The basis is different at alternative marketing locations. Thus, for effective marketing, it is important to be aware of the local basis at country elevators, as well as at nearby processors or terminals. Local cash prices thus reflect two components: the futures price and the local basis. Figure 1 helps illustrate this point. It is helpful to think of local cash prices in terms of the futures component and the basis component when examining marketing alternatives.
Producer hedging involves selling corn futures contracts as a temporary substitute for selling corn in the local cash market. Hedging is a temporary substitute, since the corn will eventually be sold in the cash market.
Hedging is defined as taking equal but opposite positions in the cash and futures market. For example, assume a producer who has harvested 10, bushels of corn and placed it in storage in a grain bin.
By selling 10, bushels of corn futures the producer is in a hedged position. In this example, the producer is long owns 10, bushels of cash corn and short sold 10, bushels of futures corn.
Since the producer has sold futures, price has been established on the major component of the local cash price. This can be seen in Figure 1, which illustrates that the futures component is the most substantial portion of the local cash price. Selling futures in a hedge leaves the local basis unpriced. Thus, the final value of the corn is still subject to fluctuations in local basis.
However, basis risk variation is much less than futures price risk variation. By selling futures, the producer has eliminated the financial loss which would occur on the cash grain from a futures price decline. The hedge position is removed or lifted when the producer is ready to sell the corn in the cash market. It is lifted in a simultaneous two-step process.
The producer sells 10, bushels of corn to the local grain elevator and immediately buys back the futures position. The purchase of futures offsets the original short sold position in futures, and selling the cash grain converts the position to the cash market.
Hedging involves taking opposite but equal positions in the cash and futures markets. If you own 10, bushels of corn as discussed above, you are long cash corn.
If you sell 10, bushels of corn on the futures market you are short corn futures. If the price increases as shown in Figure 2, the value of the cash corn also increases. However, the futures contract incurs a loss because you sold short corn futures and now have to buy corn futures at the higher price to close out the futures position.
If both the cash and futures prices increase by the same amount, the increase in the value of the corn will exactly offset the loss in the futures market. The net price received from the hedge is exactly the same as the cash price when the hedge was initiated not including trading cost, interest on margin money, or storage costs. If the price decreases as shown in Figure 3, the value of the cash corn also decreases.
However, the futures contract results in a gain because you sold short corn futures and now can buy corn futures back at a lower price to close out the futures position. If both the cash and futures price decrease by the same amount, the decrease in the value of the corn will exactly offset the gain in the futures market.
The net price received from the hedge is exactly the same as the cash price when the hedge was initiated not including trading cost, interest on margin money, and storage costs. The difference between the cash price and the futures price is the basis. The basis in the illustrations in Figure 2 and 3 is the same when the hedge is lifted as when it was initially placed.
The futures exchange matches the buyer or seller, enabling price discovery and standardization of contracts while taking away counter-party default risk, which is prominent in mutual forward contracts.
While hedging is encouraged, it does come with its own set of unique challenges and considerations. Some of the most common include the following:. With new asset classes opening up through local, national, and international exchanges, hedging is now possible for anything and everything. Commodity options are an alternative to futures that can be used for hedging.
Care should be taken when assessing hedging securities to ensure they meet your needs. Bear in mind that hedgers should not get enticed by speculative gains. When hedging, careful consideration and focus can achieve the desired results. CME Group. Intercontinental Exchange. Soft Commodities Trading. Advanced Options Trading Concepts. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.
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Your Practice. Popular Courses. Table of Contents Expand. Hedging Commodities. How This Works: Producer Hedge. How This Works: Consumer Hedge. Challenges to Hedging. The Bottom Line. Key Takeaways Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security.
Contract Sizes One standard contract for grain is 5, bushels. Mini contracts of 1, bushels can also be traded. Standard contract sizes for livestock is in pounds. The chart below specifies common commodities, and the standard contract size. Individuals can trade multiple contracts at once i. It is important for individuals to plan the price at which they are willing to sell or buy a contract.
Once individuals initiate a futures contract, the price at which they bought or sold the contract is locked-in. Futures contracts require all buyers and sellers to maintain a margin account to offset the risk of the broker who underwrites the contract.
Margin is collateral deposited by the hedger or speculator. The contract value is calculated by multiplying the size of the contract by the current price. A producer must maintain a certain margin level to keep the contract. Futures contracts generally do not result in physical delivery of the commodity.
Instead, futures contracts are most frequently settled by offsetting the position, which eliminates the requirement to make or take delivery of the commodity. Offsetting a contract means taking the opposite position on the same futures contract at the new market price.
A gain is experienced on a futures contract if the price at which the contract is sold is greater than the price at which it was bought. This removes his obligation to deliver beans to the futures contract buyer. This removes her obligation of receiving cattle from the futures contract seller. Futures contracts expire on the business day prior to the 15th calendar day of the contract month. If a contract is not offset by expiration, it requires the individual to make or receive delivery of the commodity.
The reason futures contracts rarely result in delivery is because as the contract expiration date approaches, the futures price converges to the cash price. Producers and users of the commodity will still sell or purchase the physical product locally in the cash market.
This saves the producer time and money by not needing to haul their commodity long distances to deliver on the futures contract. This also allows speculators to trade contracts. Download as PDF. Futures contracts for agricultural commodities are standardized with respect to: Commodity corn, soybeans, wheat, feeder cattle, live cattle, lean hogs Delivery Month the month the contract expires Delivery Location location to deliver the commodity Quantity number of bushels of grain or pounds of livestock Quality specific U.
Before trading a futures contract, hedgers and speculators must make decisions about the following: Position Buy or Sell Contract month and year Number of contracts Price Position The two positions one can take to initiate a futures contract are to sell or buy, which are also called short and long positions.
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