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How futures markets work: Straight hedge

Nevil Speer Hedging Example
For many, the futures market can be confusing. But learning how it works can help your marketing strategy.

I came across some market commentary in early May proclaiming cattle feeders had achieved their best sales of the year. This despite the cash market trading in the low $120s. The logic was something like this: Feedyards sold cattle early in the week at $122 per cwt. Meanwhile, the spot futures market on that given day was $112; that equated to a $10 basis.

To this marketer commenter, that meant “You can add that on to the sale price of $122 because when they’re short the board that means they can pick up that extra money – tack on 10 bucks on $122 and you’re suddenly at $132.”  

Unfortunately, that’s NOT how it works. As a result of that misunderstanding of how futures work, Industry At A Glance will highlight some basics around risk management over the next several weeks. With that, perhaps one of the most misunderstood principles of hedging revolves around the concept of basis. 

Basis equals the difference between the cash market and the futures market (cash minus futures). This week’s illustration highlights two generalized examples outlining its importance. 

Nevil SpeerHedging Example

Let’s assume that cattle marketed in early- to mid-May went on feed at some point between mid-November and mid-December.  

At that time, CME’s June live cattle contract averaged roughly $114.50 per cwt. A feedyard would sell (or short) June futures contracts to implement a hedged position at $114.50.  

During the past five years, May’s basis average has been a positive $9.75. Therefore, at the time of placing the hedge, the feedyard’s expected selling price would be $124.25 ($114.50 + $9.75). 

The feedyard is now indifferent to what occurs in the futures market – they are protected against downside market risk. The only remaining price risk revolves around basis.   

Now fast-forward to the first week of May; the cattle are ready to be marketed. The cash market averaged $123.75 while the futures had drifted back to $114. The basis was right in line with the five-year average.  

The feedyard markets the cattle at $123.75 while simultaneously negating the short position in the futures market by purchasing June contracts at $114 – thereby facilitating a 50¢ profit. The net selling price is $124.25 ($123.75 + $.50). 

Basis is NOT added on to the cash market to determine net sales price as the commentator noted. Meanwhile, two weeks later, basis had weakened to $6.50 against $110 live cattle futures contract, with the outcome being a relatively lower net sales price. 

The net selling price in that instance is $121 ($114.50 - $110 in the futures market totals $4.50, plus cash market of $116.50). In other words, the hedge remains the same but the net selling price is less because basis had weakened.    

The two examples illustrate the concept of basis risk. Once the hedge is placed, the feedyard is still prone to basis risk (i.e. weakening basis) but becomes indifferent to price risk or price movement in the futures market. 

However, that reality also means potential for missing strong moves to the upside (opportunity risk); that’s where put options come into play. More on that next week. 

Speer serves as an industry consultant and is based in Bowling Green, Ky. Contact him at [email protected]

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