MRKT 325 Lecture Notes - Lecture 2: Basis Risk, Forego, Cme Group
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Department of Agricultural Economics
AECN/MRKT 325
Marketing of Agricultural Commodities
Module 1 (A)
•Marketing with futures contracts (review)
oshort hedge: selling with futures contracts
olong hedge: buying with futures contracts
otarget and realized prices
obasis risk
Department of Agricultural Economics
Readings
•“Study Guide to Hedging with Grain and Oilseed Futures and
Options” (CME Group booklet) –Chapters 2 and 3 (p.9-23)
•“Study Guide to Hedging with Livestock Futures and
Options” (CME Group booklet) –Chapters 5 to 8 (p.13-24)
•“An Introduction to Futures and Options –Chapter 5:
Hedging and speculating (p.49-55)
•Suggested (in case you feel the above material is not enough)
o“Agricultural Futures and Options” –Chapter 1: The basics of
commodity futures (p.15-25)
(Posted on Canvas)
Department of Agricultural Economics
Marketing with futures contracts
•Futures contracts are used to anticipate a transaction that is
planned to be executed in the cash market in the future
oprice is locked in several weeks or months in advance
•This process is typically called “hedging”
omain purpose is to eliminate price risk (price is locked in)
ostrategy to manage risk
•Note that hedger (buyer or seller) will:
obenefit if price in the future is worse than the price locked in with
futures contract
oforego profit if price in the future is better than price locked in with
futures contract
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Department of Agricultural Economics
Hedging (marketing with futures contracts)
•Objective of the hedger is to reduce risk:
opass futures price risk to someone else (speculators) and stay
with basis risk
•Basis risk is typically smaller than price risk
•Effectiveness of hedge depends on predictability of basis
obasis does not need to be zero, but it needs to be predictable
for a hedge to be effective
Department of Agricultural Economics
Hedging (marketing with futures contracts)
•There are basically two types of hedge
oshort hedge: sell commodity using futures contracts
olong hedge: buy commodity using futures contracts
•Example: corn producer (short hedger)
oplans to sell corn in the future
osells futures contracts to hedge his future sale of corn (lock in
today the price of future sale)
•Example: grain elevator or processor (long hedger)
oplans to buy soybeans in the future
obuy futures contracts to hedge his future purchase of soybeans
(lock in today the price of future purchase)
Department of Agricultural Economics
Short hedge (selling with futures contracts)
Producer sells
corn for future
delivery
corn
futures
market
Somebody is
buying and will
take delivery only
in the future
Note that, for the producer selling corn, it
doesn’t matter who the buyer is. Remember
that trading in futures markets is impersonal.
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Department of Agricultural Economics
Short hedge (selling with futures contracts)
•In June:
ocorn producer is planning to harvest and sell corn in the fall
(harvest)
osells crop using futures contracts
•Note that, by selling crop in June using futures contracts,
producer is:
omaking a commitment to deliver his crop at harvest
oagreeing to get paid in the fall the price he is trading now
ohe is locking in today the price he will receive in the fall
Department of Agricultural Economics
Short hedge (selling with futures contracts)
•Fall (harvest): producer has two alternatives
(1) deliver corn to futures market and receive price traded when he
entered the futures contract in June
net price received = futures price traded in June –transportation cost
Producer’s
farm
Delivery area
of futures
market
drive to delivery area, deliver corn and
pay transportation cost
get paid the price traded in June
Note: if producer is already located in the delivery area of futures
market, transportation cost is negligible and hence net price received
will be essentially the futures price traded in June
Department of Agricultural Economics
Short hedge (selling with futures contracts)
•Fall (harvest): producer has two alternatives (cont’ed)
(2) get out of futures contract and sell to local elevator (or any other
buyer) at current spot price
oproducer is paid the current spot price
oproducer realizes a gain or loss when he offsets futures contract
net price received = spot price at harvest + gain/loss with futures
contract
Producer’s
farm
Delivery area
of futures
market
Sell to local buyer
and receives local
spot price
Offsets futures
contract; realizes
gain or loss
Document Summary
Module 1 (a: marketing with futures contracts (review, short hedge: selling with futures contracts, long hedge: buying with futures contracts, target and realized prices, basis risk. Readings: study guide to hedging with grain and oilseed futures and. Options (cme group booklet) chapters 2 and 3 (p. 9-23: study guide to hedging with livestock futures and. Options (cme group booklet) chapters 5 to 8 (p. 13-24: an introduction to futures and options chapter 5: Hedging and speculating (p. 49-55: suggested (in case you feel the above material is not enough, agricultural futures and options chapter 1: the basics of commodity futures (p. 15-25) (posted on canvas) Producer sells corn for future delivery corn futures market. Somebody is buying and will take delivery only in the future. Note that, for the producer selling corn, it doesn"t matter who the buyer is. Producer"s farm drive to delivery area, deliver corn and pay transportation cost get paid the price traded in june.
