Hedging 101
Price Risk Management for Cow-Calf Producers: Part 3
Cow-calf producers use various strategies to manage price risk. Hedging is a formal price risk management tool that allows a producer to directly manage the risk associated with changes in expected market prices.
Background-Today most agricultural commodities are traded in futures markets—largely under the CME Group (Chicago Mercantile Exchange). Local or cash prices are generally driven by futures prices, plus any differences in transportation costs, nearby markets, etc. Future markets allow for “price discovery” when there are enough potential buyers and sellers that are willing to commit to purchase or sell a specific amount of a specific commodity at a future date. Today very little physical delivery of commodities occurs, but futures markets are widely used by market participants to manage price risk in commodity markets. Better knowledge of current and expected price levels allows a business to make decisions and plan for the future.
Buyers and sellers of commodities use futures markets to “hedge” or protect their anticipated profit margin from unexpected prices change. This article focuses on hedging feeder cattle. Producers can hedge feeder cattle prices with either futures or options. We will use the example of a producer who is calving in February and plans to sell around mid-August.
A futures contract allows a producer to set a specific price at a future date, subject to changes in basis, or the difference between cash and futures prices. The current August futures price for feeder cattle is around $186 per cwt. A hedge is placed by establishing a short position (“selling”) for an August feeder contract at $186 per cwt. If actual August futures and cash prices are lower when calves are sold, the producer’s loss in the cash value of the calves is balanced by a gain in the value of the futures market position. However, if actual August prices are higher, the producer’s gain in the cash market is balanced by a loss in the futures market. Further, if futures prices go up, the producer may face a “margin call” or have to put additional money into a “margin account”. Margin calls may be a disadvantage of a futures contract for some producers.
An options contract, or a ‘put option’ in the case when you are selling feeder cattle, gives the producer the right but not the obligation to sell at a specific price in a specific futures contract. For example, a producer selling feeder cattle in August currently can purchase a put option at strike price of $186 per cwt. This put option would cost around $7.50 per cwt and allow the holder to sell the August contract at $186 any time before expiration. This position sets an effective price floor around $178.50 per cwt plus expected basis. The producer can still benefit from higher actual prices, less the cost of purchasing the option.
There are a few other considerations. A producer must pay a commission to a broker to establish a futures contract or purchase an option. A potential disadvantage of using futures is the necessity of tying up capital, temporarily, in a margin account. The cost of purchasing an option may deter some producers. Another issue for cow-calf producers may be the required minimum contract size of 50,000 pounds, which is equivalent to about 71 700-pound calves.
Livestock Risk Protection (LRP) is an insurance product that is very similar to a put option but has the advantage of no minimum number of animals. The next article in this series will cover the costs of LRP.
We at the Southwind Extension District thank Dr. Jennifer Ifft, KSU Ag Economics Specialist, for allowing the use of this 8-part series to help our district’s beef producers. Questions regarding this series can be directed through Chad Guthrie at [email protected], or by contacting your local extension office.
This article is the third in an 8-part series on price risk management for cow-calf producers. The first part of the series will focus on price risk and different management alternatives. The later part of the series will focus on Livestock Risk Protection, an insurance product available to Kansas producers, that pays out when market prices for feeder cattle (or fed cattle or swine) are lower than expected. While LRP has been available for 2 decades, recently policy changes make it more affordable to producers. Funding for this work was provided by the North Central Extension Risk Management Education Center, the USDA National Institute of Food and Agriculture Award Number 2018-70024-28586.
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