls

Delivery Commitment? FC: Delivery commitment of X bushels for $X price Hedge: No delivery commitment to elevator

Basis Commitment? FC: Set cash basis / Hedge: Varying cash basis

New Crop DEC 2008 Corn Examples for March 3, 2008

CBOT December 2008 Corn Prices

Futures Hedge for Harvest Delivery

Forward Contract for Harvest Delivery

Put Option Price Floor

Call Option Price Coverage

CBOT DEC 2008 CornJanuary 2006 – March 2008

2008 Preharvest Corn HedgeHedging on Monday, March 3, 2008 Target Sales Date: November 15, 2008

Corn Futures Price (3/3/08) December ‘08 CBOT Corn = $5.76 1/2

Expected Corn Basis $0.05-$0.25 under DEC CBOT Corn on November 15 th

2008 Corn Hedge Expected Price = $5.58 /bu

DEC 08 CBOT Corn - Basis - Broker $5.76 - $0.17 - $0.01 = $5.58

Cash Corn Basis: Dighton, KSYears 2005-2008

($0.40)

($0.30)

($0.20)

($0.10)

$0.00

$0.10

$0.20

$0.30

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Basi

s (

Cash

- F

utu

res)

2008 2007 2006 2005

Cash Corn Basis: Scott City, KSYears 2005-2008

($0.30)

($0.20)

($0.10)

$0.00

$0.10

$0.20

$0.30

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Bas

is (

Cas

h -

Fu

ture

s)

2008 2007 2006 2005

Cash Milo Basis: Dighton, KSYears 2005-2008

($0.70)

($0.60)

($0.50)

($0.40)

($0.30)

($0.20)

($0.10)

$0.00

$0.10

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Bas

is (

Cas

h -

Fu

ture

s)

2008 2007 2006 2005

Cash Milo Basis: Scott City, KSYears 2005-2008

($0.70)

($0.60)

($0.50)

($0.40)

($0.30)

($0.20)

($0.10)

$0.00

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Bas

is (

Cas

h -

Fu

ture

s)

2008 2007 2006 2005

New Crop Corn Hedge ExampleScenario A: Falling Corn PricesDate Cash Transactions

Futures Basis Expt. $: $5.58 ($5.76 - 0.18*) By November 15, 2008

On 3/3/08 No Cash Transactions

On 3/3/08 Expt Sell DEC 08 @$5.76 ($0.18)

On 11/15/08 Sell Cash Corn @ $3.58

On 11/15/08 Actual Buy DEC 08 @$3.76 ($0.18)

Net Gain/Loss on Futures: Gain of $2.00 /bu ( - $0.01 broker)

Final Net Price = $5.58 /bu Cash $3.58 + $2.00 Futures Gain

New Crop Corn Hedge ExampleScenario B: Rising Corn PricesDate Cash Transactions

Futures Basis Expt. $: $5.58 ($5.76 - 0.18*) By November 15, 2008

On 3/3/08 No Cash Transactions

On 3/3/08 Expt Sell DEC 08 @$5.76 ($0.18)

On 11/15/08 Sell Cash Corn @ $7.58

On 11/15/08 Actual Buy DEC 08 @$7.76 ($0.18)

Net Gain/Loss on Futures: Loss of $2.00 /bu ( - $0.01 broker)

Final Net Price = $5.58 /bu Cash $7.58 – $2.00 Futures Loss

2008 New Crop Corn Forward Contract Utica, Kansas Garden City Coop, Utica, KansasMar. 5, 2007 – Feb. 29, 2008Source: DTN Bid Analyzer

$5.47 /bu on 2/29/08FC Basis: $0.18 /bu underCBOT DEC 2008 Corn Futures

2008 New Crop Milo Forward Contract Utica, Kansas Garden City Coop, Utica, KansasMar. 5, 2007 – Feb. 29, 2008Source: DTN Bid Analyzer

$5.15 /bu on 2/29/08 FC Basis: $0.50 /bu underCBOT DEC 2008 Corn Futures

DEC 2008 Corn Put-Call Option Prices

$0.95 $0.92$0.85 $0.84

$0.70 $0.68$0.60

$0.54

$0.74$0.65$0.59$0.55

$0.49

$0.76$0.75

$0.00

$0.75

$1.50

$5.30 $5.40 $5.50 $5.60 $5.70 $5.80 $5.90 $6.00 $6.10 $6.20 $6.30

Strike Prices

Pre

miu

ms

/ Bu.

Put Option Premiums Call Option Premiums

DEC 2008 Corn Futures Close:$5.76 /bu on March 3, 2008

DEC 2008 Corn Put Option Values

$0.00

$0.30

$0.60

$0.90

$1.20

$1.50

$5.30 $5.40 $5.50 $5.60 $5.70 $5.80 5.9

Strike Prices

Pre

miu

ms

/ Bu.

Put Time Value Put Intrinsic Value

DEC 2008 Corn Futures Close:$5.76 /bu on March 3, 2008

"In the Money" Puts:Futures < SP

"Out of the Money" Puts:Futures > SP

DEC 2008 Corn Put Price Floors

$4.6

1

$4.6

5

$4.7

1

$4.7

5

$4.7

6

0.18 0.18 0.18 0.18 0.180.49 0.55 0.59 0.65 0.74

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$5.30 $5.40 $5.50 $5.60 $5.70 $5.80

Strike Prices

Pre

miu

ms

/ Bu.

Floor Price* Basis Put Premium Broker Fee

At the Money: $5.76 /bu (3/3/08)

Results of Buying a $5.30 DEC 2008 Corn Put Option @ $0.49/bu

$3.58$4.08

$4.58$5.08

$5.58$6.08

$6.58$7.08

$5.07 $5.07 $5.07 $5.07 $5.07$5.57

$6.07$6.57

-$1.00

$1.00

$3.00

$5.00

$7.00

$9.00

$3.76 $4.26 $4.76 $5.26 $5.76 $6.26 $6.76 $7.26

Futures Prices

Net

Ret

urns

/ B

u

Cash Price Net Put Return Net Price Received

DEC 2008 Corn Call Option Values

$0.00

$0.30

$0.60

$0.90

$1.20

$1.50

$5.30 $5.40 $5.50 $5.60 $5.70 $5.80 $5.90 $6.00 $6.10 $6.20 $6.30

Strike Prices

Pre

miu

ms

/ Bu.

Call Time Value Call Intrinsic Value

DEC 2008 Corn Futures Close: $5.76 /bu on March 3, 2008In the Money Calls:

Futures > SP

Out of the Money Calls:Futures < SP

DEC 2008 Corn Call Price CoverageMinimum Price Increase Needed to Cover Call Premium Cost

$5.4

0

$5.5

0

$5.6

0

$5.8

0

$5.9

0

$6.0

0

$6.2

0

$6.3

0

$5.3

0

0.540.600.680.700.750.840.850.920.95

$0.00

$1.50

$3.00

$4.50

$6.00

$7.50

$9.00

$5.30 $5.40 $5.50 $5.60 $5.70 $5.80 $5.90 $6.00 $6.10 $6.20 $6.30

Strike Prices

Pre

miu

ms

/ Bu.

Strike Price Call Option Premiums Broker Fee

At the Money: $5.76 /bu (3/3/08)

Results of Buying a $5.80 DEC 2008 Corn Call Option @ $0.75 /bu

$0.50$1.00

$1.50$2.00

($0.77) ($0.77) ($0.77) ($0.77)($0.27)

$0.23$0.73

$1.23

-$1.50

$0.00

$1.50

$3.00

$4.50

$4.26 $4.76 $5.26 $5.76 $6.26 $6.76 $7.26 $7.76

Futures Prices

Net

Ret

urns

/ B

u

Call Purchase Price Call Selling Price Broker Fee Net Call Returns

DEC 2008 Corn Futures Close:$5.76 /bu on 2/26/08

New Crop NOV 2008 Soybeans Examples for March 3, 2008 CBOT November 2008 Soybean Prices

Basis History (2005-2008)

Futures Hedge for Harvest Delivery

Put & Call Option Premiums

CBOT NOV 2008 SoybeansJanuary 2006 – March 2008

Cash Soybean Basis: Dighton, KSYears 2005-2008

($1.60)

($1.40)

($1.20)

($1.00)

($0.80)

($0.60)

($0.40)

($0.20)

$0.00

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Basi

s (

Cash

- F

utu

res)

2008 2007 2006 2005

Cash Soybean Basis: Scott City, KSYears 2005-2008

($1.60)

($1.40)

($1.20)

($1.00)

($0.80)

($0.60)

($0.40)

($0.20)

$0.00

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Bas

is (C

ash

- Fut

ures

)

2008 2007 2006 2005

2008 New Crop Soybean Frwd. Contract Utica, Kansas Garden City Coop, Utica, KansasMar. 5, 2007 – Feb. 29, 2008Source: DTN Bid Analyzer

$13.14 /bu on 2/29/08FC Basis: $1.10 /bu underCBOT NOV 2008 Soybean Futures

NOV ‘08 Soybean Put-Call Option $s

$2.40

$2.10 $2.15

$1.78 $1.72$1.77$1.63$1.56$1.43$1.34

$0.00

$1.00

$2.00

$3.00

$13.40 $13.60 $13.80 $14.00 $14.20 $14.40 $14.60 $14.80 $15.00 $15.20 $15.40

Strike Prices

Pre

miu

ms

/ Bu.

Put Option Premiums Call Option Premiums

NOV 2008 CBOT Soybean Close:$14.47 /bu on March 3, 2008

NOV 2008 Soybean Put Price Floors

$10.

94

$11.

05

$11.

12

$11.

25

$11.

31

1.10 1.10 1.10 1.10 1.101.34 1.43 1.56 1.63 1.77

$0.00

$3.00

$6.00

$9.00

$12.00

$15.00

$18.00

$13.40 $13.60 $13.80 $14.00 $14.20 $14.40 $14.50

Strike Prices

Pre

miu

ms

/ Bu.

Floor Price* Basis Put Premium Broker Fee

At the Money: $14.47 1/2 /bu (3/3/08)

NOV 2008 Soybean Call Price CoverageMinimum Price Increase Needed to Cover Call Premium Cost

$14.

00

$14.

20

$15.

00

$15.

40

2.40 2.10 2.151.78 1.72

$13.

40

$0.00

$3.00

$6.00

$9.00

$12.00

$15.00

$18.00

$21.00

$13.40 $14.00 $14.20 $15.00 $15.40

Strike Prices

Pre

miu

ms

/ Bu.

Strike Price Call Option Premiums Broker Fee

At the Money: $14.47 1/2 /bu (3/3/08)

New Crop July 2008 HRW Wheat Examples for March 3, 2008 KCBT July 2008 HRW Wheat Prices

Basis History (2005-2008)

Futures Hedge for Harvest Delivery

Put & Call Option Premiums (2/22/08)

KCBT JULY 2008 HRW WheatFebruary 2007 – March 2008

Cash Wheat Basis: Dighton, KSYears 2005-2008

($1.40)

($1.20)

($1.00)

($0.80)

($0.60)

($0.40)

($0.20)

$0.00

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46Weeks during Year (Consecutive Order)

Bas

is (

Cas

h -

Fu

ture

s)

2008 2007 2006 2005

Cash Wheat Basis: Scott City, KSYears 2005-2008

($1.20)

($1.00)

($0.80)

($0.60)

($0.40)

($0.20)

$0.00

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Week of Year (Consecutive Order)

Bas

is (

Cas

h -

Fu

ture

s)

2008 2007 2006 2005

2008 New Crop Wheat Frwd. Contract Utica, Kansas Garden City Coop, Utica, KansasMarch 5, 2007 – Feb. 29, 2008Source: DTN Bid Analyzer

$10.30 /bu on 2/29/08FC Basis: $0.60 /bu underKC July 2008 Wheat Futures

JULY ‘08 HRW Wheat Put-Call Option $s

1.251.37 1.431.42 1.37 1.32 1.27 1.22

1.001.14

1.081.030.980.930.88 0.920.961.04

1.13

$0.00

$0.70

$1.40

$2.10

$10.40 $10.50 $10.60 $10.70 $10.80 $10.90 $11.00 $11.20 $11.30 $11.40 $11.50

Strike Prices

Pre

miu

ms

/ Bu.

Put Option Premiums Call Option Premiums

JULY 2008 KCBT Wheat Close:$10.99 /bu on March 3, 2008

JULY 2008 KC Wheat Put Price Floors

$9.0

0

$9.0

5

$9.1

0

$9.1

5

$9.2

0

$9.2

4

$9.3

3

$9.4

1

$9.4

5

0.60 0.60 0.60 0.60 0.60 0.60 0.60 0.60 0.600.88 0.93 0.98 1.03 1.08 1.14 1.25 1.37 1.43

$0.00

$3.00

$6.00

$9.00

$12.00

$15.00

$10.50 $10.60 $10.70 $10.80 $10.90 $11.00 $11.20 $11.40 $11.50

Strike Prices

Pre

miu

ms

/ Bu.

Floor Price* Basis Put Premium Broker Fee

At the Money: $10.99 /bu (3/3/08)

JULY ‘08 KC Wheat Call Price CoverageMinimum Price Increase Needed to Cover Call Premium Cost

$10.

50

$10.

60

$10.

70

$10.

80

$11.

00

$11.

20

$11.

30

$11.

40

$11.

50

1.15 1.37 1.32 1.27 1.22 1.13 1.04 1.00 0.96 0.92$1

0.40

$0.00

$3.00

$6.00

$9.00

$12.00

$15.00

$10.40 $10.50 $10.60 $10.70 $10.80 $11.00 $11.20 $11.30 $11.40 $11.50

Strike Prices

Pre

miu

ms

/ Bu.

Strike Price Call Option Premiums Broker Fee

At the Money: $10.99 /bu (3/3/08)

Concluding Thoughts

on Grain Marketing

Goals, Plans & Strategies

Goals in Grain Marketing

A. Price Improvement To raise average grain selling price

B. Price Risk Reduction To reduce seller’s downside price risk

C. Average Pricing via Sequential Sales

D. Financial Management Oriented Goals Enterprise cost or whole farm profit objectives

E. Combination Goals Difficult to enhance price AND reduce risk

Improving the Selling Price of Grain Farmer’s Most Common Marketing Goal:

To improve average grain selling price!

To maximize grain selling price subject to the need to manage harmful downside price risk

Specific Goals: Getting better than the... Average price available

Middle (50%) price available

Harvest price

Reducing Grain Price Risk

A. Goal: Reducing price risk by protecting from harmful price moves

To maximize grain selling price subject to the need to manage harmful downside price risk

B. Grain Sellers are motivated to: Protect themselves from downside price risk Possibility profit from price increases

C. Tools for Reducing Grain Price Risk: Forward Contracts & Hedges: To lock in prices MPCs & Put Options: To set price floors

Average Pricing via Sequential Sales Deliberately pricing portions of the crop at

different times of the marketing year

Average Pricing….(+) AVOIDS selling 100% at market LOWS

(–) ALSO AVOIDS selling 100% at market HIGHS

Benefits of Average Pricing: Adds structure & discipline to marketing plans Is a form of price risk management

Combining Grain Marketing Goals Difficult to both Enhance Prices & Reduce

Price Risk at the same time Example: Higher returns & price variability from pre-

harvest futures hedges vs. buying put options

Principle of Price Risk Management Higher net grain selling prices will tend to be

sacrificed in terms of lost pricing opportunities or the cost of managing price risk

If Prices : Cash Sales > Options-Fwd. Contracts If Prices : Fwd. Contracts > Options-Cash Sales

Types of Grain Marketing Strategies1) Routine Strategies

Grain marketed each year at the same time using the same marketing tools regardless of market conditions

• Example: Preharvest hedge 1/3 of exp. production, sell 1/3 at harvest, store rest on farm for 6 months then sell

2) Systematic Strategies Allowing for yearly variation in marketing actions

based on Key Market Indicators

• Key #1: Preharvest Prices vs. CCC Loan Rates• Key #2: Years following Short Crops

Types of Grain Mktg. Strategies (more)3) Strategies Using Expert Forecasts

When people profit from their superior ability to forecast grain market trends & marketing decisions

• In general, it is difficult for individuals to predict market price direction better than other market participants

4) Strategies Using Market-Based Forecasts Using futures, options & basis information as key

market indicators for making marketing decisions

• Key #1: “Wide” Cash Grain Basis @ harvest• Key #2: “Higher / Lower than normal” preharvest

hedge profits

How Efficient are Grain Futures Markets at Determining Grain Prices? How Efficient are Grain Markets?

Define “Market Efficiency”

Opinions: From Very to Moderately Efficient

Key Issue: “Do Grain Marketing Strategies Exist that are more profitable than selling at harvest?”

The degree of Futures Market Efficiency will affect choice of Grain Marketing Strategies

Marketing Challenges & BenefitsA. The Challenge of Grain Marketing Decisions

It is Difficult to obtain higher grain selling prices!!

B. Grain Marketing’s Relative Importance(K-State Study of KFMA Farms for 1987-1996)

High 1/3 vs Middle 1/3:Yields: +17%; Costs: –37%; Prices +12%, More Notill

Low 1/3 vs Middle 1/3:Yields: –18%; Costs: +28%; Prices –12%, Less Notill

Study Critique: Not measuring effectiveness of marketing practices used, only Hi/Lo Profit

C. Production is 1st priority; Marketing #1.A

Futures Margins Initial Margin Deposit:

Required up front, good faith deposit by exchanges

Margin Account Losses/gains in futures position reflected here Minimum required margin account balance

Margin Deposit Additional money required when margin account falls

below minimum balance due to losses in futures position

Wheat Margin Deposit ExampleSell 5,000 bu July KCBT Wheat @ $10.50/bu on 2/5/08

Prices Trend Up2/5:Sell $10.50 KC July Wheat Initial Deposit = $1,500

Minimum Deposit = $1,000

6/1: KC July Wheat @ $11.50

Loss in Futures ($5,000)

Account balance ($3,500)

Margin Call +$4,500

New Account balance = $1,000

Prices Trend Down2/5:Sell $10.50 KC July Wheat Initial Deposit = $1,500

Minimum Deposit = $1,000

6/1- KC July Wheat @ $9.50

Gain in Futures +$5,000

Account balance $6,500

Margin Call = $ 0

New Account balance = $6,500

Questions or Comments?

K-State Agricultural Economics Department Website:

www.Agmanager.Info