of price protection must be treated as ordinary income or loss. Therefore,business firms that keep their records on an accrual basis and value their inventories at market at year-end must take into account gains or losses on the open futurescontracts hedged against the cash commodity or against forward sales or purchases.This interpretation has been called into question, however, by more recent courtdecisions, especially the Arkansas Best case. Check with your tax advisors.If the hedger values inventories at cost or the lower of costs or market unrealized gains, losses usually are not taken into account until the futures market154
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transactions and their corresponding cash trades are closed. Therefore, taxpayerswho value their inventories at the lower costs or market have an opportunity to deferincome tax liability from one period to the next by closing out all loss futures positions and simultaneously placing their hedges into another delivery month.All of this is quite complicated and very dependent on the overall positionand business strategy of the business firm. Accounting rules have a particularimportance here. That’s why it’s so important that the manager of a firm involvedin hedging integrate the hedging decisions into the overall strategy of the firm.The important point here is that hedging should not always be an automaticreflex. The decision to hedge should be considered carefully in light of its costs andits benefits. For a further explanation of this concept and an example of this decision-making process at work, see the beginning of Chapter 24.
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Chapter 15
Hedging—The Basis
Here’s a practical example from a few years ago that shows you the significanceof basis in hedging.The telephone rang and Bart Jones answered. It was Bob Thompson, hiscommodity broker, calling to talk to him about hedging the cattle he had on feed.“Your cattle should be ready for market in June,” Bob said, “and right nowJune futures are at $61.50. I think you ought to sell them now and lock in that price.”Bart thought for a minute. The 80 head he had on feed would be about theequivalent of two futures contracts. June cattle futures prices had been rising steadily, but recently had leveled off in the $61 to $62 range. He doubted they would bemuch higher by June, and they could be lower. At $61.50, he figures he’d have abouta $4 per hundredweight profit margin.“Okay,” he said, “sell two June contracts at $61.50.” Ten minutes later Bobcalled back to tell him the two contracts were sold at $61.50 and instructed Bartto send him $1,500 in margin money. Bart did so and then relaxed, figuring hehad sold his cattle at $61.50 and secured his $4 per hundredweight profit.When June rolled around, Bob called again to suggest that Bart lift his hedgeby buying back the futures and delivering his cattle at his normal market—a meat157Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 15
packing plant located about 15 miles away. Since Bart knew that delivery on thefutures contract was not the normal route followed in hedging, he did as Bob suggested. He lifted the hedge at $62.50, futures prices having gone up slightly, andhe sold his steers, graded USDA Choice, to the nearest packer for a price of $61.But when Bart calculated his net, he found that he had lost $1 per hundredweight on the futures transaction, not counting his commissions and interest he couldhave earned on the margin deposit and, he had sold his cattle for $1.05 per hundredweight less than the futures had been on that day. His net profit was only $2.50per hundredweight. He was puzzled by it all; he wasn’t sure whether he had beensold a bill of goods by his broker about “locking” $61.50 or whether the localpacker had cheated him by giving him so much less than the futures price.Bart had made his mistake by assuming that the futures price quoted to himequated with prices at his local market. He forgot about the most important elementin hedging: calculating the basis or adjusting the futures price to represent his localarea.
THE IMPORTANT DIFFERENCEA futures contract represents a specific time, quality, quantity, and location of acommodity. When Bart sold the futures, he was entering into a contract for thedelivery of 40,000 pounds of choice-grade, fat animals delivered in Omaha,Nebraska, or Sioux City, Iowa (or at certain other delivery points at a premium ordiscount). Hence, in judging whether the futures price at $61.50 was the “right”price for him at that time, Bart should have first determined how the futures pricerelated to the price where he usually markets his cattle.Had Bart known that the prices for his local area were usually $1.50 underthe futures, he would have known he was not locking in a net price at $61.50 onhis hedge and that the $61 price paid by his local packer when deliverable futureswere selling at $62.50 was “about right.”The essence of profit or loss in hedging is the basis. This is true for any hedgein any commodity. The basis is the difference between two prices representingdifferent locations, different qualities, different markets, or different times. Hence,if one is hedging a product of different quality in the cash market than is reflected in the futures contract, one must account for that difference in the basis calculations. We will use the term “basis” in this discussion to mean the aggregate ofall these, or simply the difference between a trader’s local cash price and the futuresprice at any given time.Before beginning a hedging operation, close attention should be paid to historic price relationships for the time period covering the proposed hedge.With futures contracts such as those for live cattle, feeder cattle, and livehogs—which are continuously produced, non-storable commodities—the rela158
Hedging—The Basis
tionship of the cash price to the futures price has relatively little meaning exceptduring the contract month. Hence, it is sometimes difficult to get a good hedgefor commodities such as cattle that are ready for market in a non-delivery month.Accurate estimation of what the basis will be for a particular delivery month is,therefore, most important in effective hedging of these commodities. If the produceraccurately forecasts the difference between his price and the futures price at the timeof the sale of his product, he will have a virtually perfect price-protecting hedge.For a semi-storable or storable commodity, such as corn, the basis primarily reflects two main factors: the cost of storage between two time periods and location differences.Because there are costs for storing actual corn and there are virtually no similar costs for holding futures contracts, cash prices usually gain in relation to futuresprices during the storage period. The price of cash corn, therefore, should usuallybe below the price of futures by the amount of storage cost from any given pointin time to the date of maturity of the futures. March futures, for example, will usually be below the May futures by the cost of storage between March and May.Futures markets are not always “normal.” When immediate supplies arescarce, futures markets often become “inverted.” That is, nearby contracts are athigher prices than the more distant contracts.The pork belly market of a few years ago illustrates this point. The Februarypork belly contract was selling at as much as a 600-point premium to August bellies. March and May were at similarly extreme, but slightly lower, levels. Thispremium reflected short near-term supplies and high cash prices, as well as traders’expectations that the “hog cycle” was beginning to turn upward and that suppliescould be considerably more plentiful by late summer.Then, as succeeding pig crop reports released during the winter months indicated that, because of a variety of factors, farmers’ farrowing intentions wouldapparently not be met as soon as had been expected, the premium gradually shrunk.By May, the premium over August was only 200 points, still an inverted marketbut much less so than before.Fully storable commodities such as wheat, for example, are also subject tothese influences. In fact, futures for all commodities are affected to some degreeby temporary weather conditions, import/export agreements, near-term shortage oroversupply, and other factors. These should be made a part of any evaluation of yourbasis in a particular commodity futures contract.In actual practice, the basis for the par delivery area represented in the futurescontract tends to narrow toward zero as the delivery time for the futures contractapproaches. The reason for this is simple. If on April 1 the cash price of the commodity is $1 below the April futures price, merchants will buy the actual commodity, sell the April commodity future, and make a certain profit. As they do this,the two prices rapidly converge until the basis narrows and the profit opportunitydisappears.159
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This convergence of the cash and futures prices during the delivery monthmeans simply that the futures price tends to reflect actual values in the cash market. This convergence does not usually occur during non-delivery months. Hence,in non-delivery months, the basis for non-storable commodities is likely to beunstable and difficult to predict accurately.
CALCULATING THE BASISThere are two primary methods of determining the basis for any local market: (1)historic price relationships and (2) actual cost calculation.To calculate the basis with the first method, you simply obtain past futuresprices and compare them with prices at your local market for the same quality product. Usually, you will find that basic patterns repeat themselves year after year.Hence, you can learn to predict basis levels for particular months. If you were figuring the basis for live cattle at Kansas City, Missouri, you might find that KansasCity prices normally have been 50 cents per hundredweight below the prices paidat the specified futures delivery point of Omaha. The basis would, therefore, be 50cents, and any producer who normally markets at Kansas City would adjust thefutures price by 50 cents per hundredweight when figuring the basis. See Figure 15.1for a historical basis for Texas Panhandle steers versus Chicago Mercantile Exchangelive cattle futures for September and December futures. Note that the patterns follow closely each year, and the levels vary only slightly.To calculate the basis with the second method, you must obtain the actual costof transporting the cattle from the local market to the location represented by thefutures contract. Hence, to determine the basis between Kansas City and Omahavia this method, you estimate the cost for transportation (including shrink), interest charges, insurance charges, and the like and use this total to adjust for youractual basis at Kansas City.If Bart had calculated his basis correctly using costs, he would have had thefigures shown in Table 15.1, and he would have known that a $61.50 futures pricereally meant $60 at his local market.As mentioned above, there are many factors that cause the basis for any localmarket to vary over a period of time. These include such things as changes in localsupply and demand, changes in local production costs, the predicted size of a futurecrop, changes in government programs, and local market receipts.The basis may not work out perfectly because the price relationships describedabove don’t always follow their theoretical models—that is, cash and futures don’talways move up and down in unison.Nor do they always converge exactly at delivery time. And there is the difference in the strength of the relationship between the cash and futures prices for
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Figure 15.1 Basis Relationship
semi-storable commodities, such as pork bellies, as opposed to non-storable commodities, such as live hogs.Another bug in the theoretically perfect hedge is the fixed size of the futurescontract, which must be used to hedge. A cattle futures contract on the ChicagoMercantile Exchange is 40,000 pounds, which equates roughly with 40 head of fatcattle. If you are feeding 60 head, the sale of one contract leaves one-third of yourcattle unhedged. The sale of two contracts would “overhedge” your herd.Despite all these imperfections, however, hedges do work and even an imperfect hedge may be better than no hedge at all.
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Table 15.1 Allowing For BasisJan. 15
June 10June 10
Summary:
Sell June futures @$61.50Transportation differential$1.00Interest & commission.15Other marketing expenses.35Basis$1.50Expected net localized price$60.00Sell live cattle @$61.00Buy back futures @62.50Loss on futures($62.50 – $61.50) $1.00Net realized price for cattle($61 – $1)Expected price from hedge= $60Realized price= $60
In summary, the Bart Jones example above illustrates several key ingredientsin any hedging program. They are:a. Know your costs of production so that you can determine whether thefutures price is allowing you to hedge at a profit.b. Know what the futures price represents in time, quality, quantity, and location and how that corresponds to the commodity you are hedging.c. Know your basis—the relationship between your local price and the futuresprice.When you know these things, you can apply the basic principles to hedgingany commodity.It should be emphasized that a perfect hedge is not necessarily one in whichyou get a better price by hedging, but rather it is one in which you achieve yourtarget price through correct calculation of the basis.It also should be emphasized that hedging is not an operation that should betaken lightly. It takes hard work to hedge effectively. Hedging decisions should begiven as much attention as any other aspect of the business. Hedging will not guarantee a profit. If a business manager can’t control costs in the cash market, hedging will not help. Hedging will not make a good manager out of a poor manager,but it can make a good manager an even better one.162
Chapter 16
Your Banker and Hedging
One of the most important relationships a hedger has is with his banker. A goodbanker can assist a hedger in a number of ways, not only in lending money butalso in providing advice. Bankers are in a unique position to teach their customershow to use futures markets, and it is in their best interest to do so because futuresmarkets and hedging provide lenders with an opportunity to improve the qualityof their loans.A good loan can be made even better by hedging. Producers who have learnedthis are finding that, with increasing frequency, hedging helps them secure loans.Futures trading can aid the overall profitability of a business by providing a gooddeal of flexibility in the timing of purchases and sales, thus allowing a businesspersonto select the most favorable time of the year for making price decisions.As pointed out earlier, when producers hedge, they “lock in” or ensure themselves of achieving a price within a fairly small price range. Thus, when they cometo their bankers for loans, they will be able to assure the bankers of the exact price,within a small margin of error, that they will receive for the products they havehedged. The bankers, therefore, have a greater assurance that the loans will be repaid.
163Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 16
THE LOAN PACKAGEWhen a banker makes a loan secured by hedged collateral, it is usually a goodidea to coordinate the management of the hedge account at the brokerage house withthe management of the loan account at the bank. This coordination has to start atthe very beginning, when the terms of the loan are being considered. At that point,the banker will be interested in what the loan is to be used for and from whatsource the funds for repayment will come.In considering the first question, it is usual on most hedged collateral loansthat the funds loaned be used not only for the business purpose stated by the borrower, but also that the banker agree to allow the funds to be used for meetingmargin calls on the futures exchange. Just as a speculator should not speculatewith too little capital, a hedger should not try to hedge without sufficient capitalto meet expected margin calls. Bankers who would refuse to take this second stepand lend for purposes of making margin calls on hedged collateral could soon findtheir customers without a hedge (brokers are required to close out accounts whenmargin calls are not met), thus reducing the quality of the loan and removing anyguarantee of the price to be obtained for the hedged collateral.The second question, pertaining to the source of funds for repayment, goesto the heart of cash flow management. When the futures market price moves in favorof the hedger’s futures position, the cash market has moved against him. For example, assume a farmer sells hog futures to hedge against hogs he is fattening. If theprice declines, the farmer will have a gain on his futures transaction, but the hogswill be worth less. But the gain on the futures side will be paid into the farmer’sbrokerage account each day, and that money is available for payment to the bankto reduce the loan amount.On the other hand, if the price of the futures increases, the farmer will havelost money on his short futures position, and will be required to pay his broker, incash, the amount of the loss. This loss will be offset by the increase in the valueof the collateral.For example, suppose a hog farmer plans to buy 700 feeder pigs weighing40 pounds each and to use his own feed, fattening them to 230 pounds each.Suppose further that, at the time he buys the feeder pigs, the farmer hedges byselling four futures contracts (each contract represents 40,000 pounds or 175 hogs)for fat hogs at $41.65 per hundredweight. If the banker requires the hogs and thefarmer’s feed as collateral for the loan and lends 85 percent of the value of the fathogs, the farmer will have a loan of about $57,000.Now, if the cash and futures prices for the fat hogs decline to $35 per hundredweight, the banker will find that the value of the collateral (56,350 = 1610cwt. × $35 per cwt.) has fallen below the original amount of the loan—a dangerous situation for the banker. It is likely he will ask for a prepayment on the loanto restore the 85 percent ratio of loan to collateral value.164
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Because the farmer has hedged, he will have no problem making the prepayment because, as the futures price fell from $41.66 to $35, the farmer’s brokerageaccount was credited in cash with the gain on his futures position. The money,except for the original margin in the brokerage account, can be withdrawn andtransferred directly to the bank to reduce the loan without actually closing out thefutures position.If per chance the futures market had risen to $45 per hundredweight, thefarmer would have been called on to meet a margin call because the market wouldbe above the level at which he previously sold. This increase in price would resultin the loan ($57,000) being worth only about 78 percent of the value of the collateral(72,450 = 1610 cwt. × $45 per cwt.). The bank should be willing to increase theloan back to the 85 percent level of the collateral value. This amount can then beused to meet the margin calls.From this example, it becomes clear that management of the hedge and loanaccounts needs to be coordinated. The hedge becomes important in upgrading thequality of the loan and assuring repayment. Management of the loan accountbecomes important in maintaining the hedge. And the key to good management inboth is good management of cash flow.There are several important points for both hedgers and lenders to keep inmind. These include:1. A hedge will not make a bad loan a good loan. Loans should be made onthe basis of whether the underlying purpose for the loan is justified, noton the basis of whether it is hedged or not.2. Hedging is not for everybody and should not be undertaken solely for thepurpose of securing a loan.3. Whether the collateral is hedged or not will have no impact on the interest rates charged for the loan. Research has shown that the most likelyimpact will be an increase in the debt-to-equity ratio or the lending of alarger amount of money on a given equity base.4. The hedger and the lender need to have a thorough understanding of thehedger’s cost of operation and the margin of profit represented in anyhedge transaction.The biggest danger confronting both the lender and the hedger is that the“hedger” will succumb to the temptation of “speculation” and thereby take positions in the futures market that jeopardize his loan as well as his whole financialstructure. It is not unusual for a producer to sell a futures contract, thus hedging,and after a short time to find that the market has moved against him, causing aloss. The producer reasons that if he simply “hedged” a little more at this higherlevel by selling even more contracts, he will recover his loss and even “make a little money” when prices ultimately fall. Alas, prices don’t fall, but continue rising.165
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The producer finds himself strapped for cash to meet the margin calls. His bankerfinds out what the producer has done when he comes in for a bigger mortgage onthe farm.Another temptation is for the hedger to trade in and out of his position, removing the hedge when prices move slightly against him and trying to put it back onat a better price. The usual result of this activity is huge commission costs and agreat danger of being whipsawed, i.e., the hedge won’t be “on” when a major market move occurs.A third temptation is that the hedger, particularly after initial successes,begins to think that because he is so intimately familiar with the market he can “outspeculate those speculators.” He therefore begins to speculate heavily out of all proportion to financial ability, thus jeopardizing his loan and business.The banker can protect against these happenings by keeping tight control ofthe hedge and the hedger. Any banker who makes a loan on hedged collateralshould include the following as part of his control procedures:1. Frequent consultation with the hedger for purposes of reviewing his strategy.2. Insistence that the borrower and the broker sign an agreement requiringthat the banker receive a copy of all orders entered into the account.3. That any profits accruing to the account be kept in escrow for the bank untilthe account is closed and the loan repaid.4. That the broker provide a monthly statement of account activity to thebanker.The hedger also should assure the banker that other accounts will not beopened for purposes of speculation. In addition, it is not unusual for a banker torequire hedges to sign agreements that, under special circumstances, allow thebanker to “take over” management of the hedge account and even make deliveryof the collateral on the futures contract.
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Commodity Hedging in Action
Even if the only real hedging you’ll ever do is in an argument with someone else,if you are going to trade futures, it is important to know basically when and howfarmers, processors, and others hedge their products and services in the futuresmarkets. Their hedging can have an impact on futures prices that means profit orloss to you. In previous chapters you learned about the importance of basis and theimportance of your banker in hedging. Now let’s make the process of hedgingcome alive with some real down-to-earth examples. We’ll see how important it isto know your costs of production and to calculate accurately your break-even pointas well as your basis. We’ll cover commodity hedging in this chapter and financial futures hedging in Chapters 23 through 25.For the first part of this chapter, you are going to be short-hedging cattle.Then you will be in the meat packing business and will buy futures to protect theprice you will pay for hogs you will actually buy at a later date. We could as easily make the example a grain elevator in North Dakota buying wheat from a farmer.The concepts are essentially the same, although the arithmetic would be different.Lastly, we’ll demonstrate the use of the grain market to earn storage charges forgrain you have harvested. Again, we could easily make the commodity gold orsilver or any other storable commodity. The concepts would be the same.167Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 17
To do an effective job of hedging, the first thing you need is good information. You must know your costs in the cash market—the relationships betweenyour price at the local level and the futures price (the basis)—and you should haveknowledge of what the futures price is and what it represents. The last is especially important, because the futures contract very specifically defines the quality and location of the commodity being traded. If the quality or location of thecommodity a hedger is concerned with in the cash market differs from the commodity deliverable in the futures market, he should take that into account in calculating the net localized price the hedger is trying to establish in the futures. And,lastly, you should have a knowledge of the fundamental economic and seasonal factors that affect the prices of your product and how these act over time.
THE SHORT HEDGE—CATTLELet’s assume you are operating a feedlot, and in January you bought 189 feeder cattle averaging 703 pounds in weight. The accompanying Table 17.1 summarizes yourhedge program. You intend to feed them to an average of 1,100 pounds each. Totalcost for the purchase of the animals averages $58.09 per hundred pounds, and youestimate that it will cost you $67 per hundredweight to feed them to their finishing weight of 1,100 pounds. Your estimated break-even point is $61.54 per hundredweight (total weight divided by total cost).Using procedures learned in the previous chapter, you estimate your basis forcattle in your local area at $1.50 per hundredweight. This should be added to yourbreak-even price along with any profit you hope to make. Let’s assume that youexpect a $30 per head profit (equivalent to $2.73 per hundredweight). Adding thebasis and expected profit to your break-even point provides you with a target priceof $65.77 per cwt. This is the price at which you must sell the future for your hedge.The 189 head of cattle is the equivalent of about five contracts of fat cattle.(Contracts are for 40,000 pounds each.) Because you expect that they will reachthe 1,100 pound level by June, you select June futures for your hedge. Let’s assumethat on five successive days, starting in late January, you sell one futures contracteach day for an average futures sale price of $65.40 per hundredweight. You arenow hedged, i.e., you have sold the cattle you are raising on a futures contract.Now assume that time passes, the cattle gain weight, and on June 11, 188 head(one died) are sold to a meat packer for $60.60 per hundredweight. On that sameday, you buy back your five June futures contracts at $62.05 per hundredweight.Note that the basis (62.05 – $60.60) is equal to $1.45 per hundredweight—notquite equal to the $1.50 you had estimated. Note also that the sale price of $60.60per hundredweight is $.71 per hundredweight below your break-even point. Thisloss on the sale of the animals is more than compensated for, however, by the$3.35 profit made on the futures side.168
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Table 17.1 Summary of Short Cattle HedgeI. Estimated Costs, Break-even and Target PricesJan. 26—Bought 189 feeder cattle weighing703 lbs. at $58.09Estimated gain 397 lbs. at $67 cwt.Total costs estimated
$77,182.4450,272.11$127,454.55
1,100 lbs. × 189 head (207,099 lbs.) divided into$127,454.55 = $61.54 estimated break-even cost.Estimated sale date: June 16 (Use June Futures)Break-even$61.54 cwt.Estimated basis1.50 cwt.$63.04 cwt.Profit desired2.73 cwt.Target price
($30 per head dividedby 1,100 lbs.)
$65.77
II. The HedgeYou need to sell 207,900 lbs. of June live cattle futures (5 contracts of 40,000 lbs.each) to ensure a $65.77 price and a possible profit of $30 per head.Jan. 31—Sold 1 June futures at $64.00Feb. 2—Sold 1 June futures at 64.50Feb. 5—Sold 1 June futures at 65.00Feb. 5—Sold 1 June futures at 65.50Feb. 8—Sold 1 June futures at 68.00200,000 lbs. sold at average futures price of $65.40 cwt.June 11—Bought 5 June futures @62.05 cwt.Difference3.35 × 200,000 lbs. = $6,700.00Less commission($50 per contract)250.00$6,450.00III. The ResultsJune 11—Sold 188 head at $60.60 cwt.(delivered to packer June 11) averaging 1,093 lbs.Actual purchase costs$77,182.44Actual feedlot costs50,340.86Actual marketing costs23.83Actual interest2,551.50Feeding lossFutures gainNetActual break-even$61.63 cwt.Actual cost of gain63.14 cwt.Actual basis1.45 cwt.Actual profit$3,648.70 or$19.39/head
Projected break-evenProject cost of gainProject basisProjected profit
$124,523.30
$127,326.60$–2,803.30+6,450.00$3,646.70$61.5467.001.50$5,670 on$30/head
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Overall, you would end up with a net profit per head of $19.39—a little morethan $10 less than you expected when you bought the feeder cattle. Why? First ofall, the cost per pound of gain was underestimated. It actually turned out to be$2.05 per hundredweight higher than had been estimated. The animals were soldat a slightly lower weight than had been anticipated (one animal died), and feedlot, marketing, and interest costs were slightly higher than expected. The resultwas that the break-even price was underestimated. This demonstrates the importance of accurate estimation of the costs.Despite the loss in the actual feeding of the cattle, there was a $6,450 net gainin the futures transactions for an overall profit of $3,646.70 or $19.39 per head. Hadyou not hedged, you would have had a loss of a little over $2,800 or about $14 perhead. In this instance, hedging definitely paid off (check through Table 17.1).
HEDGING HOGSOne of the hedges we talked about before is a forward-pricing hedge for a continuously produced, non-storable commodity. So let’s work through an example ofa live hog long hedge and see how you, a meat packer, can protect the price youwill have to pay for hogs. Although this example refers to live hogs, the conceptsexplained (know your basis