decision commodities, llc 614 billy sunday rd., suite 600 ames, iowa 50010 515.956.7880 market...

Decision Commodities, LLC614 Billy Sunday Rd., Suite 600Ames, Iowa 50010515.956.7880

www.decisioncommodities.com

MARKET BASED RISK MANAGEMENT FOR AGRICULTURE

September 2007Iowa State University

Regis Lefaucheur

New Generation Grain ContractsDecision Contracts

2

Decision Commodities

• Based in Ames, IA

• Provides innovative forward contracts to grain producers to help them take the emotion, stress and guesswork out of grain pricing

• Customer base: Iowa, Illinois, Minnesota, North Dakota, Wisconsin, Missouri

• Decision Contracts enable producers to put discipline into grain marketing

3

Decision Commodities

• What does Decision Commodities do?– Take the EMOTION out of selling– Take the GUESSWORK out of selling

– Consistently outguessing or outperforming the market is impossible.

4

“ forward contracts are always terrible ways to market…20% of the time I sold too soon, and 80% of the time I didn’t

market enough…”

What are producers saying?

“ I only sell grain when prices are in the top third of the market…”

5

Grain Industry Vocabulary

• Definitions:

– Futures price

– Basis

– Cash Price

– Spread

• Relationships

September 17, 2007 Corn Basis

6

Producer Hedging

Price Decrease Scenario

Futures

01 Feb 2007 $3.50 Sell @ $3.50

Harvest Lower $3.10 Buy @ $3.10

-$0.40 +$0.40

Price Increase Scenario Futures

01 Feb 2007 $3.50 Sell @ $3.50

Harvest Higher $3.90 Buy @ $3.90

+$0.40 -$0.40

Producer Goal: Lock in an attractive price (higher is better) – Protection against lower prices

7

Elevator Hedging


Futures

Harvest $3.20 Sell @ $3.20

January 15 sale Lower $3.00 Buy @ $3.00

-$0.20 +$0.20


Harvest $3.20 Sell @ $3.20

January 15 Sale Higher $3.40 Buy @ $3.40

+$0.20 -$0.20

Elevator Goal: Lock in the price of the grain he bought to protect his margins (storage, drying, basis, hedging)

8

End User: feed mill, ethanol


Futures

01 Feb 2007 $3.40 Buy @ $3.40

Harvest Lower $3.10 Sell @ $3.10

+$0.30 -$0.30


01 Feb 2007 $3.40 Buy @ $3.40

Harvest Higher $3.60 Sell @ $3.60

-$0.20 +$0.20

End User Goal: Lock in an attractive price (lower is better) – Protection against higher prices

9

Decision Contracts

Risk Management Continuum

Put Option Contract

Futures Contract Call Option Contract

Farmers

Price Sensitive

Elevator

Margin DependentEnd-User

Price Sensitive

Insurance against low prices

Insurance against high prices

10

Relationship Between Futures, Basis And Cash Price

Futures Price- Basis

= Cash Price(paid to the producer)

$3.5225 (Dec 2007)- $0.48

= $3.0425

See:

http://www.hoic.com/grain/bids.asp

11

Example

12

BASIS

What is BASIS?

Chicago Board of Trade - Corn Futures Price = $3.50

Processor Bid - $3.25

Warehouse Bid - $3.20

Producer Bid - $3.10

BASIS = “0.25 under”



How can a user increase or decrease the movement of grain locally if they can’t change the price on the

Chicago Board of Trade?

13

BASIS

Ethanol

River

Processing

What factors contribute to determining the BASIS?

Feed

Processing

Processing

14

BASIS

Feed

Export

Export

Ethanol

Industrial

• What impact does a BASIS change in one area have on other areas?• Which markets have the greatest influence on basis, spreads and the futures

market?

Poultry

Dairy

What factors contribute to determining the BASIS?

15

SPREAD

July Sept Spread = + $ 0.04

+ / Carry

Spread = price difference between various futures reference months

The Spread can be Carry or Inverted

Dec July Spread= - $ 2.79

- / Inverted

CBOT WHEAT

16

STORE or SELL ?

Basis

Spread

Futures price

Narrow

Inverted

High

SELL

Wide

Carry

Low

STORE

Result:

Decrease in the movement of grain

Result:

Increase in the movement of grain

What decision should a producer make?

17

EFFICIENT MARKET HYPOTHESIS

RANDOMNESS

18

Efficient Market Hypothesis

• According to Fama, an efficient market is one that accurately incorporates all known information in determining price. This is know as the efficient market hypothesis.

• Although there is considerable disagreement about the degree to which EMH holds, it has become the dominant paradigm used by economists to understand and investigate the behavior of financial and commodity markets.

• Markets for commodities and products that are widely traded in agriculture and the food industry are a model of efficiency. The compile all the information and knowledge of traders, businesses and producers, and express this data in the form of a price.

19

Efficient Market Hypothesis

• The daily pricing process in the market is usually referred to as a random walk. A commonly used analogy of a random walk is the flipping of a fair coin. Overtime, the expected change is price is zero.

• The market is all-knowing. Consistently outguessing or outperforming it is very difficult (if not impossible)

20

Randomness

• What does randomness looks like?

21

Randomness and Unpredictability

RandomnessCBOT Corn December

Futures 2007

It is easy to see patterns in random events

22

SOYBEAN – Up/Down days

Number of trading days up/downNov 01 to Oct 31 1997-2007 NOV Soybean CBOT

1 314 8 8 14 13

22

48 54

102

149

252

293

328313

267249

149

103

5742

2614 14 8 9 17

30

50

100

150

200

250

300

350

($0.

50)

($0.

35)

($0.

25)

($0.

22)

($0.

20)

($0.

18)

($0.

16)

($0.

14)

($0.

12)

($0.

10)

($0.

08)

($0.

06)

($0.

04)

($0.

02)

$0.0

0$0

.02

$0.0

4$0

.06

$0.0

8$0

.10

$0.1

2$0

.14

$0.1

6$0

.18

$0.2

0$0

.22

$0.2

5$0

.35

$0.5

0

Decision Commodities LLC

23

SOYBEAN – Up/Down days

By year (days)

Up Down Total

1997 126 126 252

1998 123 127 250

1999 114 136 250

2000 123 127 250

2001 119 129 248

2002 134 115 249

2003 145 104 249

2004 126 123 249

2005 131 119 250

2006 128 123 251

SOYBEAN TOTALS 1997-2006

Average of up/down $0.00

Standard deviation $0.08

Minimum $-0.49

Maximum $0.50

Total Days 2581

Up Days 1315

Down Days 1266

Nov 01 to Oct 31 - 1997-2007 - NOV Soybean CBOT

24

Randomness and Unpredictability

• Another way to view markets is that while prices can’t be predicted, prices aren’t all that random either.

• While we can’t guarantee that the “pattern” depicted below will be repeated in the future, this 25 year frequency histogram tends to suggest that there is some central tendency around $2.15 to $2.95 range.

Frequency of Closing Prices in CBOT December Corn 1979-2004

0

50

100

150

200

250

300

350

400

$1.6

0

$1.7

5

$1.9

0

$2.0

5

$2.2

0

$2.3

5

$2.5

0

$2.6

5

$2.8

0

$2.9

5

$3.1

0

$3.2

5

$3.4

0

$3.5

5

$3.7

0

$3.8

5

$4.0

0

25

BEHAVIORAL FINANCE AND EMOTIONS

26

Behavioral Finance and Emotions

2004 December Corn Futures

06-2003 to 09-2004

27

Behavioral Finance

• Regret: Regret management is probably a more accurate term for risk management.There is a very natural tendency to avoid regret. In grain marketing, this is often embodied into a decision not to decide. Regret is the more powerful behavioral issue. Obviously, regret can significantly impair our ability to make rational choices.

• Risk aversion: Most people are risk averse and seek to avoid risk. However, there tends to be identifiable biases in human behavior that lead to irrational decision making. One of these biases is the tendency to accept increases risk over a guaranteed loss. It reflects a tendency to underestimate the chances of “extreme” market situation occurring.

In grain marketing, this tendency leads some to accept price risk rather than pay for insurance – such as a put option purchase or guaranteed minimum price contract. Why don’t producers want to pay 5 cents to protect 50 cents?

28

Long Term Corn Prices

2007 December Corn Futures

07-2006 to 09-2007

Reference price anchoring: It is the tendency for a person to “fix” a specific figure in their mind as the perceived value.

– An example of driving with eyes fixed on the rear view mirror is establishing a target price based on last year’s market price. “Bull” or “bear” forecasts coming from newsletters, magazines, market advisors, radio shows…

– Reality takes a long time to soak in, and when it does, it is usually too late as opportunities are long gone.

29

Behavioral Finance

• Escalation: too much invested to quit.

A situation where a person enters a transaction hoping for a favorable outcome but after circumstances change to unfavorable, the person finds it difficult to escape or even adds to it.

• Endowment: Associated with the fear of giving up something.

It is more painful to give up an asset than it is pleasurable to obtain. Ownership as a positive feeling. Producers have a tendency to store grain beyond economic justification, because when it is sold, there is no opportunity to gain anymore. For grain under storage, the perceived value increases with the duration of ownership.

30

Behavioral Finance

• Which one of the following would you choose?– A. Winning a guaranteed $3,000– B. Taking an 80% chance of winning $4,000

• Now consider this option– A. Lose $3,000– B. Take an 80% chance of losing $4,000

31

Behavioral Finance

Results:• You are not alone if you said you would take the $3,000 but

roll the dice and risk losing the $4,000• As human being, we don’t deal with losses the same way we

do with gains• We will ride a loss to the bitter end while cutting a gain short

• Contributing to this mindset is a condition known as the Gambler’s fallacy, which is the belief that a successful outcome is due after a run of back luck. But chance – or the randomness of an efficient market – is not self-correcting.

Flipping 10 consecutive heads does not increase the chance that the eleventh toss will yield a tails, any more than a trend of lower grain prices ensures an up- or downswing in tomorrow’s market.

33

Agricultural Market Advisory Services

• AGMAS– Agmas study (U of I Urbana): provide a neutral

evaluation of the performance of market advisory services for corn, soybean and wheat.

– Tracking about 25-35 advisory programs per year since 1994

– Paid subscriptions obtained for each services– Recommendations recorded in “real-time”– Two important issues:

. Market advisory service performance relative to appropriate benchmarks. Predictability of market advisory service from year-to-year

– Result data available for the period 1995-2003

34


• Benchmarks:

– average of two-year marketing window (24 months) : price offered by the market

– USDA producer average : an “indicator” of marketing performance of farmers

35

Performance relative to Benchmark

Performance of Market Advisory Services Corn - Average of 1997-2003

$1.85$1.99$1.99

$2.02$2.07

$2.09$2.09$2.10$2.11

$2.13$2.14

$2.16$2.16$2.16

$2.17$2.18

$2.19$2.19$2.20

$2.21$2.22

$2.27$2.27

$2.28$2.30

$1.70 $1.80 $1.90 $2.00 $2.10 $2.20 $2.30 $2.40 $2.50

Ag Financial StrategiesPro Farmer (hedge)

Pro Farmer (cash only)Steward-Peterson Advisory Reports

Freese-NotisAllendale (futures & options)

Northstar CommodityCo-Mark

Risk Mgmt Group (options only)Risk Mgmt Group (cash only)

Risk Mgmt Group (futures & options)Brock (cash only)

Top Farmer IntelligenceAgriVisor (basic hedge)

AgriVisor (aggressive hedge)AgLine by Doane (cash only)

AgriVisor (basic cash)Progressive Ag

AgLine by Doane (hedge)Allendale (futures only)

AgriVisor (aggressive cash)Ag Review

Brock (hedge)Utterback Marketing Services

AgResource

24 Month Average: $2.15

USDA Producer Average: $2.05

36

Predictability from year-to-year

Ranking of Market Advisory Services - Corn

Rank 1999 2000 2001 2002 20031 AgResource AgResource Progressive Ag Brock (hedge) AgResource

2 Allendale (futures only) Utterback Marketing Services Top Farmer Intelligence Brock (cash only) Progressive Ag

3 AgLine by Doane (hedge) Top Farmer Intelligence Ag Review Ag Review AgLine by Doane (cash only)

4 AgriVisor (aggressive cash) Brock (hedge) Utterback Marketing Services Risk Mgmt Group (futures & options) AgLine by Doane (hedge)

5 Ag Review AgLine by Doane (hedge) Co-Mark AgriVisor (basic hedge) Ag Review

6 Top Farmer Intelligence AgriVisor (aggressive cash) Steward-Peterson Advisory Reports AgriVisor (aggressive hedge) Freese-Notis

7 AgriVisor (basic cash) AgriVisor (aggressive hedge) Risk Mgmt Group (cash only) AgriVisor (basic cash) Northstar Commodity

8 Risk Mgmt Group (cash only) AgriVisor (basic cash) Allendale (futures only) AgriVisor (aggressive cash) Brock (cash only)

9 Allendale (futures & options) AgriVisor (basic hedge) Risk Mgmt Group (options only) AgResource AgriVisor (basic hedge)

10 Brock (cash only) Risk Mgmt Group (cash only) Risk Mgmt Group (futures & options) Progressive Ag AgriVisor (aggressive hedge)

11 Utterback Marketing Services Risk Mgmt Group (futures & options) Allendale (futures & options) Risk Mgmt Group (options only) AgriVisor (basic cash)

12 AgLine by Doane (cash only) AgLine by Doane (cash only) AgriVisor (aggressive cash) Risk Mgmt Group (cash only) AgriVisor (aggressive cash)

13 AgriVisor (basic hedge) Allendale (futures only) AgriVisor (aggressive hedge) Freese-Notis Brock (hedge)

14 Brock (hedge) Risk Mgmt Group (options only) AgLine by Doane (cash only) Co-Mark Allendale (futures & options)

15 AgriVisor (aggressive hedge) Progressive Ag AgLine by Doane (hedge) Steward-Peterson Advisory Reports Co-Mark

16 Risk Mgmt Group (options only) Freese-Notis AgriVisor (basic cash) Utterback Marketing Services Risk Mgmt Group (futures & options)

17 Risk Mgmt Group (futures & options) Co-Mark Pro Farmer (cash only) AgLine by Doane (hedge) Risk Mgmt Group (options only)

18 Progressive Ag Ag Review Northstar Commodity Northstar Commodity Steward-Peterson Advisory Reports

19 Steward-Peterson Advisory Reports Brock (cash only) AgriVisor (basic hedge) AgLine by Doane (cash only) Allendale (futures only)

20 Freese-Notis Allendale (futures & options) Pro Farmer (hedge) Top Farmer Intelligence Pro Farmer (cash only)

21 Pro Farmer (hedge) Pro Farmer (cash only) Brock (cash only) Allendale (futures only) Risk Mgmt Group (cash only)

22 Pro Farmer (cash only) Pro Farmer (hedge) Brock (hedge) Pro Farmer (cash only) Top Farmer Intelligence

23 Steward-Peterson Advisory Reports Freese-Notis Allendale (futures & options) Pro Farmer (hedge)

24 Ag Financial Strategies Pro Farmer (hedge) Utterback Marketing Services

25 AgResource Ag Financial Strategies Ag Financial Strategies

Agmas Study released on 03/2005

37


• Limited evidence that advisory services outperform market benchmarks, particularly after taking risk into account

• Substantial evidence that advisory services outperform farmer benchmarks, even after taking risk into account

• Little evidence that past performance can be used to predict future performance

38

Decision Contracts

Farmers continue to identify price and income risk as their

greatest management challenge

39

December Corn CBOT Prices 1998 - 2006

$1.70$1.80$1.90$2.00$2.10$2.20$2.30$2.40$2.50$2.60$2.70$2.80$2.90$3.00$3.10$3.20$3.30$3.40$3.50$3.60$3.70$3.80$3.90$4.00$4.10$4.20$4.30$4.40$4.50

19

98

19

98

19

98

19

99

19

99

19

99

20

00

20

00

20

00

20

01

20

01

20

01

20

02

20

02

20

02

20

03

20

03

20

03

20

04

20

04

20

04

20

05

20

05

20

05

20

06

20

06

20

06

20

07

20

07

Decision Commodities LLCLast Update: September17, 2006

Setting goals

Price series for CZ contract :Average Price = $2.50

Upper Third = $ 2.51 and above Lower Third = $ 2.31 and below

Average

Price

Lower Third

Upper Third

40

Daily Average Corn Prices – 1998-2005

– Based on December Corn (CZ)– In the last 23 years for corn:

• Marketing at harvest was high price point = 4 years (93, 95, 02, 06)• High price point was spring/summer = 7 years (84, 87, 88, 90, 94, 96,04)• High price point was before spring = 12 years (85,86,89,92,94,97,98,99,00,01,03,05)

December CBOT Corn Average Prices 1997-2006(Jan 01 to November 30 - 23 months)

$2.15

$2.20

$2.25

$2.30

$2.35

$2.40

$2.45

$2.50

$2.55

$2.60

$2.65

$2.70

$2.75

$2.80

Ja

n

Fe

b

Mar

Ap

r

May

Ju

n

Ju

l

Au

g

Se

p

Oc

t

No

v

De

c

Ja

n

Fe

b

Mar

Ap

r

May

Ju

n

Ju

l

Au

g

Se

p

Oc

t

No

v

PL

AN

TIN

G HA

RV

ES

T

127

4

83%

17%


41

Corn - High Low Average Historical Prices

DEC Corn Historical Price ranges(Full length of contract)

$3.37

$3.84

$2.73

$2.93

$2.69

$3.37

$4.29

$2.29

$2.00

$1.87

$2.11

$1.86

$2.47

$2.60

$4.28

$3.77

$2.87$2.83

$3.08 $2.99$2.91

$1.93

$2.36

$2.04

$1.99

$2.38$2.39

$1.88

$1.80

$2.00

$2.20

$2.40

$2.60

$2.80

$3.00

$3.20

$3.40

$3.60

$3.80

$4.00

$4.20

$4.40

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

High Top third Average

Bottom third Low

Decision Commodities LLCLast Update: July 27, 2007

42

Decision Contracts

• Decision Commodities automated pricing models :

– Index

– Rally

– Accelerator

– Topper

43

Decision Contracts

• ...a tool that delivers execution discipline without major time requirements– Example

• You want to pre-harvest market 20,000 bushels of corn for Fall delivery, starting in January.

• The Index pricing model can, for example, price an even increment of bushels every day between January and September, achieving an average price for that time period.

• Assuming 100 (market) days between January and September, 200 bushels will be priced every day at the price of the underlying futures contract.

• You sign a forward contract with local grain elevator (specifying Decision Contracts as pricing mechanism), and deliver grain in same manner as usual.

44

Decision Contracts

ProducerGrain Elevator

Ethanol PlantCash Contract

Basis Forward futures price

Decision Contracts provides pricing mechanism for the futures price

45

Decision Contracts – “Index” Pricing Model

Index: Average Price Contract

• Prices an even increment of bushels each day for a given pricing period.

• Producer settings:– Pricing period beginning

– Pricing Period end– Delivery Period– Bushels

The Index price model will result in the average price for the specified time pricing period.

2007 Soybeans

Example:

10,000 bu100 days

100 bu would be priced each day

46

Day

$2.27

$2.28

$2.29

$2.30

$2.31

$2.32

$2.33

$2.34

$2.35

$2.36

1 2 3 4 5

0

10

20

30

40

50

60

Bu

she

ls

Decision Contracts – “Rally” Pricing Model

Rally:

Bushels price on days during the pricing period when:1) the day’s closing price is above the floor price and 2) the one day price change is less than the sensitivity level.

If UpPoint = 0 pricing occurs when price goes down.

Bushels price if one day price change less than UpPoint

Bushels to Price = Remaining Bu X Throttle Remaining Days

Producer Settings:– Pricing period beginning– Pricing period end– Bushels– Price Floor– UpPoint

– Throttle

Floor

47

Rally Example

10,000 bu = 100 X 5 (Throttle) = 500 bu 100 days

500 bu on the first day

48

Decision Contracts – “Accelerator” Pricing Model

Accelerator:

• The daily amount of bushels priced “accelerates” as the futures prices increase, and vice versa

• Bushels price on days during the pricing period when:1) the day’s closing price is above the floor price 2) pricing factor increases (decreases) as futures prices go up (or go down)

• Producer Settings:– Pricing period beginning– Pricing period end– Bushels– Floor and Pivot

Bu priced = (remaining bushels) X Throttleremaining days

49


– Throttle acts as a multiplier of daily bushels priced

December Corn Range (CZ)

Min Max Throttle

$4.10 > 10 Very Aggressive

$4.00 $4.10 4 Aggressive

$3.90 $4.00 3 Moderate

$3.80 $3.90 1 Slow

0 50 100 150 200

Daily bushels priced

PF = 1

PF = 4

PF =6

PF =10Floor

Pivot

50


December Corn 2003

Accelerator (red) = $2.41

Bu priced = 90.37 %

Floor price (purple) = $2.30

Daily bushels sold increase when

futures prices move into upper ranges,

and vice versa

51

Decision Contracts – “Topper” Pricing Model

• Topper:– Bushels will price on

days when grain prices close up sharply from the previous day, during the pricing period.

Producer Settings:– Pricing period beginning– Pricing period end– Bushels– Price Floor– Trigger

– Throttle

Number of trading days up/downDec 01 to Nov 30 - 1998-2005 - DEC Corn CBOT

0 014 5 8 10

26 34

81 86

242

407

256

198

75 66

23 20 15 14 5 8 2

188

218

0

50

100

150

200

250

300

350

400

450

($0.

20)

($0.

15)

($0.

10)

($0.

09)

($0.

08)

($0.

07)

($0.

06)

($0.

05)

($0.

04)

($0.

03)

($0.

02)

($0.

01)

$0.0

0

$0.0

1

$0.0

2

$0.0

3

$0.0

4

$0.0

5

$0.0

6

$0.0

7

$0.0

8

$0.0

9

$0.1

0

$0.1

5

$0.2

0


52

Rally Results – CBOT CZ07 – Jan 01 to July 15

RALLY - $3.88 - 100% pricedCZ07 - Jan 01 to July 15

Rally, $3.88

Floor, $3.50

$3.00

$3.20

$3.40

$3.60

$3.80

$4.00

$4.20

$4.40

Jan

-03

Jan

-12

Jan

-24

Fe

b-0

2

Fe

b-1

3

Fe

b-2

3

Mar

-06

Mar

-15

Mar

-26

Ap

r-0

4

Ap

r-1

6

Ap

r-2

5

May

-04

May

-15

May

-24

Jun

-05

Jun

-14

Jun

-25

Jul-0

5

Jul-1

6

Pric

e $

-

50

100

150

200

250

Bu

she

ls P

rice

d

Bu priced 2007

Rally Floor

CZ07 Rally - Floor: $3.50 - UpPoint: $0.00 - Throttle: 3 Decision Commodities LLC

53

Topper Results – CBOT CZ07 – Jan 01 to July 15

TOPPER - $3.92 - 100% pricedCZ07 - Jan 01 to July 15

Topper, $3.92

Floor, $3.50

$3.00

$3.20

$3.40

$3.60

$3.80

$4.00

$4.20

$4.40

Jan

-03

Jan

-12

Jan

-24

Fe

b-0

2

Fe

b-1

3

Fe

b-2

3

Mar

-06

Mar

-15

Mar

-26

Ap

r-0

4

Ap

r-1

6

Ap

r-2

5

May

-04

May

-15

May

-24

Jun

-05

Jun

-14

Jun

-25

Jul-0

5

Jul-1

6

Pric

e $

0

100

200

300

400

500

600

Bu

she

ls P

rice

d

Bu priced 2007

Topper Floor

CZ07 Topper - Floor: $3.50 - Trigger: $0.05 - Throttle: 7 Decision Commodities LLC

54

Rally Topper Results – CZ08

• Rally:• CZ08 – Jan 07 to July 08• Floor: $3.50 – Throttle: 2 – UpPoint: $0.00• $3.89 – 42% Priced

• Topper:• CZ08 – Jan 07 to July 08• Floor: $3.50 – Throttle: 7 – Trigger: $0.05• $3.96 – 40% Priced

$3.20

$3.40

$3.60

$3.80

$4.00

$4.20

$4.40

Jan

-03

Feb

-03

Mar

-03

Ap

r-03

May

-03

Jun

-03

Jul-

03

Au

g-0

3

Sep

-03

2008

55

Thank you.

Decision Commodities, LLC614 Billy Sunday Rd., Suite 600Ames, Iowa 50010515.956.7880

www.decisioncommodities.com

decision commodities, llc 614 billy sunday rd., suite 600 ames, iowa 50010 515.956.7880 market...

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