managing market risk 2 ed

Publication 1976E

To obtain additional copies:Publications SectionAgriculture & Agri-Food CanadaSir John Carling Building930 Carling AvenueOttawa, OntarioK1A 0C5(613) 759-6610

© Minister of Public Works and Government Services 1998

Catalogue No. A22-176/1998EISBN 0-662-27040-1

Also available on the internet at http://www.agr.ca/policy/risk/risk_e.html.

Aussi disponible en français sous le titre:Gérer le risque du marché: Cours d’introduction - manuel d’étude á domicile

Contacts

Agriculture and Agri-Food Canada

For additional information on risk management write to:

John Caldwell Agriculture and Agri-Food Canada Policy Branch Risk Management Section Room 361 Sir John Carling Bld. 930 Carling Ave. Ottawa, Ontario K1A 0C5

or by visiting the AAFC internet site: http://www.agr.ca/policy/risk/risk_e.html

or by sending an E-mail to:

Bobby Matheson [email protected] John Caldwell [email protected]

Canadian Farm Business Management Council

For other information on risk management tools please contact the Canadian Farm BusinessManagement Council (CFBMC) at 1-888-232-3262;

or visit the CFBMC Internet site: http://www.cfbmc.com/eng/

Other Internet Sites

For information on Futures and options and for current price information the various exchangesmaintain the following Internet sites:

The Chicago Board of Trade http://www.cbot.com/index.htmlThe Chicago Mercantile Exchange http://www.cme.com/The Winnipeg Commodity Exchange http://www.wce.mb.ca/index.html

Disclaimer

Information was taken from sources which were believed to be accurate at the time of printing. Thereader should verify current contract specifications and other relevant information before using anyof these products. The examples provided in the course material are purely for the purpose ofillustration and should not be construed in any way as a recommended trading strategy or currentmarket conditions.

Acknowledgements

Valuable comments and assistance were provided by provincial government officials from acrossCanada, as well as the staff of the Canada Farm Business Management Council. The finalorganization of the material, editing, rewrites and additions to the material were carried out byRobert Matheson and John Caldwell of Agriculture & Agri-Food Canada. The assistance of TerriEpps in editing and formatting the material is also appreciated.

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Table of Contents

Page

INTRODUCTION TO MANAGING MARKET RISK . . . . . . . . . . . . . . . . . . . . . . . -v-

UNDERSTANDING MARKET RISK ON THE FARM . . . . . . . . . . . . . . . . . . . . . . 1-11.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-11.1 The Nature of Market Risk in Agriculture . . . . . . . . . . . . . . . . . . . . . . 1-11.2 Types of Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-3

1.2.1 Price Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-111.2.2 Gross Margin Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-111.2.3 Cash Flow Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-121.2.4 Financial Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-13

1.3 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-13Market Risk Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-14

FUTURES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-12.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-12.1 Development of Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-12.2 What is a Futures Market? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-32.3 The Futures Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-42.4 The Standardized Futures Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-52.5 Forward Versus Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-62.6 Attributes of a Futures Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-62.7 Long and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-82.8 The Link Between Cash and Futures Markets . . . . . . . . . . . . . . . . . . . . . 2-9

2.8.1 Threat of Delivery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-102.8.2 The Cash Settled Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-11

2.9 The Margining Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-112.10 Closing Out A Futures Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-132.11 The Mechanics of a Simple Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-13

2.11.1 Short Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-142.11.2 Long Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-16

2.12 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-19Futures Market Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-20Hedge Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-21

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Page

BASIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-13.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-13.1 The Concept of Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-13.2 Basis for Livestock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-23.3 Basis for Grains and Oilseeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-3

3.3.1 Carrying Charge Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-43.3.1.1 Inverted Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-5

3.3.2 Transfer Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-63.3.3 Basis and Threat of Delivery . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-7

3.4 Basis Variability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-83.5 Calculating Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-113.6 Basis Quotes - Adjusted and Unadjusted Basis . . . . . . . . . . . . . . . . . . . 3-133.7 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-14Basis Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-16Basis Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-17

OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-14.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-14.1 An Example from the Private Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-14.2 Components of an Option on Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-34.3 Exchange Traded Options on Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-44.4 Option Rights and Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-54.5 Determination of Premium Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-5

4.5.1 Time Decay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-84.6 Options Classifications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-84.7 Closing Out an Option Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-104.8 How do Options Work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-124.9 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-13Options Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-14Options Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-17

HEDGING WITH FUTURES AND OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-15.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-15.1 Hedging with Futures & Options Markets . . . . . . . . . . . . . . . . . . . . . . . 5-15.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-2

5.2.1 Short Hedge - Live Cattle Example - Decline in Price . . . . . . . 5-35.2.2 Short Hedge - Live Cattle Example - Rise in Price . . . . . . . . . 5-55.2.3 Short Hedge - Hog Example - Decline in Price . . . . . . . . . . . . 5-7

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Page5.2.4 Short Hedge - Hog Example - Rise in Price . . . . . . . . . . . . . . . 5-95.2.5 Long Hedge - Feeding Barley - Rise in Price . . . . . . . . . . . . . 5-115.2.6 Long Hedge - Feeding Corn - Rise in Price . . . . . . . . . . . . . . 5-135.2.7 Short Hedge Corn Example - Decline in Price . . . . . . . . . . . . 5-155.2.8 Short Hedge - Corn Example - Rise in Price . . . . . . . . . . . . . 5-175.2.9 Short Hedge - Beans Example - Decline in Price . . . . . . . . . 5-195.2.10 Short Hedge - Beans Example - Rise in Price . . . . . . . . . . . 5-215.2.11 Short Hedge - Barley Example - Decline in Price . . . . . . . . 5-235.2.12 Short Hedge - Barley Example - Rise in Price . . . . . . . . . . . 5-255.2.13 Short Hedge - Canola Example - Decline in Price . . . . . . . . 5-275.2.14 Short Hedge - Canola Example - Rise in Price . . . . . . . . . . . 5-29

5.3 Yield Risk and Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-315.4 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-31Hedging Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-32Exercise Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-33

MANAGING EXCHANGE RATE RISK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-16.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-16.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-16.2 Exchange Rate and the Short Commodity Hedger . . . . . . . . . . . . . . . . . 6-16.3 Canadian Exchange Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-4

6.3.1 Determining Your Canadian Dollar Hedge Requirement . . . . . 6-46.4 Exchange Risk and a Short Commodity Hedge . . . . . . . . . . . . . . . . . . . 6-56.5 Exchange Rate and the Long Commodity Hedger . . . . . . . . . . . . . . . . . 6-86.6 Hedging Exchange Rate Risk With Options . . . . . . . . . . . . . . . . . . . . . 6-106.7 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-11Exchange Rate Risk Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-12

CASH MARKET CONTRACTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-17.0 Objectives of this Chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-17.1 Key Business Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-17.2 Overview and Evaluation of Main Types of Contracts . . . . . . . . . . . . . . 7-2

7.2.1 Deferred Delivery/Forward Contract (Sale) . . . . . . . . . . . . . . . 7-27.2.1.1 Deferred Delivery/Forward Contract (Procurement) 7-3

7.2.2 Basis Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-47.2.3 Grain Pricing Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-47.2.4 Delayed or Deferred Pricing (90 day tickets-Western Canada) 7-57.2.5 Hedge to Arrive/Futures Only Contracts . . . . . . . . . . . . . . . . . 7-57.2.6 Deferred Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-57.2.7 Bank Swaps - Managing Foreign Exchange Risk . . . . . . . . . . . 7-6

7.3 Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-6Cash Market Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-7

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SUMMARY COMMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-18.0 Futures, Options and Cash Market Tools . . . . . . . . . . . . . . . . . . . . . . . . 8-18.1 Protecting Against Lower Commodity Prices . . . . . . . . . . . . . . . . . . . . . 8-1

8.1.1 A Comparison with Cash Markets . . . . . . . . . . . . . . . . . . . . . . 8-38.2 Protecting Against Higher Input Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 8-4

8.2.1 A Comparison with Cash Markets . . . . . . . . . . . . . . . . . . . . . . 8-58.3 Risk Management - The First Steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-68.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-6Tools For Protection From Price Declines . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-7Tools For Protection From Rising Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-8

EXERCISE/QUIZ ANSWERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EQ-1

GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . G-1

APPENDIX - FUTURE/OPTION CONTRACT SPECS . . . . . . . . . . . . . . . . . . . . . A-1(CBOT) CORN FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-1(CBOT) SOYBEANS FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-2(CME) CANADIAN DOLLAR FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . A-3(CME) FEEDER CATTLE FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-4(CME) LEAN HOG FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-5(CME) LIVE CATTLE FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-6(WCE) CANOLA FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-7(WCE) WESTERN BARLEY FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . A-9(CBOT) OPTIONS ON CORN FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . A-10(CBOT) OPTIONS ON SOYBEAN FUTURES . . . . . . . . . . . . . . . . . . . . A-10(WCE) OPTIONS ON WESTERN BARLEY FUTURES . . . . . . . . . . . . . A-11(WCE) OPTIONS ON CANOLA FUTURES . . . . . . . . . . . . . . . . . . . . . . . A-11(CME) OPTIONS ON LIVE CATTLE FUTURES . . . . . . . . . . . . . . . . . . . A-12(CME) OPTIONS ON CANADIAN DOLLAR FUTURES . . . . . . . . . . . . A-13(CME) OPTIONS ON LEAN HOG FUTURES . . . . . . . . . . . . . . . . . . . . . A-14(CME) OPTIONS ON FEEDER CATTLE FUTURES . . . . . . . . . . . . . . . . A-14

Introduction to Managing Market Risk

INTRODUCTION TO MANAGING MARKET RISK

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Not a day goes by that we don’t hear about inflation, interest rates, unemployment, cost of living,weather disasters, wars, government cutbacks, etc. All of these can result in some form of economicimpact on each of us. In the world of agriculture, whether you are a grain or livestock producer, aprocessor or merchandiser, the inherent price risk associated with your operation cannot be ignored.An adverse price change can result in substantial economic loss at worst, or at best, reduced profits.

Managing market risk must be a key element in marketing and is increasing in importance as wemove to a global economy and reduced government support programs. Risk can take on differentforms, in varying degrees, depending on the individual or firm’s financial position, cash flowposition and need to avert risk.

Not all risks can be controlled or protected by traditional insurance. Price risk is one such risk. Asillustrated in Chapter 1, price changes can have a dramatic financial impact on agribusiness.Increased market volatility as governments remove commodity-specific programs, price supports andset aside programs will demand that attention be paid to risk management as a must for survival.

This course is designed to help you identify market risks and quantify those risks so thatappropriate/necessary risk management tools can be employed in your marketing plan. Farmingtoday, whether it be crop or livestock production, is highly specialized and heavily capitalized. Itis this high capitalization of land, buildings and machinery which expose today’s agribusiness tosignificant risk and warrants a study of risk management.

The ability to “lay off” price risk using futures markets make them a useful tool for grain andlivestock producers, processors and merchandisers alike. Cash and option contracts have links tofutures markets that need to be addressed and explained so their value can be better determined bythe individual.

The objective of this course is NOT to make you a futures trader, but rather to introduce the conceptof risk management as it pertains to farm marketing. Much time will be spent defining theterminology and jargon associated with futures options and cash contracts. The simple mechanicsof futures trading for hedging (risk management) purposes will be defined and highlighted in theexamples provided in each chapter. Examples for a variety of commodities are provided andwhile they may not always be specific to your operation or the commodity you produce, theydo illustrate how a simple hedge can be used to manage price risk.

Upon completion of this course, you will have a good, basic understanding of futures, options, andcash market contracts as risk management tools. You will acquire the necessary knowledge andunderstanding to incorporate basic risk management strategies into your marketing plan and be wellpositioned for entry into a more advanced and detailed course on futures and options.

Chapter 1 - Understanding Market Risk on the Farm Page 1-1

UNDERSTANDING MARKET RISK ON THE FARM

1.0 Objectives of this Chapter:

Upon completion of this Chapter, you will:

1. Understand the nature of risk in agricultural markets, and why having a good risk managementplan in place is important for producers.

2. Know and understand the definition of market risk and the various types of market risk:

a. Price Risk

b. Gross Margin Risk

c. Cash Flow Risk

d. Financial Risk

3. Develop a foundation for understanding the nature of risk for your own business.

This course is about managing market risk at the individual level to remain competitive and viablein the global marketplace. In this Chapter, we will define various types of risk, basic terms anddevelop some simple examples upon which to build an understanding of the impact of risk on thefarm business.

1.1 The Nature of Market Risk in Agriculture

The nature of agricultural market risk has changed over the past few years. While commodity priceshave always been volatile, and there have always been economic incentives for learning to managerisk, there have been many changes in the agricultural marketplace which make these incentiveseven more compelling.

Governments often reduced the impact of commodity price volatility with programs designed tostabilize price, yield or revenue. Some governments have even managed grain stocks to maintainprice levels. Many of these programs have been wound down or modified because of two mainfactors: reduced overall levels of support under most stabilization programs and increasedagricultural trade liberalization. For commodities such as pork and beef, the changes have beenbeneficial decreasing the chances of countervailing action by the US in particular, as Canadianagricultural exports continue to grow.


The changes in Canada and the US have been quite dramatic. For example, in Canada most of thecommodity-specific price and income programs have been wound down and the main stabilizationprograms are now Crop Insurance and the Net Income Stabilization Account. The US has removedmost of its programs including the ability to manage the supplies of feed grains and wheat. Manybelieve that the inevitable result is larger swings in the number of acres of crops resulting in greaterprice variability. Whether or not this is true is not that relevant. The bottom line is that pricevariability occurs in the market and producers must now become more self-reliant in riskmanagement to remain competitive.

The last few years have provided ample evidence of the degree that prices can fluctuate. During thesummer of 1996, compelling arguments were being made that it would be impossible to rebuildstocks of feed grains even with a good harvest. Feed grain prices rose to record levels and manymarket analysts felt that prices would stay high for the foreseeable future. Subsequently, crop yieldsaround the world were higher than anyone thought possible, stocks began to increase much soonerthan expected and prices dropped back to previous levels.

The Chicago Board of Trade (CBOT) September 1996 and March 1997 corn futures price charts inFigure 1 illustrate the extent of price variability in the 1996 to 1997 period. The vertical lines onthese charts indicate the daily high and low prices for the two futures contracts while the horizontaldash denotes the day’s closing price. (The bars at the bottom of the charts are the number ofoutstanding futures contracts). The variability in these futures prices is representative of cash cornprices during the same period.


The most interesting thing about the charts is the relative change in prices over a fairly short timeperiod. Prices rose by $1.39/bu from August 1995 until July 1996 for the September 1996 contract.In the following five month period prices had fallen below previous levels to $2.60/bu. Over the 18month period prices had both risen and fallen by more than 50%.

Price swings of this nature are not confined to the individual commodity, especially not ones as basicto agriculture as feed grains or wheat, and spilled over into the oilseed and livestock markets. Forbeef feedlot operators without any price risk protection plans, margins were squeezed by the higherfeed costs. At the same time, feed grain and oilseed producers who didn’t lock in the high pricesbefore harvest by hedging lost potential market revenue as prices fell.

With the changes in policy and the world agricultural markets, producers need to be able to managerisk in years such as 1996 and, there will be an increasing payoff to good risk management.

1.2 Types of Market Risk

Agricultural producers are faced with a wide range of risks including production, environmental,legal, human resources and marketing. Marketing is the process which transforms productionactivities into financial success. This section focuses on the various types of market risk: price,gross margin, cash flow and financial. In many cases these terms are very closely related andinterchangeable.


Barley Example:

Two hundred acres of barley are planted based on an expected market price of $2.40/bu. Expectedyield is 90 bu/acre, and the cash cost of producing the barley is $90.00/acre, or $1.00/bu. The latterincludes out-of-pocket expenses such as seed, fertilizer, cash rent, interest, etc. The actual finalmarket price at harvest is $1.40/bu.

Barley: Expected Result Actual Result

If price = $2.40 = $1.40Cash Cost = $1.00 = $1.00Gross Margin = $1.40 = $0.40

Yield/acre = 90 = 90Cash Inflow/acre = $216.00 = $126.00Cash Outflow/acre = $90.00 = $90.00Net Cash Flow/acre = $126.00 = $36.00

With 200 acres Cash Inflow = $43,200 = $25,200Cash Outflow = $18,000 = $18,000Net Cash Flow = $25,200 = $7,200


Corn Example:

Five hundred acres of corn are planted based on an expected market price of $3.50/bu. Expectedyield is 120 bu/acre, and the cash cost of producing corn is $360.00/acre, or $3.00/bu. The latterincludes out-of-pocket expenses such as seed, fertilizer, cash rent, interest, etc. The actual finalmarket price at harvest is $2.50/bu.

Corn: Expected Result Actual Result

If price = $3.50 = $2.50Cash Cost = $3.00 = $3.00Gross Margin = $0.50 = ($0.50)

Yield/acre = 120 = 120Cash Inflow/acre = $420.00 = $300.00Cash Outflow/acre = $360.00 = $360.00Net Cash Flow/acre = $60.00 = ($60.00)

With 500 acres:Cash Inflow = $210,000 = $150,000Cash Outflow = $180,000 = $180,000Net Cash Flow = $30,000 = ($30,000)


Canola Example:

Two hundred acres of Canola are planted based on an expected market price of $7.50/bu. Expectedyield is 35 bu/acre, and the cash cost of producing the canola is $96.25/acre, or $2.75/bu. The latterincludes out-of-pocket expenses such as seed, fertilizer, cash rent, interest, etc. The actual finalmarket price at harvest is $5.50/bu.

Canola: Expected Result Actual Result

If price = $7.50 = $5.50Cash Cost = $2.75 = $2.75Gross Margin = $4.75 = $2.75

Yield/acre = 35 = 35Cash Inflow/acre = $262.50 = $192.50Cash Outflow/acre = $96.25 = $96.25Net Cash Flow/acre = $166.25 = $96.25

With 200 acres:Cash Inflow = $52,500 = $38,500Cash Outflow = $19,250 = $19,250Net Cash Flow = $33,250 = $19,250


Soybean Example:

Five hundred acres of soybeans are planted with an expected yield of 40 bu/acre yield and cash costsof $250.00/acre or $6.25/bu. With an expected price of $8.00/bu, the enterprise has a positive netreturn of $35,000. The final price at harvest ends up being $6.00/bu.

Soybeans: Expected Result Actual Result

If price = $8.00 = $6.00Cash Cost/bu = $6.25 = $6.25Gross Margin = $1.75 = ($0.25)

Yield/acre = 40 = 40Cash Inflow/acre = $320.00 = $240.00Cash Outflow/acre = $250.00 = $250.00Net Cash Flow/acre = $70.00 = ($10.00)

With 500 acres:Cash Inflow = $160,000 = $120,000Cash Outflow = $125,000 = $125,000Net Cash Flow = $35,000 = ($5,000)

Cha

pter

1 -

Und

erst

andi

ng M

arke

t Ris

k on

the

Far

mPa

ge 1

-8

1 Stric

tly sp

eaki

ng, t

his c

ateg

ory

also

incl

udes

the

cost

of f

orag

e an

d co

ncen

trate

s sin

ce th

e ex

ampl

e on

ly fo

cuse

s on

the

feed

gra

in c

ompo

nent

of th

e ra

tion.

Wes

tern

Fee

dlot

: A

ctua

l Res

ults

Exp

ecte

d R

esul

tSc

enar

io I

Scen

ario

II

Sc

enar

io II

I

If pr

ice

- cat

tle=

$93.

00/c

wt

=$8

5.00

/cw

t$9

3.00

/cw

t$8

5.00

/cw

t- b

arle

y=

$3.0

0/bu

=$3

.00/

bu$3

.50/

bu$3

.50/

buTo

tal C

ost/h

ead

=

$

1,14

0.00

=$1

,140

.00

$1,1

65.0

0$1

,165

.00

Bre

ak e

ven/

cwt

=$9

1.20

=$9

1.20

$93.

20$9

3.20

Gro

ss m

argi

n/cw

t=

$1.8

0=

($6.

20)

($0.

20)

($8.

20)

Cas

h In

flow

/hea

d=

$1,1

62.5

0=

$1,0

62.5

0$1

,162

.50

$1,0

62.5

0C

ash

Out

flow

/hea

d=

$1,1

40.0

0=

$1,1

40.0

0$1

,165

.00

$1,1

65.0

0N

et C

ash

flow

/hea

d=

$22.

50=

($77

.50)

($2.

50)

($10

2.50

)

With

1,0

00 h

ead:

Cas

h In

flow

=

$

1,16

2,50

0=

$1,0

62,5

00$1

,162

,500

$1,0

62,5

00C

ash

Out

flow

=

$

1,14

0,00

0=

$1,1

40,0

00$1

,165

,000

$1,1

65,0

00

Wes

tern

Fee

dlot

Exa

mpl

e:Th

e fee

dlot

ope

rato

r exp

ects

to se

ll th

e ste

ers w

hen

they

reac

h 1,

250

lb fo

r $93

.00/

cwt,

and

that

the f

ed b

arle

y pr

ice w

ill b

e $3.

00/b

u. C

ash

cost

s hav

e bee

n pu

t in

two

cate

gorie

s: b

arle

y an

d no

n-fe

ed. T

he n

on-f

eed

cost

s of a

$99

0.00

/ani

mal

are t

he fe

eder

stee

r, ve

t and

med

icin

eex

pens

es, m

orta

lity

loss

es, t

rans

porta

tion

to an

d fr

om th

e fee

dlot

, lab

our,

inte

rest

, etc

.1 It i

s ass

umed

it ta

kes 5

0 bu

of b

arle

y to

fini

sh ea

chst

eer.

In th

e fir

st m

arke

t sce

nario

, the

act

ual f

inal

pric

e of

fini

shed

stee

rs is

$85

.00/

cwt i

nste

ad o

f $9

3.00

/cw

t. In

the

seco

nd sc

enar

io,

the a

ctua

l pric

e of b

arle

y is $

3.50

/bu

inst

ead

of $

3.00

/bu.

You

will

not

ice t

hat w

hen

feed

cost

s inc

reas

e by $

0.50

the p

rofit

mar

gin

is w

iped

out.

Und

er th

e thi

rd sc

enar

io, e

very

thin

g go

es w

rong

and

both

the p

rice o

f fin

ishe

d st

eers

and

the p

rice o

f bar

ley

mov

e aga

inst

the f

eedl

otop

erat

or.

Cha

pter

1 -

Und

erst

andi

ng M

arke

t Ris

k on

the

Far

mPa

ge 1

-9

2 Stric

tly sp

eaki

ng, t

his c

ateg

ory

also

incl

udes

the

cost

of f

orag

e an

d co

ncen

trate

s sin

ce th

e ex

ampl

e on

ly fo

cuse

s on

the

feed

gra

in c

ompo

nent

of th

e ra

tion.

Eas

tern

Fee

dlot

: A

ctua

l Res

ults

Exp

ecte

d R

esul

tSc

enar

io I

Scen

ario

II

Sc

enar

io II

I

If pr

ice

- cat

tle=

$80.

00/c

wt

=$7

5.00

/cw

t$8

0.00

/cw

t$7

5.00

/cw

t- b

arle

y=

$2.5

0/bu

=$2

.50/

bu$3

.50/

bu$3

.50/

buTo

tal C

ost/h

ead

=

$

975.

00=

$975

.00

$1,0

25.0

0$1

,025

.00

Bre

ak e

ven/

cwt

=$7

8.00

=$7

8.00

$82.

00$8

2.00

Gro

ss m

argi

n/cw

t=

$2.0

0=

($3.

00)

($2.

00)

($7.

00)

Cas

h In

flow

/hea

d=

$1,0

00.0

0=

$937

.50

$1,0

00.0

0$9

37.5

0C

ash

Out

flow

/hea

d=

$975

.00

=$9

75.0

0$1

,025

.00

$1,0

25.0

0N

et C

ash

flow

/hea

d=

$25.

00=

($37

.50)

($25

.00)

($87

.50)

East

ern

Feed

lot

Exam

ple:

The f

eedl

ot o

pera

tor e

xpec

ts to

sell

the s

teer

s whe

n th

ey re

ach

1,25

0 lb

for $

80.0

0/cw

t, an

d th

at th

e fed

corn

pric

e will

be $

2.50

/bu.

Cas

hco

sts h

ave b

een

put i

n tw

o ca

tego

ries:

cor

n an

d no

n-fe

ed.

The n

on-f

eed

cost

s of a

n $8

50.0

0/an

imal

are t

he fe

eder

stee

r, ve

t and

med

icin

eex

pens

es, m

orta

lity l

osse

s, tra

nspo

rtatio

n to

and

from

the f

eedl

ot, l

abou

r, in

tere

st, e

tc.2 F

or a

1,25

0 lb

anim

al th

is re

sults

in a

tota

l non

-fee

dpr

ice

of $

68.0

0/cw

t. T

he fe

ed c

ompo

nent

is si

mpl

y th

e co

st o

f cor

n. I

t is a

ssum

ed it

take

s 50

bu to

fini

sh e

ach

stee

r. In

the

first

mar

ket

scen

ario

, the

act

ual f

inal

pric

e of

fini

shed

stee

rs is

$75

.00/

cwt i

nste

ad o

f $8

0.00

/cw

t. In

the

seco

nd sc

enar

io, t

he a

ctua

l pric

e of

cor

n is

$3.5

0/bu

inst

ead

of $

2.50

/bu.

Und

er th

e th

ird s

cena

rio, b

oth

the

pric

e of

fini

shed

ste

ers

and

the

pric

e of

cor

n m

ove

agai

nst t

he fe

edlo

top

erat

or.

Cha

pter

1 -

Und

erst

andi

ng M

arke

t Ris

k on

the

Far

mPa

ge 1

-10

3 Stri

ctly

spea

king

, thi

s cat

egor

y al

so in

clud

es th

e co

st o

f soy

bean

mea

l sin

ce th

e ex

ampl

e on

ly fo

cuse

s on

the

corn

com

pone

nt o

f the

ratio

n.

Hog

Fin

ishi

ng:

Act

ual R

esul

ts

E

xpec

ted

Res

ult

Scen

ario

ISc

enar

io II

Scen

ario

III

If pr

ice

- hog

s=

$145

.00/

hog

=$1

25.0

0/ho

g$1

45.0

0/ho

g$1

25.0

0/ho

g- c

orn

=$3

.50/

bu=

$3.5

0/bu

$4.0

0/bu

$4.0

0/bu

Tota

l Cos

t/hog

=

$1

26.2

5=

$126

.25

$130

.00

$130

.00

Bre

ak e

ven/

hog

=$1

26.2

5=

$126

.25

$130

.00

$130

.00

Gro

ss m

argi

n/ho

g=

$18.

75=

($1.

25)

$15.

00($

5.00

)

Cas

h In

flow

/hog

=$1

45.0

0=

$125

.00

$145

.00

$125

.00

Cas

h O

utflo

w/h

og=

$126

.25

=$1

26.2

5$1

30.0

0$1

30.0

0N

et C

ash

flow

/hog

=$1

8.75

=($

1.25

)$1

5.00

($5.

00)

With

1,0

00 h

ogs:

Cas

h In

flow

=

$14

5,00

0=

$125

,000

$145

,000

$125

,000

Cas

h O

utflo

w=

$

126,

250

=$1

26,2

50$1

30,0

00$1

30,0

00N

et C

ash

flow

=

$1

8,75

0=

($1,

250)

$15,

000

($5,

000)

Hog

Fin

ishi

ng E

xam

ple

For t

his h

og e

xam

ple

the

feed

ratio

n is

a c

ombi

natio

n of

cor

n an

d so

ybea

n m

eal.

The

ope

rato

r exp

ects

to se

ll th

e ho

gs w

hen

they

reac

h20

0 lb

for a

$14

5.00

/hog

, and

that

the

fed

corn

pric

e w

ill b

e $3

.50/

bu.

Cas

h co

sts

have

bee

n pu

t in

two

cata

gorie

s: c

orn

and

non-

feed

.Th

e new

feed

cost

s of t

he h

og ar

e the

feed

er h

og, v

et an

d m

edic

ing

expe

nses

, mor

talit

y lo

sses

, tra

nspo

rtaito

n to

and

from

the b

arn,

labo

ur,

inte

rest

etc

.33 I

t is a

ssum

ed it

take

s 7.5

bu

of c

orn

to fi

nish

eac

h ho

g. I

nt th

e fir

st m

arke

t sce

nario

, the

act

ual f

inal

pric

e of

fini

shed

hog

sis

$12

5.00

/hog

inst

ead

of $

145.

00. I

n th

e sec

ond

scen

ario

, the

actu

al p

rice o

f cor

n is

$4.

00/b

u in

stea

d of

$3.

50/b

u. U

nder

the t

hird

scen

ario

the

pric

e of

fini

shed

hog

s fal

ls a

nd th

e pr

ice

of c

orn

rises

.


1.2.1 Price Risk

In the corn and soybean examples the price risk is most evident with losses resulting in each case.A $1.00 drop in the corn price resulted in a $30,000 loss on 500 acres. On the same acreage, a $2.00drop in the soybean price results in a $5,000 loss. While the percentage price drop is high, neitheris unrealistic given the variability in feed grain prices that we saw during 1996 and 1997 in Section1.1. While losses were not recorded in the barley and canola example there were losses in terms offorgone income of $18,000 and $14,000 respectively.

For the cattle feeder the percentage drop in the cattle price is much less in both the east and the west.Despite this fact, the loss with 1,000 head of cattle is still high at $77,500 in the west and $37,500 inthe east. The results for the two regions of the country are not directly comparable as the expectedprices and cost of production do differ.

Even if cattle prices remain stable there is still the risk of increased feed costs. With a barley priceincrease of $0.50/bu the feedlot costs are higher by $25,000 while an increase of $1.00/bu in the cornprice results in a net loss of $25,000, a drop of $50,000 from the expected level of income. If bothoccurred, a fall in the cattle price and a rise in feed prices, the net cash flow would be fall by $125,000in the west and $112,500 in the east.

The price risk in each example or market scenario is dependent on whether you are buying or sellingthe commodity. The risk for a producer who will be selling the commodity is the possibility of lowerprices. At the same time many producers face the risk of higher input prices.

1.2.2 Gross Margin Risk

The real damage price risk causes to an operation is its effect on the operation’s margins. While theargument can be made that potential price swings are small relative to overall price levels, they canbe huge relative to the operation’s margins.

We define gross margin as the difference between the selling cost per unit of the final productand the cash (or direct) cost of producing the unit. Since gross margin includes only cash or directcosts, it measures how much remains and will contribute to the overhead, labour, management andreturn on investment for the operation. Gross margin risk is the chance that gross margins willbe less than expected.

Returning to the different commodity examples, we can see the potential impacts on gross margin.In each case there was a dramatic decline in the actual gross margin, even in instances where theprice decline(s) were not large.


Gross Margin Risk ExamplesCommodity Expected Gross

Margin Actual Gross

MarginDecline from

Expected Margin(%)

Barley $1.40/bu $0.40/bu 71%

Corn $0.50/bu ($0.50/bu) 200%

Canola $4.75/bu $2.75/bu 42%

Soybeans $1.75 ($0.25/bu) 114%

Feedlot (west)* $1.80/cwt ($8.20/cwt) 556%

Feedlot (east)* $2.00/cwt ($7.00/cwt) 450%

Hogs* $18.75/hog ($5.00/hog) 127%* Actual margin based on a fall in price and increased feed costs.

People who are in commodity businesses often have small margins. The examples presented here arenot unrealistic and are representative of the position of many farmers. It follows that, that if marginsare tight and the risk is high, there will be high payoffs to good risk management.

1.2.3 Cash Flow Risk

The problem with price or gross margin per unit is that the numbers involved are often relativelysmall and, therefore, do not address the problem of managing cash flow. All enterprises have cashinflow from operations and cash outflow for production costs. The difference between the inflow andoutflow is known as net cash flow. At its simplest level, cash flow risk is the risk of not meetingfinancial obligations as they become due. The business may be profitable over the production periodbut the producer may not have the cash available when accounts payable or loan payments becomedue.

The examples show that the cash requirements for an equivalent acreage of soybeans are smaller thanfor corn because soybeans require less fertilizer. Therefore, there is less cash flow risk, even withgreater price volatility. Based on these assumptions, 500 acres of corn requires $180,000 inproduction costs while 500 acres of soybeans requires $125,000.

Finishing cattle is one of the riskiest and most cash intensive operations in agriculture. A modest1,000 head feedlot can have cash requirements as high as $1 million. In all three of the cattlescenarios, net cash flow was negative for both regions of the country. This indicates the level of cashflow risk that is associated with even modestly adverse steer and feed price movements when marginsare tight.


1.2.4 Financial Risk

Financial risk is closely linked with cash flow risk. For the person who is highly leveraged and needsto borrow most, or all of their operating cash requirements, the two risks are comparable. Financialrisk is the ability of the enterprise to generate sufficient profits at the end of the production cycle tocover both fixed and variable costs as well as living expenses and machinery replacement. Cash flowrisk is more a matter of timing, whereas financial risk is a question of profitability.

If each of the operators of these enterprises in each of these examples had borrowed 100% of theircash requirements, they all would have been faced with financial ruin or learned about the phrase“living off your equity,” pledging long-term assets as security against short-term operating debt.

1.3 Chapter Summary

� The various types of market risk are price, gross margin, cash flow and financial risk. By nothedging a producer is exposed to all these risks, be it a price decline for the commodities they sellor a price increase for the commodities they buy. In essence they are cash market speculators.In many ways producers who do not hedge are in the same situation as a futures marketspeculator.

� The producer’s costs of speculating are much greater due to the high costs incurred producingthese commodities. The size of the actual investment in inputs and capital all increase the riskto the producer. While the futures market speculator may face losses in addition to brokeragecommissions and interest on the margin, these can be limited by getting out of the market. Aproducer doesn’t always have that flexibility given the livestock are already in the pen or crop inthe ground. It can be argued that farmers who are cash market speculators are in a riskier positionthan futures market speculators - farmers are literally betting the farm!

� With the changes in both support programs and the nature of agricultural markets producers havehad to become more-self reliant in the area of risk management. Risk management is relevant formost operations as a way of limiting risk in terms of price, gross margin, cash flow and financialstability. It is a means of maintaining farm viability and protecting existing levels of equity.

Keep in mind there are a variety of tools available and they will not all suit your individual needs. There are numerous private market instruments as well as government programs designed to managerisk. It is important to know what tools are available, the advantages and disadvantages of each tooland how they can be used individually or together to manage risk. This will help you to become amore effective manager and allow you to continue to be competitive in the global marketplace. Thefollowing chapters will discuss how futures, options and cash contracts can be used to manage pricerisk.


Market Risk Quiz

1. Is the management of market risk less or more important than in the past? Explain.

Individual risk management will be more important in the future. Governments have reduced the level of funding for direct income support as a result of budgetary constraints and in response to an increased emphasis on global trade liberalization. For sectors such as livestock this has reduced the risk of countervail action which would be detrimental to Canadian producers.

2. For one or more enterprises on your farm, indicate:

a. Your expected price per unit for the next year.b. Your expected cash cost per unit for the next year.c. Your expected gross margin for the next year.d. Your expected net cash flow for the next year.e. What the effect will be on gross margin and net cash

flow if your selling price for the commodity is 40% less than your expectedprice.

f. What the effect will be on gross margin and net cash flow if your purchase price for an important commodity input is 50% more than you expected.


- NOTES -

Chapter 2 - Futures Page 2-1

FUTURES MARKETS


At the end of this Chapter, you will:

1. Know why and how futures markets evolved.

2. Understand the nature of the futures contract.

3. Understand the margin process.

4. Understand the difference between cash and futures markets.

5. Understand the role of arbitrage in linking cash and futures prices.

2.1 Development of Futures Markets

The underlying principles of commodity futures trading are not new, evolving out ofnecessity over centuries. We can trace formalized trading practices back to the days of theRoman Empire. These early markets established a fixed time and place for trading in acentral marketplace, via barter or currency exchange. Despite the rise and fall of the manycivilizations in man’s history, the principles of the central marketplace have not onlysurvived, but have continued to evolve.

Much of the evolution of the marketplace developed out of the chaos created by a lack ofboth storage facilities and standards of measurement and quality. For agriculturalcommodities with typically short harvest periods, consumption was normally spread overlonger periods often leading to massive price swings.

The desire of many merchants to regulate these markets led to strict rules for trading andstandards for quality and measurement being developed. This established a level ofconduct acceptable to local authorities that allowed these formalized markets to be self-regulating. Arbitration procedures were established to handle disputes and ensureperformance according to the rules and regulations of the specific marketplace. These arethe underlying principle of today’s commodity and stock exchanges.

Establishing formalized trading practices and strict rules led to the practice of “forwardcontracting.” These trading instruments have a long history. In medieval times merchantstravelled extensively agreeing to buy products in one area, only to resell them elsewhere.The merchant would agree to take delivery of a product and then reach an agreement witha customer in another area or port to accept delivery at some specified time in the future.These verbal and written contracts did little to establish a visible or known value for the


products being traded due to a lack of price reporting.

The development of the New World created new problems in the marketplace. In NorthAmerica, the area we know today as the US Midwest, experienced turmoil due to a lack ofstorage facilities, adequate transportation routes and standards regarding grades andmeasurements. Coupled with the extremes of weather, these problems led to the logicaldevelopment of formalized trading and futures markets.

The early 1800s was a period of erratic supply and demand swings. Grain and livestockwere brought to regional markets at similar times each year. These seasonal deliveriesoften exceeded the immediate needs of processors and packers. Buyers, seeing the largesupply, would bid prices lower. Even with lower prices, processors could not find marketsfor all the final products.

Many farmers, faced with the long costly travel back home, were left with no choice butto dump their grain in the streets. Later in the year, due to a lack of storage and higherdemand, prices would skyrocket. The resulting large price swings frustrated farmers,processors and consumers. The conditions were intolerable on their own, but poortransportation routes such as dirt and plank roads, and frozen waterways further aggravatedmarket conditions.

Large price swings created by disruptions in supply made it difficult for merchants andprocessors to establish stable markets. As a result of the development of centralmarketplaces such as Chicago, legislative changes were enacted to improve rural roadconditions, build inland waterways and expand storage facilities. At the same time, grainand livestock producers, elevators and processors began contracting for forward delivery.Introduction of forward contracts encouraged the development of storage facilities ascontract prices reflected the additional cost of storage.

In 1848, the Chicago Board of Trade (CBOT) was established, with membership from abroad base of business interests. The objective was to alleviate the market chaos thatexisted that time. In its early years the CBOT traded forward contracts, cash commitmentsto buy and sell grain for delivery sometime in the future. All aspects of the contract:quality, quantity, delivery period, delivery location and price were negotiated bilaterallybetween the buyer and seller.

Forward contracts, although a great improvement over simple cash trading, still had theirdrawbacks. Bitter disputes arose between buyers and sellers due to contract defaults.These defaults occurred because there was no standardization of quality and quantity.

In 1865, in response to these issues and in an attempt to move to self-regulation, the CBOTformalized grain trading even further by standardizing contracts, and initiating a marginingsystem to protect against contract defaults. These new standardized contracts specifiedquantity, quality, location and time of delivery of the various commodities. These contractswere called futures contracts. In 1904, following the CBOT, the Winnipeg Commodity


1The Winnipeg Commodity Exchange had originally been formed in 1897 to trade forward cash contracts.

Exchange began to trade futures contracts1.

The introduction of futures contracts allowed commodity exchanges to attract moremembers that, in turn, increased trading volumes and liquidity. Futures contracts attractedspeculators who saw an opportunity to profit from price changes by assuming the risk thatmany sought to avoid. The price risk inherent in the production, processing and marketingof agricultural commodities and metals motivated many people to use the futures marketto reduce risk. This transfer of risk is called hedging and is practised by hedgers.

Today’s futures markets retain the basic principles derived during the past century, whileincorporating changes and new products. Futures are actively traded for a wide range ofagricultural commodities, energy, precious metals, foreign currencies, stock indices andgovernment debt instruments. In 1982, the Chicago Board of Trade introduced trading ofoptions on futures. The early ‘90s saw the Winnipeg Commodity Exchange follow suit byintroducing options on futures for canola, barley and wheat.

Futures and options play critical roles in today’s economy by providing risk managementand price discovery for the agricultural, mining, energy, banking and financial sectors.As the world moves closer to more liberalized trade and a global economy, one can onlyexpect the futures role in our economy to expand.

2.2 What is a Futures Market?

A futures market is where buyers and sellers meet to trade commitments to make or takedelivery of commodities. This is usually done in an auction atmosphere with public outcryby commissioned agents of the actual buyers and sellers. Commodities traded in this wayinclude agricultural products, precious metals, energy, stock indexes, and financialinstruments.

Futures prices are discovered through a continuous worldwide flow of information thatinfluences both the current and future supply and demand expectations of the buyer andseller. By being linked to the cash market the price discovery process in the futures marketsserves to determine prices in both markets. Futures exchanges provide a centralized facilitywhere buyers and sellers meet. The rules, price reporting and product offerings (futurescontracts) of an exchange enable its members (commercial firms and individuals) tomanage the risks associated with their businesses.

� Futures markets are primarily used for price discovery and risk management. Inthis sense, they are financial instruments, rarely used for actual transfer of theunderlying physical commodity.

� Futures markets trade futures contracts that specify a standardized commodity,quality, quantity, location and delivery period.


� These contracts are binding legal agreements to make or take delivery of specifiedcommodities.

� In order for a trade to occur in the futures market, there must be a buyer and sellerwho agree on a price. There must be a promise to make delivery (the seller) andto take delivery (the buyer). This commitment to make or accept delivery can beoffset so that usually there is no actual delivery of the physical commodity.

2.3 The Futures Contract

Futures markets trade futures contracts that are legally binding agreements that predefinethe quality, quantity, location and period for delivery of a specified commodity. Openoutcry negotiates price and is determined when there is agreement between the buyer andthe seller to make a transaction. For every seller there must be a buyer and for everybuyer there must be a seller in order for a futures trade to occur.

� The seller of a futures contract enters a commitment to MAKE delivery of aspecified commodity. This is called a short position.

� The buyer of a futures contract enters a commitment to TAKE delivery of aspecified commodity. This is called a long position. Note that it is only acommitment to make or take delivery.

� The seller’s obligation to MAKE delivery of the product is with the clearing house.

� The buyer’s obligation is to TAKE delivery of the product and pay the price to theclearing association. The clearing association pays the seller.


Because selling a futures contract (short position) is a promise to MAKE delivery of aspecified quantity and quality and buying a futures contract (long position) is a promise toTAKE delivery, the two transactions are essentially offsetting positions. The obligationto deliver can be fulfilled or offset by buying a comparable futures contract with the sameexpiry month.

This offsetting feature is what makes future markets unique and attractive to both hedgersand speculators. The vast majority of futures positions are fulfilled by offsetting.

2.4 The Standardized Futures Contract

All futures contracts are standard making it clear for buyers and sellers what obligation theymust meet with respect to quantity and quality, delivery location and timing of deliveries.The following table provides some examples of contract specifications.

Quantity � 5,000 bushels

� 20 metric tonnes

� for corn, wheat, beans and oats on Chicago Board of Trade (CBOT)

� for canola, barley, feed wheat on Winnipeg Commodity Exchange (WCE)

Quality � #1 Canada Canola, #2 Canola at discount (WCE)

� #2 corn or soybean, #1 at premium, #3 at discount (CBOT)

� Deliverable grades predetermined by the Exchange,

Location � Chicago - corn, beans� Par Area - 150 km radius around

Saskatoon for canola� Lethbridge - buyer’s facility less

freight zone back off to origin for barley plus “non-par” points

� Pre-defined areas, locations, facilities where physical deliverycan be used to satisfy a short futuresposition.

Time � NOVEMBER canola� DECEMBER corn

� Each contract is specific about its delivery period within a particular month

Price (not pre-defined)

� The price is not predetermined and isnegotiated by open outcry betweenbuyers and sellers.

� The Exchanges do monitor pricelevels and sets minimum levels forprice movements and maximum dailyprice movements. For example, theWCE canola futures price can onlymove in increments of $.10/tonne to adaily maximum of plus or minus$10.00/tonne versus the previous day’ssettlement price

See Appendix for detailed contract specifications.


2.5 Forward Versus Futures Contracts

With a forward contract, the buyer and seller bi-laterally negotiate all aspects of thecontract. The exchange of the physical commodity between the buyer and the seller isanticipated and expected at the negotiated location.

Futures contracts are standardized and predefine the quality, quantity, delivery period anddelivery location of each contract. The buyer and seller are left to negotiate, by auction andopen outcry, the price and the number of contracts to trade. Trading of futures contractsrarely results in the actual exchange of the physical commodity.

CONTRACT ELEMENT FORWARD CONTRACTS FUTURES CONTRACTS

Price negotiated privately open outcry

Quantity negotiated privately standardized

Quality negotiated privately standardized

Delivery Period negotiated privately standardized

Delivery Location negotiated privately standardized

Transfer of PhysicalProduct

expected rarely occurs

2.6 Attributes of a Futures Market

Price Discovery

As ongoing changes to supply and demand occur, buyers and sellers incorporate thisinformation into the marketplace. When buyers and sellers are in agreement, a tradeis made and a market price is reported. This price, as discovered through open outcryas trades are executed, is a visible example of the forces of supply and demand at work.The change in the futures price for the day is the consensus of the buyers and sellers forthat day.

Price Risk Management

The offsetting ability of a futures contract allows hedgers to take equal but offsettingfutures positions from that which they hold in the cash market. This allows the hedgerto transfer price risk until such time as the cash position has been reduced or liquidated.This is the main economic justification for futures markets and a primary attraction tohedgers.


Liquidity

This is a key to any successful futures market. All participants need smooth, orderlyprice movements that allow ease of entry to and exit from the marketplace. Constantparticipation and competition of buyers and sellers allow entry to and from themarketplace without significant price impact. The greater the volume of trade withouta price impact, the more the market is said to be “liquid”.

Efficiency

The futures market enables all participants to trade large volumes at a relatively lowtransaction cost. This efficiency is attractive to buyers and sellers.

Zero Sum Gain

Futures trading is frequently referred to as a zero sum gain, any profits by marketparticipants are a result of losses by other participants in the market. For hedgers thisis not a concern as their gains or losses are offset in the cash market.

Hedgers

Processors, producers, merchandisers having a financial interest in the physicalcommodity may use futures to reduce price risk by taking an equal but opposite positionin the futures market. This is known as hedging. Hedgers are risk adverse, wishing toavoid risk and tend to hold futures positions for long periods of time.

Speculators

Futures traders that typically have no interest in the physical commodity. They tradefutures strictly for the intention of profiting from a favourable price change.Speculators are risk takers. Speculators do not generally hold futures positions for longperiods of time.


2.7 Long and Short

GOING LONG

Traders who buy a futures contract can make a profit if the futures are sold back at a higherprice. The buying of futures is referred to as going long.

GOING SHORT

Traders who sell futures (go short) with the intention of buying them back later at a lowerprice make a profit. Traders can sell futures even if they don’t own the underlyingphysical commodity as the futures position and commitment to make delivery can beoffset by going long prior to expiry. A speculator or may choose purchase thephysical commodity in the cash market and make delivery on the futures contract.


Because the profits and losses in the futures market mirror those in the cash market,hedgers are attracted to the futures market. By taking an opposite position in the cashmarket, hedgers can reduce price risk. The losses in the cash market are offset by gains inthe futures market and vice versa.

A buyer who will need feed grains later in the year can buy futures. This is referred to asa buy or long hedge. Producers of grain, oilseeds or livestock can protect themselvesagainst a potential decline in the price of their products by selling futures. This is referredto as a sell or short hedge.

2.8 The Link Between Cash and Futures Markets

It is the link between cash and future markets which allow hedgers to use the market tooffset cash price risk. The strength of the relationship is measured by basis, the differencebetween the local cash price and the relevant futures price, and is discussed in the followingchapter.

While basis is usually not constant it is an important concept to understand as it willdetermine the effectiveness of any hedge. A relatively stable or predictable basis isrequired to ensure futures and cash profits or losses offset one another. The threat ofdelivery (or the settlement process with cash settled contracts, section 2.10.2) helps tomaintain the cash and futures market relationship.

Cash Markets Localized markets where buyers and sellers bilaterally negotiate the quality, quantity,


delivery period, location and price that results in title transfer of the commodity. Thephysical commodity is exchanged between buyer and seller.

Futures Markets

Buyers and sellers trade contracts of a predetermined quantity, quality, location anddelivery period for a specified commodity. Futures markets are typically viewed as a papermarket as the actual physical commodity is rarely exchanged between the buyer and seller.Futures prices are often used as a benchmark for cash prices.

2.8.1 Threat of Delivery

Cash and futures prices tend to move in the same direction, although not always by the sameamount. This is because futures contract commitments can be fulfilled by actual delivery ofthe physical commodity (or in some cases, an amount of money representing the value of thecommodity). Delivery can occur only during the delivery month of the futures contract at thespecified delivery location. The long, or buyer of a futures contract, is required to accept andpay for the physical commodity immediately. At that time, the buyer assumes all costsassociated with owning the physical inventory including storage and interest.

� This process ensures that cash and futures, over time, remain linked. If cash buyers bidprices too far below the futures prices, sellers (owners) of cash inventory can sell futuresand make delivery. Cash and futures prices would eventually converge.

� The lack of offers in the cash market would eventually draw increased bids from thebuyers. At the same time, the increased selling pressure in the futures market would pushfutures prices lower.

� The above scenario is an example of “threat of delivery”. Threat of delivery ensuresconvergence of cash and futures over time and enhances the integrity of the futures contractand the futures price.

Conversely, if cash prices are too high relative to futures, a cash buyer can buy futures andstand for delivery, i.e., take delivery of the physical commodity. In this circumstance, the longtrader receives the product, at the low futures price, which the long can then sell back into thecash market at the high cash price. These actions will eventually drive up the price of futuresand drive down the price of the cash commodity until there is no economic advantage tocontinue to do so.

The act of buying in one market and selling in the other market, or vice versa, ensures thatcash and futures will converge. The “threat” that delivery can be either made or takenensures that prices of cash and futures will track closely or arbitragers will force themtogether in an attempt to earn profits from any price disparities.


2.8.2 The Cash Settled Contract

Convergence of a cash settled contract is ensured at maturity through the final settlement pricewhich is set equal to the actual underlying cash price index.

Prior to expiry, if the futures price is high relative to the cash price index prior to finalsettlement, there is an incentive for the longs and other individuals to sell the futures causingthe futures price to fall. By selling the contract back now, a long position will capture a profitwhich may disappear by holding the position to expiry at which time the futures settlementprice will equal the actual underlying cash price index. At the same time, those individualswho need the physical product may view the cash price as being too low and buy physicalproduct creating higher a cash price.

Similarly, if futures prices appear low relative to the cash price index, there is an incentive forthe shorts and other individuals to buy the futures prior to expiry causing futures price toincrease. By buying the futures contract back now, a short position will capture a profit whichmay disappear by holding the position to expiry at which time the futures settlement price willequal the underlying cash price index. At the same time, those individuals who are holdingphysical product may view cash prices as being too high and sell off additional product causinga decline in cash prices. In either case, the cash and futures markets will converge as the finalsettlement date approaches.

2.9 The Margining Process

Margin money is the good faith or earnest money required to enter into a futures contract.The clearing association, through the margining process with its members, ensures performanceby the buyer and seller of the futures contract. Only clearing members may deal with theclearing association and therefore, clearing members are financially liable to the clearingassociation. Clearing members include exchange members, licenced to deal with the public.

� Futures clearing merchants (FCM’s) or brokers are licenced exchange members whorepresent the public’s interest on a commission basis and collect the initial margin fromtheir customers.

� Initial or original margin is the amount of money requested when a futures transactionoccurs. These initial margins, expressed as a fixed amount per futures contract are usually5% to 10% of the contract’s value and are established by the exchange. The exchange mayadjust initial margin requirements upward or downward with changes in the level of pricevariability (volatility) in the futures market.

� Individual commodity brokers usually set their initial margin requirements at higher levelsto the public for financial security and to reduce the frequency of margin calls.

� The clearing association, in order to maintain financial integrity of the futures contract and


to ensure contract performance on an ongoing basis, requests additional margin funds ifthe market moves against a futures position.

� At the close of the day all open futures positions, based on the initial margin level plus orminus cash, must equal the closing futures price. This process is referred to as markedto market daily.

� The futures market does not use a debt system. Margins must be posted immediately uponentering into a futures transaction and positions are marked to market daily. Marked tomarket means that the clearing house balances all open futures positions at the daily close.

MARGIN EXAMPLE“A - Long”ACCOUNT

“B - Short”ACCOUNT

Account Deposit $2,300.00 $2,300.00

Initial Margin ($2,300.00) Day 1: “A” buys 10 NOVcanola @ $400“B” sells 10 NOVcanola @ $400

($2,300.00)

Account Balance $2,300.00 $2,300.00

UnrealizedGain/(Loss)

$1,000.00 Day 2: NOV futures rise to$405

($5/mt X 200 mt = ± $1,000)

($1,000.00)

Account Balance $3,300.00 $1,300.00

Margin calls $0.00 $1,000.00

Account Balance $3,300.00 $2,300.001. Initial margin requirements of $230.00 per contract, therefore, 10 contracts X $230 = $2,3002. Maintenance level of $160.00 per contract, therefore, 10 contracts X $160 = $1,600

� For example, if a short futures position is “offside” from the close of the market where theclosing futures price is higher than the previous closing price, the difference must be paidin cash to the clearing association. The corresponding long futures position is in a positiveposition and the clearing association would credit the long’s account.

� When an account’s initial margin funds are drawn down to a maintenance or variationmargin level predetermined by the exchange, the broker requests additional funds from theproducer. This request for additional funds is referred to as a margin call. Margin callsare expected to be deposited prior to the next business day.

This margining process is why commodity futures have often been viewed as risky. The


leverage provided by the margining process can allow a trader to hold a larger position fora fraction of the full cost. At the same time the margining process established by the clearingassociation and the respective membership maintains a high level of financial integrity.

With the increase in the futures price, the short’s account is debited while the long’s accountis credited by the change in the contract value. In the example, “A - Long” is credited with$1,000.00 and “B - Short” is debited $1,000.00. On Day 2, B’s account is below themaintenance level of $1,600.00 required by the exchange. A maintenance or variation margincall is issued for $1,000 to bring the account back to the original level. Credits and debits aremade to each account based on the daily settlement price.

2.10 Closing Out A Futures Position

The obligations of a futures contract can be fulfilled through the delivery process or by offset. For cash settled contracts there is no delivery requirement or obligation. Care should be takenin considering delivery on contracts where that is possible. The holder of the contract shouldbe familiar with the conditions of delivery, which will vary by contract, to ensure delivery canbe fulfilled where and when desired. In the case of offset the holder of the futures contract takesan equal and opposite position to the current futures position.

If short:

1. Deliver the commodity and accept payment where and when possible.

2. Buy back the same number of futures contracts (offset original position).

If long:

1. Take delivery of the commodity and pay for it in full where and when possible.

2. Sell back the same number of futures contracts (offset the original position).

2.11 The Mechanics of a Simple Hedge

Hedging with futures allows producers to establish a fixed local price, subject to changes in thebasis, due to the offsetting nature of the cash and future markets. Any losses (profits) in onemarket will be offset by profits (losses) in the other market. That is why a hedger should notbe concerned that the futures market is in itself a zero sum game, for any loss there must be aprofit and vice versa. It is not important whether a profit/loss occurs in the futures market butwhether a similar offsetting loss/profit is made in the cash market. The end result is theproducer, by hedging with futures, is locking in a fixed price. How effective the producer isin locking in the price will be dependent on basis, which is discussed in the next chapter.


2.11.1 Short Hedge

It is February and the expected cash price for October is $400 and the October futures price istrading at $420. The producer decides to lock in a portion of the production to be sold in lateSeptember at $400. In making this decision the producer has determined that the $400provides an adequate return on the crop or id prices are expected to be lower prices in the fall,the hedge will limit any potential loss.

Since the producer will be holding the physical commodity (long the cash) a short position istaken in the futures market. In this instance, the October futures are sold at $420 in February.The producer is short the October futures. In September, when the commodity is marketed,the hedge is lifted at $440 by buying (going long) October futures. Since the futures price hasrisen the short futures position results in a loss of $20 (sold at $420 in February and boughtback at $440 in September).

The other side of the hedge is the cash market. In this case the basis is assumed to be constantso the cash price also rises by $20 from $400 to $420. So in the cash market the producer sellsthe commodity for an additional $20, offsetting the $20 loss in the futures market.


It is the net sum of both the futures and cash transactions which will determine how effectivethe hedge is in locking in the price. Whether the transactions completely offset will depend onthe basis. What is important to recognize is that once a futures hedge is placed it does notmatter whether the futures price rises or falls as long as the cash price moves in the samedirection and hopefully by the same magnitude. In this example basis was constant so the endresult is a fixed price of $400 - the profit and loss exactly offset each other.

Why give up the profit in the cash market as a result of the short position in the futures?A hedger will give up this profit to avoid the possibility of lower profits or higher losses as aresult of a fall in the expected cash price. In February the producer did not know whether theprice in late September would be higher or lower. The hedge allowed the producer to reducethe risk of a lower price.

The following graph illustrates what would have happened if prices had fallen by $20. Nowthe short futures position results in a profit of $20 which will offset the loss in the cash. Sowhile the hedge gives up the upside potential in the cash market, it protects against thepossibility of a falling price.


2.11.2 Long Hedge

The long hedger is sitting on the opposite side of the table from a short hedger. The shorthedger grows and sells the commodity whereas, the long hedger uses the commodity and is abuyer. Thus, in the case of a long hedger everything is the reverse of the short hedge position,as indicated in the following table:

Short Hedge Long Hedge

Opening Futures Trade Short Futures (Sell) Long Futures (Buy)

Closing Futures Trade Long Futures (Buy) Short Futures (Sell)

Cash Long Short

Decrease in Futures Price Profit Loss

Increase in Futures Price Loss Profit

Decrease in Cash Price Loss Profit

Increase in Cash Price Profit Loss


It is February and the futures price for September corn is trading at $3.25/bu. when theexpected September cash price is $3.25/bu.. A feedlot decides to lock in a portion of the fallfeed costs to be purchased in September at $3.00/bu.. In making this decision the producer hasdetermined that with feed costs of $3.00/bu. an adequate return can be made on the cattle.

Since the producer will be buying the physical commodity (short the cash) a long position istaken in the futures market. In this instance, September futures are bought at $3.25/bu. inFebruary and the producer is now long September corn. In September, when the corn ispurchased, the hedge is lifted at $2.90/bu. by selling (going short) September futures. Sincethe futures price has fallen the long futures position results in a loss of $0.35/bu. (bought at$3.25/bu. in February and sold back at $2.90/bu. in September).

The other side of the hedge is the cash market. In this case the basis is assumed to be constantso the cash price also falls by $0.35/bu. from $3.00/bu. to $2.65/bu.. So in the cash market theproducer buys the corn for $0.35/bu. less, offsetting the $0.35/bu. loss in the futures market.


If the price of corn had risen the producer would have paid a higher price for the feed in thecash market. However, the higher cost of the feed would have been reduced by a equal profiton the futures transaction. This would have resulted in a net feed cost of $3.00/bu.

It is the net sum of both the futures and cash transactions which is important and whichdetermines how effective the hedge is in locking in the price. What is important to recognizeis that once a futures hedge is placed it does not matter if the futures price rises or falls as longas the cash price moves in the same direction and hopefully by the same magnitude. In thisexample basis was constant so the end result is a fixed price of $3.00/bu. - the profit and lossexactly offset each other.


2.12 Chapter Summary

� Futures markets evolved as a means of price discovery over time enabling marketparticipants to “ration” supplies accordingly. While futures are “paper” markets, they aretied to cash markets. As a result of the threat of delivery and cash settlement, cash andfutures prices tend to converge at the expiry of the contract. It is this feature of futuresmarkets which allow hedging to occur, a loss in one market can be offset, in whole or inpart, by a gain in the other.

� Holding the physical commodity for future sale is considered long the cash while expectingto buy the commodity in the future is considered short the cash. These positions can behedged by taking an opposite position in the futures market, short and long the futuresrespectively. Arbitrage, margining and the clearing process all ensure contract obligationsare met.

� The offsetting nature of a futures contract basically establishes a fixed price for thecommodity. It is important hedgers consider the timing of the hedge in order not to missattractive pricing opportunities or avoid further price decreases. A good marketing planwhich is set up and adhered to throughout the production cycle can help address some ofthese questions.


Futures Market Quiz

1. The interaction of buyers and sellers in the futures market help to discover___________ and to provide for a ___________ marketplace.

a) competition, noisyb) price, liquidc) futures, centrald) standardization, new

2. Futures markets evolved from cash markets to cash forward markets out of______________.

a) chaos caused by the Roman Empireb) chaos caused by erratic supply, poor storage facilities and large price swingsc) desperation by men who wanted to fix prices

3. Futures markets are traded on the floor of the exchange where price is determinedby:

a) the Clearing Associationb) auction and open outcryc) ticker taped) exchange observers

4. Margin money in futures markets is referred to as:

a) good faith, earnest moneyb) profitc) space on a paged) the broker’s fee


Hedge Exercises

1) Short Hedges:

It is early April and given the traditional basis level for November contracts, producers expectthe following November cash prices. Producer can protect against lower prices by going shorton the relevant December futures contract. For simplicity all prices are in Canadian dollarsand the basis level is constant.

Expected Prices for November Commodity Expected November

Cash PriceDecember Futures Price

(April 15)

Barley $120.00/mt $145.00/mt

Corn $3.50/bu $3.85/bu

Hogs $150.00/ckg $160.00/ckg

Canola $353.00/mt $360.00/mt

Slaughter cattle $88.00/cwt $96.00/cwt

On November 1 the local cash prices for barley, corn and hogs have fallen while the canola andcattle prices have risen. Each producer sells the physical commodity and at the same time liftsthe hedge at the current December futures prices. Calculate the final price for each of thecommodities given the local cash prices and current December futures prices.

November PricesCommodity November

Cash PriceDecember Futures Price

(November 1)

Barley $90.00/mt $115.00/mt

Corn $2.50/bu $2.85/bu

Hogs $120.00/ckg $130.00/ckg

Canola $378.00/mt $385.00/mt

Slaughter cattle $95.00/cwt $103.00/cwt


BarleyTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Long Cash

Sell (Short) DECfutures

Expected Price$120.00/mt

$145.00/mt

NOVEMBER 1:Sell (Short) Cash Buy (Long) Dec

Futures

Actual Sale Price$90.00/mt $115.00 /mt

Profit (Loss) ($30.00/mt) $30.00/mt

Gain on FUTURES offsets Loss on the CASH Price

CornTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Long Cash


Expected Price$3.50/bu

$3.85/bu


Futures

Actual Sale Price$2.50/bu $2.85/bu

Profit (Loss) ($1.00/bu) $1.00/bu


HogsTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Long Cash


Expected Price$150.00/ckg

$160.00/ckg


Futures

Actual Sale Price$120.00/ckg $130.00/ckg

Profit (Loss) ($30.00/ckg) $30.00/ckg



CanolaTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Long Cash


Expected Price$353.00/mt

$360.00/mt

NOVEMBER 1:Sell (Short) CashBuy (Long) Dec

Futures

Actual Sale Price$378.00/mt $385.00 /mt

Profit (Loss) $25.00/mt ($25.00/mt)

Gain on Cash offsets Loss on the Futures Price

Slaughter CattleTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Long Cash


Expected Price$88.00/cwt

$96.00/cwt

NOVEMBER 1:Sell (Short) CashBuy (Long)Dec

Futures

Actual Sale Price$95.00.cwt $103.00/cwt

Profit (Loss) $7.00/cwt ($7.00/cwt)

Gain on Cash offsets Loss on the Futures Price


2) Long Hedge

The cattle or hog feeder has the risk of higher feed costs on corn or barley. Assume theproducer expects to buy barley at $25/mt under the futures, delivered in May or corn at$0.25/bu under. There is enough grain in storage to feed until that time. The July barleyfutures contract is currently trading at $125/bu while the July corn is trading at $3.25. Theproducer can forward contract the livestock for late August delivery for a profit. If the priceof barley or corn increases the profit margin could be wiped out and result in a loss position.

On May 1 the cash prices of barley and corn have risen to $130/mt and $3.90/bu respectively.The July futures barley price is $155/mt while the corn is trading at $4.15/bu. Fill out thefollowing tables and determine the producer’s final cost for either of the feed grains.

BarleyTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Short CashBuy (Long) Julfutures

Expected Price$100.00/mt.

$125.00/mt

May 20:Buy (Long) CashSell (Short)JulFutures

Actual Purchase Price$130.00/mt. $155.00/mt

Profit (Loss) ($30.00/mt.) $30.00/mt.


CORNTRANSACTION NOV. CASH (Physical) DEC FUTURES

APRIL 15:Short CashBuy (Long) Julfutures


$3.25/bu

May 20:Buy (Long) CashSell(Short) JulFutures

Actual Purchase Price$3.90/bu $4.15/bu




- NOTES -

Chapter 3 - Basis Page 3-1

BASIS


After completing this Chapter, you will:

1. Understand the definition of basis.

2. Understand why basis is different for grains and oilseeds versus livestock.

3. Understand the difference between “unadjusted basis” and “adjusted basis.”

4. Understand the importance of basis as a measure of the relationship between cashand futures prices.

3.1 The Concept of Basis

Basis measures the relationship between cash and futures contracts and is calculated as thedifference between the local cash price and the relevant futures price (cash price -futures price = basis). Basis quotes, unless otherwise specified, are usually relative to thenearest futures contract. The basis will be negative or “under” when the cash price is lessthan futures or positive or “over” when the cash price is higher than the futures. Forexample:

� Basis = $350.00 cash price minus $320.00 futures price = + $30.00 basis (cash is$30.00 over futures)

� Basis = $210.00 cash price minus $240.00 futures price = - $30.00 basis (cash is $30.00under futures)

The term “basis” is derived from the fact it helps define the terms of local cash salesrelative to the future’s contract price and delivery points. If the basis for canola in EasternSaskatchewan is $10.00 under the nearby, canola cash prices in Eastern Saskatchewan are$10.00/mt less than the nearby futures price. If nearby canola futures prices are$325.00/mt, then cash prices are $315.00/mt in Eastern Saskatchewan. If basis remainsconstant over time, the local cash price will only change in response to movements in thefutures price.

Basis has different economic meaning for continuously produced commodities such aslivestock and seasonally produced, storable commodities such as grains and oilseeds.The following sections will examine the elements which determine basis for thesevarious commodities.


3.2 Basis for Livestock

Pricing in livestock markets is very different from in grains and oilseeds markets.Livestock are not storable and are in continuous supply. Prices move up and down assupply or demand change. While meat is carried in inventory, the price has a very smallrole in allocating inventories of live animals over time. As a result there is no carryingcharge relationship.

What then explains futures spreads; the differences between each of the futures contractmonths? Transfer costs (merchandising costs -- freight, interest, death loss) are acomponent of the basis at the local non-delivery points. The second component is futureprice expectations.

Suppose that in January the lean hog carcass underlying cash price, in the US, for thefutures contract is $75/.00cwt. In Table 3.1 we see the future prices for each futurescontract on that day and the resulting basis. These basis observations are simply forecasts,expectations that the underlying cash price will rise $3.00/cwt from January until midFebruary, then fall by $5.00/cwt by mid April, then rise again by $7.00/cwt by mid June.

Table 3.1: Livestock Basis Calculation (US$/cwt)

Expiry Month Futures Price Basis

February $78.00 -$3.00

April $73.00 +$2.00

June $80.00 -$5.00

As North American livestock futures contracts are only traded in the US, Canadianproducers face additional complications in the calculation of basis. First, the basis needsto be adjusted for the exchange rate. Secondly, prices may be based on different weightmeasures and grades and require additional adjustments.

For example, cash prices for hogs are quoted in metric carcass weight units while theUS futures is a lean carcass price per hundred Imperial pounds. The basis for 100 indexhog prices in Ontario after adjustment and conversion shows a strong seasonal patternwhich is relatively stable year-to-year.


3.3 Basis for Grains and Oilseeds

Grains and oilseeds are harvested during certain months of the year and stored throughoutthe year. Futures prices play a role in the storage of grains and oilseeds by providingincentives to store or conversely disincentives to store the commodity when supply is verytight. This will be reflected in the spread between the various futures expiry month pricestraded for grains and oilseeds. This relationship is reflected in the basis which indicateswhat the market will pay in terms of carrying and transfer charges.


3.3.1 Carrying Charge Markets

Carrying costs or charges are the variable costs of holding grain from one month to the nextat the delivery point (Chicago for corn, soybeans, winter wheat; Thunder Bay for feedwheat; Saskatoon for canola; Lethbridge for barley). The main cost of carry is interest. Forexample, if the price of corn in Chicago is $3.00/bu in November and the prime interest rateis 6% there is an opportunity cost of $0.015/bu/month to hold the corn.

If basis is equal to carry, Chicago cash prices will be 1.5 cents under the December futuresprice. This carrying charge relationship is a fundamental factor in determining thedifference in prices between various futures months (futures spreads).

Since the March corn futures contract is representative of prices three months afterNovember, the carrying charge condition is met if March futures are $0.045/bu aboveDecember (three months times $0.015/mo). Assuming this carrying charge condition carriesforward the May futures price will be $0.03 higher than March. The basis for March andMay is $0.06 under and $0.09, respectively. Using $3.00 as the November cash price, theresulting futures prices are illustrated below.

Carrying Charge Market

The carrying charge relationship is often thought of as an "equilibrium condition" in themarket. Demand and supply should be equal over time, in this instance from Decemberto May. When the price differences between the cash and the various futures months areequal to carrying costs, the market is said to be at full carry. There is no incentive tostore more product and producers will be indifferent between selling in the current cashmarket or holding the corn.


Basis can be thought of as a price and can send a signal to make a transaction. Assume thatnew information comes into the market that indicates there will be a shortage of corn inMarch. This has the immediate effect of bidding up the March futures price to $3.08/bu.It still costs $0.06 to carry corn from November to March, but March is now offering $0.08.Basis is $0.08 under March instead of $0.06 under. It is more attractive to store corn untilMarch than to sell it in the current cash market.

By going short or selling futures the producer can lock in a March price of $3.08/bu atChicago for the corn in storage. Of course, the very act of withholding corn from thecurrent cash market puts upward pressure on the cash price and selling futures putsdownward pressure on the futures price. This tends to move them back toward a basisrelationship that reflects full carry. A fundamental factor that drives this relationshipis the threat of delivery or final settlement at the underlying cash price index in the caseof cash settled contracts.

3.3.1.1 Inverted MarketsThe opposite of a carrying charge market is an “inverted market.” Inverted markets aremarkets in which the deferred futures month price is less than the nearby month’s price.Carrying charge markets are more typical to commodities that have a short harvest periodand are stored throughout the year. Inverted markets do occur in grain and oilseed marketswhen the supply is tight relative to demand. Demand bids the nearby market price abovethe forward market price providing a disincentive to storing grain. Markets can be invertedbetween old crop and new crop months.

JAN MAR MAY JUL. $300.00 $295.00 $290.00 $286.00


1 The basis (futures minus cash) for Tokyo prior to July should approximate the transfer cost fromSaskatoon to Tokyo minus the remaining carrying charges to July. In this example, the basis is negative in early September (carrying charges to July are higher than the transfer costs) but becomespositive as the carrying charges incurred are added to the actual cash prices.

3.3.2 Transfer Costs

Transfer costs (merchandising costs -- freight, interest, risk) are normally reflected in thebasis for markets which are outside the delivery or pricing area of the futures contract. If,say canola basis is related to carrying costs at the Saskatoon delivery area, what would thebasis be at a surplus or deficit location? In each of the following graphs the futures priceremains constant. The Saskatoon cash price is represented by the dashed line.

One would expect the basis in a surplus area, say Eastern Saskatchewan, to be the futuresprice minus both the remaining carrying charges to July and transfer costs to the deliveryor pricing point. The cash price in Eastern Saskatchewan will be lower by the cost ofcarrying the canola to July and the transfer costs.

In October the basis will be wide reflecting the lower Eastern Saskatchewan cash price forcanola as little or no carrying costs have been incurred to that point in time. The July futuresprice reflects the full cost of carry to July. The July basis should narrow as carrying chargesare incurred and added to the cash price. The cash price increases and the basis eventuallyequals the transfer or transportation costs.

For a deficit area, such as Tokyo, the final July basis1 should be the transfer costs of movingcanola to Tokyo from Saskatoon. Prior to July the Tokyo cash price will be equal to theSaskatoon cash price plus transfer costs. The Tokyo cash price will rise as the carryingcosts charged from September onward are added to the Saskatoon price.


3.3.3 Basis and Threat of Delivery

In Chapter 2 the threat of delivery was discussed and how it helps to keep the relationshipbetween futures and cash markets, as measured by basis. This holds true for transportationand storage costs. The following examples show how the threat of delivery works in thecash of both a negative (surplus area) and positive (deficit area) basis for storablecommodities.

NEGATIVE BASIS

If the cash bids are too low at the delivery point - sell futures and hold the inventory. Ifenough people do this, selling pressure forces futures prices down. Meanwhile, a lack ofofferings in the cash market encourages buyers to raise cash bids. Cash and futures movetogether as shown below.


POSITIVE BASIS

If the cash price is high relative to the futures price at the delivery point - sell inventory intothe cash market and buy futures. If enough people do this, selling pressure forces cashprices down. Meanwhile, increased buying raises the futures price. The end result is cashand futures prices move together.

Both sets of transactions are known as “arbitrage,” simultaneous buying and selling in thecash and futures markets. Arbitragers will buy in the low-priced market and sell in thehigh-priced market. Because of the delivery process or the way cash settled contracts aresettled, arbitragers force cash and futures toward each other until only carrying and transfercosts are reflected in the basis -- cash and futures prices converge.

This relationship between cash and futures caused by the “threat of delivery” attractsboth hedgers and speculators to the futures market. It is ironic that, because traders donot have to make or accept delivery, futures may seem to be a synthetic, “paper” market.Yet, the fact that delivery can occur establishes the link between futures and cashmarkets.

3.4 Basis Variability

It is the basis which determines how effective a hedge on futures will be for the producer.Depending on whether the futures hedge is short (long the cash), or long (short the cash) theimpacts of a basis change will differ. This becomes more relevant if it becomes necessaryto lift the hedge prior to expiry of the futures contract or you are in area where delivery onthe futures contract may not be possible.


Consider the short hedge example in chapter 2 where both the futures price ($420) and cashprice ($400) moved in the same direction and by the same amount. The result was a perfecthedge. Any losses/profits in one market were offset by the opposite position in the othermarket. Now consider two other possible outcomes:

i) The cash price only rises by $10

The cash price is less than the futures price so the basis is negative. The cash price rises byless ($10 in this example) than the futures price, so the basis is now wider. The same thingwould happen if the cash price decreased by more than the futures price, when prices arefalling. Fill out the table below to determine the net effect on both the futures and cashtransactions and the overall effect on the hedge.

Basis Widens - Short HedgeCash Futures

Feb.: Position long short Price $400 $420Oct.: Position short long Price $410 $440NET $10 ($20)

* See Answer section.


In the case of a long hedge, where the producer will be buying the physical commodity inOctober, the overall net effect is reversed resulting in additional profit. The results will alsodiffer for the short hedge where the basis is positive, the cash price is higher than the futuresprice, in which case the basis actually narrows. When the cash price rose by less than thefutures price the positive basis actually narrows and there is an overall net loss on the shorthedge.

ii) The cash price rises by $25

The cash price rises by an additional $5 versus the futures price so the basis narrows. Thesame thing would happen if, when prices are falling, the cash price decreases by less thanthe futures price. Fill out the table below to determine the net effect on both the futures andcash transactions and the overall effect on the hedge.

Basis Narrows - Short HedgeCash Futures

Feb.: Position long short Price $400 $420Oct.: Position short long Price $425 $440NET $25 ($20)

* See Answer Section


If the basis was positive and the cash price rose by more than the futures price the resultswould have been reversed and the short hedger would have suffered an overall loss on thehedge. A long hedger would have had a net overall profit on the hedge.

In the first case the short hedger would have a net loss of $10 while in the second a net profitof $5. The fact the local basis may not converge to historical levels is basis risk andproducers should be aware of this. Keep in mind, however, that basis risk is less than priceand basis risk combined. Producing a commodity which is unpriced or unhedged isequivalent to taking on all of the risk - basis included.

To help understand basis better, work through some examples. The table below lists theoverall impacts of a change in the basis under different scenarios. By looking at basishistorically and/or seasonally it will be much easier to assess current market conditionsin both cash and futures markets and the implications for basis.

Impact of Basis Change on Overall HedgeExpectedBasis

Short Hedge Long Hedge

Basis Widens Basis Narrows Basis Widens Basis Narrows

Negative loss profit profit loss

Positive profit loss loss profit

3.5 Calculating Basis While information on current and historical basis may be available from local producerassociations or elevators, it may be necessary to develop your own basis series. The mannerin which the basis is calculated is relatively simple but in the case of a US futures there isthe added complication of converting the US price to Canadian dollars. For some contracts,such as hogs a conversion from a carcass price to live weight is also required to calculatethe basis properly. Lets look at a historical basis chart and graph for western live cattle. The futures price, inCanadian dollars, is the weekly average of the daily closing price for the nearest deliverymonth. Daily prices were first converted to Canadian dollars using the daily or spotCanadian/US exchange rate. In the event of a dramatic difference between the currentexchange rates and expected rates, forward or future exchange rates should be used tocalculate the basis. The weekly futures average price is subtracted from the average Albertalive steer cash price to calculate the basis.


L ive Cattle Basis Calculation - A lberta (1997)W eek Alberta Cash Futures Price Alberta Basis

Ending ($Cdn/cwt) ($Cdn/cwt) ($Cdn/cwt)3-Jan-97 80.56 89.17 -8.61

10-Jan-97 78.78 87.97 -9.1917-Jan-97 80.02 88.35 -8.3324-Jan-97 79.39 87.62 -8.2331-Jan-97 79.90 86.80 -6.907-Feb-97 81.22 88.38 -7.16

14-Feb-97 83.94 89.14 -5.2021-Feb-97 84.82 92.56 -7.7428-Feb-97 87.12 95.39 -8.27

7-M ar-97 87.65 94.02 -6.3714-M ar-97 87.13 93.47 -6.3421-M ar-97 87.05 94.07 -7.0228-M ar-97 86.79 93.91 -7.12

4-Apr-97 86.03 90.43 -4.4011-Apr-97 87.33 89.33 -2.0018-Apr-97 87.96 90.38 -2.4225-Apr-97 85.03 89.81 -4.782-M ay-97 85.41 90.22 -4.819-M ay-97 86.82 90.38 -3.56

16-M ay-97 85.48 90.71 -5.2323-M ay-97 84.31 89.69 -5.3830-M ay-97 81.83 90.09 -8.26

6-Jun-97 80.63 88.15 -7.5213-Jun-97 82.47 88.17 -5.7020-Jun-97 83.92 89.00 -5.0827-Jun-97 81.95 88.62 -6.67

4-Jul-97 83.82 88.50 -4.6811-Jul-97 81.62 88.15 -6.5318-Jul-97 81.53 90.69 -9.1625-Jul-97 82.91 92.15 -9.241-Aug-97 84.98 94.35 -9.378-Aug-97 84.30 96.84 -12.54

15-Aug-97 84.51 97.25 -12.7422-Aug-97 83.25 95.83 -12.5829-Aug-97 81.81 94.88 -13.07

5-Sep-97 80.08 93.40 -13.3212-Sep-97 81.43 95.85 -14.4219-Sep-97 79.87 94.94 -15.0726-Sep-97 79.32 94.34 -15.02

3-Oct-97 80.76 91.57 -10.8110-Oct-97 81.16 91.53 -10.3717-Oct-97 83.05 92.14 -9.0924-Oct-97 87.75 93.19 -5.4431-Oct-97 87.32 94.55 -7.237-Nov-97 85.98 94.07 -8.09

14-Nov-97 86.47 94.07 -7.6021-Nov-97 87.73 95.39 -7.6628-Nov-97 88.13 95.78 -7.65

5-Dec-97 86.81 96.52 -9.7112-Dec-97 87.15 95.63 -8.4819-Dec-97 84.77 94.00 -9.2326-Dec-97 84.21 94.49 -10.28


1997 Alberta Live Cattle Basis

-16.00

-14.00

-12.00

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

1997

/01/03

1997

/01/24

1997

/02/14

1997

/03/07

1997

/03/28

1997

/04/18

1997

/05/09

1997

/05/30

1997

/06/20

1997

/07/11

1997

/08/01

1997

/08/22

1997

/09/12

1997

/10/03

1997

/10/24

1997

/11/14

1997

/12/05

1997

/12/26

Week of

$/cw

tOn the first business day of the delivery month a switch is made to the next futures contract.For example, from February 1st to March 31st the April futures contract price is used butbeginning April 1st the June futures contract price is used. This results in a continuousseries. Another alternative is to pick a relevant futures delivery month and track the basisfor that contract throughout the year.

3.6 Basis Quotes - Adjusted and Unadjusted Basis

With increased volatility in the Canada/US exchange rates, Canadian producers producingcommodities priced or hedged in US futures markets face the risk of an adverse movementin the exchange rate. An appreciation in the value of the Canadian dollar lowers theCanadian price while a fall in the value of the dollar increases the Canadian price. For thosecommodities traded on a Canadian Exchange any adverse changes in the currency whichimpact on cash prices will be reflected in the futures price. Therefore the Canadiandenominated futures price also protects against adverse exchange rate movements.


� When basis is quoted as the local cash price in Canadian funds minus the futuresprice in Cdn dollars it is referred to as the adjusted basis. In some cases the basismay be quoted as local cash price in Canadian funds minus the futures price in USdollars which is the unadjusted basis. Be sure you know which basis is beingquoted.

� Changes in the adjusted basis are a result of shifts in the local supply and demandconditions, carrying charges and transfer costs whereas changes in the unadjustedbasis can also be a result of a changing Canadian exchange rate.

� The advantage of looking at the adjusted basis is that the impact of the exchange rateis removed from the basis. Exchange rate risk itself can be minimized by hedgingthe exchange rate or locking in a fixed forward rate.

� In calculating the adjusted basis for a futures contract convert the US price intoCanadian funds by using a forward exchange rate rather than the current exchangerate. In order to hedge, it is the exchange rate at that future point in time which isrelevant. The forward exchange rate as quoted by a bank or dollar futures contractrate traded on the Chicago Mercantile Exchange can be used to make thisconversion.

Hedging of future and cash prices denominated in US dollars is explained in Chapter 6.

Local price - Futures Price X Exchange Rate = ±Local Basis.

3.7 Chapter Summary

� While cash and futures move up and down together, they seldom move by the sameamount. Thus it becomes important to understand the basis relationship betweenyour local cash prices and the futures prices for both storage and non-storablecommodities.


� Basis for storable commodities (i.e., grains and oilseeds) at a futures delivery point(e.g., Chicago, Saskatoon or Lethbridge) is related to carrying costs. In other words,we expect the cash price on a given date to be under the nearest futures price byapproximately the cost of storage between that date and the time the futures contractmatures. If basis is wider (i.e., cash is under futures by more than the cost ofstorage), then there is an incentive to store. If the basis is narrower, then there is anincentive to sell in the cash market.

� Prices in local markets are related to the delivery point price by transportation andhandling costs. A producer selling in a surplus producing area would expect a priceequal to the cash price at the delivery point less freight and handling costs. At adeficit point local cash prices should be greater than the delivery point price by thecost of moving grain to the deficit area. Grain prices are all related - across time bystorage costs and across space by transportation and handling costs.

� Each location has its own unique basis pattern that reflects its location and its supplyand demand situation. Producers need to be aware of local basis patterns in orderto be able to evaluate hedging opportunities. One can have little idea what theoutcome of a hedge will be, unless one has some expectation of the expected basiswhen the hedge is completed.

� There is no storage cost relationship in livestock futures. Livestock futures aresimply forecasts of the cash price during the delivery month and at set deliverypoints in the US Midwest. The basis at the delivery point is simply the expectedchange in the cash price at the delivery point. Basis at non-delivery points is relatedto the delivery point basis by transportation costs in the same manner as grains.

� The impact of the exchange rate on the basis can make it more difficult to followmarket signals influencing basis. It is much easier to gauge changes in changes inmarket supply and demand over time and space using the adjusted basis.

� It is important to keep in mind basis may not follow historical patterns and can vary.There may be changes in carrying charges, transfer costs, or the nature of themarkets may change themselves. For example a deficit area could suddenly becomea surplus area as the local demand and supply for the commodity changes over time.

� The discussion points out the one variable which a futures or an options contractcannot hedge, basis. When basis risk is a concern, producers should first considerforward cash contracts or a combination of basis and futures or options.


Basis Quiz

1. Adjusted basis is:

a) the current basis corrected for historic trendsb) the basis in Canada calculated after converting Canadian cash prices to US

equivalentsc) the basis in Canada calculated after converting US futures prices to

Canadian fundsd) none of the above

2. When the local basis for a commodity is expressed in a common currencyand is negative:

a) it is said to be “under”b) it likely means the local area is surplus the productc) it means futures are higher than cashd) all of the above

3. If live cattle futures are at $75 US/cwt, the cash price in Southern Alberta is$95 Cdn/cwt and the Canadian dollar is trading at $0.74 US, the adjustedbasis in Southern Alberta is:a) $10.00 overb) $10.00 underc) $6.35 Cdn/cwt under

$75 US futures ÷ $0.74 US exchange rate = $101.35 Cdn;$101.35 Cdn - $95 Cdn cash price = adjusted basis minus $6.35

d) $5.42 overe) cannot be determined with this information

4. A canola producer in Eastern Saskatchewan sells November canola futuresat $425.00 Cdn/mt. The producer expects the local basis to be $15.00Cdn/mt under in October. What price does the producer expect to receivein October?$410.00 Cdn/mt ($425.00 futures less $15 “under” basis =$410.00).


L ive Cattle Basis Calculation - Ontario (1997)W eek O ntario Cash Futures Price Ontario Basis

Ending ($Cdn/cw t) ($Cdn/cw t) ($Cdn/cwt)3-Jan-97 87.88 89.17 -1.29

10-Jan-97 86.46 87.97 ____17-Jan-97 85.00 88.35 ____24-Jan-97 83.84 87.62 ____31-Jan-97 83.93 86.80 ____7-Feb-97 81.86 88.38 ____

14-Feb-97 81.84 89.14 ____21-Feb-97 84.91 92.56 ____28-Feb-97 86.94 95.39 ____

7-M ar-97 88.27 94.02 ____14-M ar-97 87.73 93.47 ____21-M ar-97 87.23 ____ -6.8428-M ar-97 87.77 ____ -6.14

4-Apr-97 89.13 ____ -1.3011-Apr-97 87.94 ____ -1.3918-Apr-97 90.28 ____ -0.1025-Apr-97 90.13 ____ 0.322-M ay-97 89.26 ____ -0.969-M ay-97 91.27 ____ 0.89

16-M ay-97 91.20 ____ 0.4923-M ay-97 ____ 89.69 0.1130-M ay-97 ____ 90.09 -0.29

6-Jun-97 ____ 88.15 0.4313-Jun-97 ____ 88.17 -1.5420-Jun-97 ____ 89.00 0.9927-Jun-97 89.73 88.62 ____

4-Jul-97 88.44 88.50 ____11-Jul-97 88.85 88.15 ____18-Jul-97 89.28 90.69 ____25-Jul-97 90.88 92.15 ____1-Aug-97 92.73 94.35 ____8-Aug-97 93.32 96.84 -3.52

15-Aug-97 91.05 97.25 -6.2022-Aug-97 90.22 95.83 -5.6129-Aug-97 89.74 94.88 -5.14

5-Sep-97 88.94 93.40 -4.4612-Sep-97 88.21 95.85 -7.6419-Sep-97 87.71 94.94 -7.2326-Sep-97 86.89 94.34 -7.45

3-O ct-97 85.82 91.57 -5.7510-O ct-97 83.36 91.53 -8.1717-O ct-97 85.13 92.14 -7.0124-O ct-97 86.18 93.19 -7.0131-O ct-97 86.73 94.55 -7.827-Nov-97 85.98 94.07 -8.09

14-Nov-97 86.88 94.07 -7.1921-Nov-97 86.90 95.39 ____28-Nov-97 87.39 95.78 ____

5-Dec-97 87.90 96.52 ____12-Dec-97 87.97 95.63 ____19-Dec-97 88.82 94.00 ____26-Dec-97 90.62 94.49 -3.87

Basis Exercise: Complete Historical Basis Table


- NOTES -

Chapter 4- Options Page 4-1

OPTIONS


Upon completion of this Chapter, you will:

1. Understand what an option is and how it works.

2. Understand what factors influence the premium.

3. Understand the notion of time decay.

4. How to hedge with options.

An option gives the buyer the right but not the obligation to either buy or sell anunderlying asset at a specified price.

While agricultural options are relatively new compared to futures, it is not a new concept. Theyresemble an insurance product in that a premium is paid for protection against an adverse pricemovement.

4.1 An Example from the Private Sector

Perhaps the best way to describe an option is by example. Options have been used extensivelyfor years in real estate. An option is simply a contract between two parties. One party, uponpaying a premium ($) assumes the right to buy the specified underlying asset (land) at a specificprice within a specified time. The receiver of the premium (the grantor of the right) is obligatedto sell if the buyer chooses to exercise that right. They predetermine the price to sell the landat the time they enter the contract.

Let's look at a specific example . . .

A pension fund owns a large office building in the downtown core. A real estate brokerage firmrepresenting a foreign interest would like to buy the building for their clients. The pension fund,although receiving good revenue from its tenants, is interested in selling the building andrealizing a good return on its investment. Because foreign interests are involved, it could takeseveral months to complete the deal so the real estate broker purchases an option on thebuilding.


On March 2, the real estate broker offers the pension fund a $100,000 (non-refundable,nondeductible) option for the right to purchase the office building. The option specifies apurchase price of $50 million that can be exercised any time within the next 90 days or by May31 at the latest. The broker feels that this will allow the clients enough time to arrange financingto pay for the building and have the funds ready for release by a local bank. The pension fundagrees to the option and receives the $100,000.

� Who is the holder of the right?

� Who is the issuer or grantor of the right?

� What is the underlying asset of the option?

� At what price will the deal be struck or the right exercised?

� What premium did the buyer or holder of the option pay?

� When does the buyer's right (option) expire?

� What happens to the premium money if the option expires without being exercised?

� What happens to the premium money if the option is exercised before or on the expiry date?

� What happens to the office building if the option expires without being exercised?

� What happens to the office building if the option is exercised before or on the expiry date?

� When can the buyer exercise the right provided by the option?


4.2 Components of an Option on Futures

HOLDER (buyer) GRANTOR (writer, seller) ASSET STRIKE PRICE (exercise price)

PREMIUM EXPIRY DATE

Buyer (holder)

Pays the premium and has the right but not the obligation to either buy (CALL option)or sell (PUT option) the underlying asset (futures contract). The buyer’s financial exposureis limited to the cost of the premium.

Seller (writer)

Receives the premium and has an obligation to the buyer. The seller incurs the risk of anyadverse change in the futures price, must post margin and make any margin calls.

Underlying Asset

Futures contracts, i.e., � November beans� December corn� June live cattle� November canola

Strike Price

Set in increments predetermined by the exchange (i.e., 10 cents US/bu for corn and $10.00Cdn/mt for canola). The buyer selects which available strike price to bid on while the sellerdecides which strike price to offer.

Premium

Determined by auction and open outcry.

Expiry

Predetermined by the exchange. On grains, options usually expire about two weeks priorto first day of the delivery month.


4.3 Exchange Traded Options on Futures

Put and call options are available on futures. Both are distinct and can occur without anyprevious ownership or position. The following examples are for at-the-money options whichis why the premium is the same for both options.

CALL:

Gives the buyer of the option the right, but not the obligation, to BUY (go long) theunderlying asset (futures) at a specified price (strike price) within a specified time period(expiry).

May example:

DECEMBER LIVE CATTLE 70US CALL AT 1.5US

- December live cattle futures is the underlying asset - $70US/cwt is the strike price - CALL (right to buy) is the option type - $1.50US/cwt is the premium

PUT:

Gives the buyer of the option the right, but not the obligation, to SELL (go short) theunderlying asset (futures) at a specified price (strike price) within a specified time period(expiry).

May example:

DECEMBER LIVE CATTLE 70US PUT AT 1.5US

- December live cattle futures is the underlying asset - $70US/cwt is the strike price - PUT (right to sell) is the option type - $1.50US/cwt is the premium


4.4 Option Rights and Obligations

BUYER

- pays the premium

- financial risk is limited to thepremium

- pays no margin money

- has the right but not the obligationto take a position in futures.

- Right to buy futures with a CALL

- Right to sell futures with a PUT

- right to offset

- right to let the option expire

SELLER

- receives the premium

- incurs the risk of unlimitedchanges in futures price -- less thevalue of premium

- must pay margin & margin calls asposition is marked to market daily.

- has an obligation to provide afutures position if the buyerdemands right.

- Sell futures if sold CALL

- Buy futures if sold a PUT

- right to offset

- has an obligation until the expirydate or the option is offset

OPTIONS TRADING:

� Options are traded in a contract pit on the floor of the exchange, typically close to theunderlying futures contract pit.

� Options are traded like futures (auction style and open outcry).� The price of the option is the premium.

4.5 Determination of Premium Value

� The option premium is the price the option trades at.� The premium is determined through bids and offers.� The premium comprises both intrinsic value and time values.


Intrinsic Value

Refers to how profitable an option would be if it were exercised. The marketplace measuresoption profitability by comparing the strike price to the current futures price.

� A PUT option is profitable when the strike price is greater than the current futures price orstrike.

� A CALL option is profitable when the strike price is less than the current futures price.

This difference between the strike price and current futures price or profit is known as theintrinsic value. If the option is not profitable to exercise then the intrinsic value is $0.00.

Time Value

Time value is the portion of the option premium related to the amount of time left to theoption’s expiry and the perceived risk that the option could be exercised prior to expiry.

One of the most significant factors affecting the time value of an option is volatility. Volatilityis the “risk factor” in the option premium. The greater the volatility or variability of theunderlying futures markets, the greater the perceived risk that the option could be exercised andthe higher premium. The value of the risk premium depends on the volatility of the underlyingfutures price, the amount of time until the option expires, the level of the strike price versus thecurrent futures price, and interest rates. The greater the volatility of the underlying futuresmarkets and time to expiry of the option, the higher the time value.

Premium Values of Put and Call Options ($ US)Dec Corn Put Strike = $2.70 Dec Corn Call Strike = $2.70

Futuresprice

$2.50 $2.70 $2.90 $2.50 $2.70 $2.90

premium $0.25 $.05 $.05 $.05 $.05 $0.25

intrinsicvalue

$0.20 $0.00 $0.00 $0.00 $0.00 $0.20

time value $0.05 $0.05 $0.05 $0.05 $0.05 $0.05


Calculate the time value and intrinsic value of each of the option premiums listed on thefollowing page. The futures price is given to you. REMEMBER, time value plus intrinsicvalue must equal the given option premium. NOTE THAT SCOOBIE FUTURES SETTLEDAT $188.00.

OPTIONS ON SCOOBIESScoobie Futures= $188.00

STRIKE PRICE PREMIUM INTRINSIC VALUE TIME VALUE

200 P $15.00

200 C $8.00

195 P $14.00

195 C $10.00

190 P $12.50

190 C $10.50

185 P $9.00

185 C $12.00

180 P $6.00

180 C $16.00

P = PUTC = CALLTIME VALUE = Premium - Intrinsic ValueINTRINSIC VALUE = Strike price versus futures and profitable to exercise (in-the-money)


4.5.1 Time Decay

Options are a wasting asset; its value declines over time. As an option approaches its expirydate and it is not in-the-money, its time value declines since the probability that the option willbecome profitable to exercise is reduced. This decline in value over time is referred to as timedecay. Time decay of an option begins to accelerate in the last 60 to 30 days before expiry,providing the option is not in-the-money.

In the case of options that are deep in-the-money, time value decays more rapidly. Themarketplace finds these options too expensive compared to other strike prices or the use offutures. In addition, the holder of the option discounts the time value to attract a buyer in orderto realize the intrinsic value. The greater the certainty about an option’s expiry value, the lowerthe time value. Conversely, the greater the uncertainty about an option’s expiry value, thegreater the time value.

OPTIONS TIME DECAY

ASSUMES CONSTANT FUTURES PRICE AND VOLATILITY

4.6 Options Classifications

How options are classified:

� Relationship of the strike price to the price of the underlying futures contract.� An option can move from one class to another as the underlying futures price changes.


The three (3) main classifications of options are:

In-the-money: If the option is “in-the-money” there is intrinsic value.

Out-of-the-money: If the option is “out-of-the-money” there is no intrinsic value.

At-the-money: If the option strike price is equal to the current futures price,the option is “at-the-money.”

OPTIONS CLASSIFICATIONS - PUTS versus CALLS

PUTS (P) CALLS (C)

In-the-money strike price is greater than the strike price is less than futures the futures

Example: December corn 2.70/bu P, November barley 120/mt C,futures = $2.50/bu futures = $140/mt.

Out-of-the-money strike price is less than the strike price is greater than futures the futures

Example: December corn 2.70/bu P, November barley 120/mt. C,futures = $2.78/bu futures = $111/mt.

At-the-money strike price is equal to the futures strike price is equal to price the futures price

Example: December corn 2.70/bu P, November barley 120/mt. C,futures = $2.70/bu futures = $120/mt.


CONDITION CLASSIFICATION

NOV 5.75 C, futures @ $6.00 ________

DEC 2.70 P, futures @ $2.80 ________

NOV 4.00 P, futures @ $3.60 ________

DEC 110 C, futures @ $110 ________

DEC 140 P, futures @ $110 ________

NOV 5.50 C, futures @ $5.62 ________

NOV 4.75 C, futures @ $5.00 ________

DEC 2.60 C, futures @ $2.50 ________

DEC 2.70 P, futures @ $2.70 ________

Options Classification Exercise

4.7 Closing Out an Option Position

Once an option has been purchased, the buyer can remove or liquidate the option position in oneof three ways. It is possible to exercise, offset an option or allow it to expire.

a) Exercise

� American options can be exercised at any time during the life of the option up to andincluding the day of expiry. Most exchange traded options are of this type. The buyer andseller of the option are both assigned a relevant futures position based on the contract expiryand strike price. Any time value will be lost. The holder of the option can obtain theintrinsic value of the option after it is exercised by immediately offsetting the futuresposition.


� A buyer is only motivated to exercise an option when it is deep-in-the-money or theoption is close to expiry. It is this “threat” of exercise which attracts option buyers andplaces obligation on option sellers. It is why option sellers are required to margin theiroption positions just as if they held the underlying futures.

� If your option is in-the-money at expiry, some exchanges will automatically exercise youroption.

� Pay close attention to the expiry dates of options. In options on US commodities you loseany intrinsic value if you let it expire and it had intrinsic value. Notice of exercise must beprovided to the exchange through your broker.

Exercising an option places you in the futures market. If an option holder (buyer) exercisesa CALL option, the holder will receive a long futures position at the strike price. If an optionholder (buyer) exercises a PUT option, the holder will receive a short futures position at thestrike price.

Option Exercise - Relevant Futures Positions

Call option Put option

buyer assigned long futures position short futures position

seller assigned short futures position long futures position

Many option buyers use options for hedging to avoid the risk of margin calls associated withfutures. Therefore, understanding what happens when you exercise an option and how to exitthe subsequent futures position is important.

b) Offset the Option

If you buy an option the position can be closed out by selling an identical option. So if youpurchased a Dec. put with a strike of $2.70/bu you can offset by selling a Dec. put with a strikeof $2.70/bu. The same hold true for call options. Offsetting an option is the most common wayof closing out option positions as the buyer of the option is able to capture any remaining timevalue plus any existing intrinsic value.

c) Let the option expire

By doing nothing the options purchased will simply expire. Producers might decide to allowthe option to expire if there is no intrinsic value and the time value is less than the cost of offsetor early exercise. The total cost is then limited to initial premiums and commission costs.


4.8 How do Options Work?

As we have seen in the recent exercises, option values (premiums) go up and down dependingon the type of option and in which direction the underlying futures price moves. Options workmuch like insurance. The holder of the policy pays a premium for protection against adverseprices. If prices do not move adversely, the holder (buyer) of the “policy” loses the premium.

Options offer the farm manager an excellent opportunity not available with futures. The farmmanager can hedge a grain or livestock position without giving up the entire “upside.” Theupside means higher prices for the seller or lower prices in the case of the buyer of the physicalcommodity.

This insurance allows producers to establish with some level of certainty a minimum or floorprice for the product. For buyers of the commodity, it is a maximum or ceiling price. In orderto calculate the expected floor (ceiling) price add the strike price and expected basis and thensubtract (add) the premium.

Calculating Expected Price with Options

Put option - Floor Price Call option- Ceiling Price

Strike Price $2.80/bu $2.80/bu

Expected Basis ($0.20)/bu ($0.20)/bu

Premium ($0.10)/bu $0.10/bu

Expected Price $2.50/bu $2.70/bu

If the basis remains unchanged, the minimum price the producer will receive is $2.50/bu. Itis not fixing the level of return. If cash prices rise, the producer is able to benefit and canimprove on the $2.50/bu. With a call option the producer is protected against rising input costswhile at the same time can benefit from lower cash prices.


4.9 Chapter Summary

� A commodity option grants the buyer the right, but not the obligation, to take a futuresposition at a given (strike) price. The buyer of a PUT option has the right but not theobligation to be short futures at the strike price. The buyer of a CALL option has the rightbut not the obligation to be long futures at the strike price. The buyer of an option pays theseller (option “writer”) a premium.

� If the option strike price is higher than the futures market price, in the case of a PUT, orlower than the futures market price, in the case of a CALL, then the option is “in-the-money.”

� An in-the-money option premium will have both intrinsic and time value. The intrinsicvalue is the difference between the strike price and the futures market when the option is in-the-money. An “out-of-the-money” option will have only time value.

� Time value can be thought of as the risk premium that the buyer pays the seller to take onthe risk of having to deliver an unprofitable short or long futures position. The value of therisk premium depends on the volatility of the underlying futures price, the amount of timeuntil the option expires, the level of the strike price versus the current futures price, andinterest rates.

� Buying an option provides an alternative way to manage price risk. For those whose cashmarket risk is that prices will fall, the alternative is to buy a PUT. One can think of this asthe alternative for a short hedge. For those whose cash market risk is prices will rise, thealternative is to buy a CALL.

� There are two substantial advantages that options have over futures as risk managementtools. First, unlike futures, there are no margin calls. The only payment is the originalpremium. It reflects the maximum loss that can occur on the option. The second advantageis that the producer is covered against the risk of an adverse price movement, but can benefitfrom an advantageous price movement.

� In this regard, options are very much like insurance; you pay the writer (the underwriter) apremium to protect against an adverse price movement. You hope you will not collect onthe insurance because by not collecting, it means that the price movement was beneficialto you.

� The main disadvantage of options is having to pay the premium up front. One needs tocarefully weigh the cost of the premium against the potential benefit.


Options Quiz

1. An option premium is:

a) determined by the exchangeb) set at expirationc) determined when exercisedd) negotiated by open outcry

2. A CALL option gives the buyer:

a) the right, but not the obligation, to sell a futures contractb) the obligation to sell a futures contractc) the right, but not the obligation, to buy a futures contractd) the obligation to buy a futures contract.

3. A CALL option with a strike price of $95.00 and the underlying futures at$105.00 is said to be:

a) out-of-the-moneyb) a bad buyc) at-the-moneyd) in-the-money.

4. A PUT option will protect the buyer against:

a) a price increaseb) a crop failurec) a price decline d) a widening basis.


5. A CALL option with a strike price of $100.00 gives the buyer the right, butnot the obligation to:

a) buy the underlying futures at $100.00b) sell the underlying futures at $100.00c) pay the premiumd) receive the premium

6. When a CALL option is exercised, the seller of a CALL:

a) receives a short futures positionb) receives a long futures positionc) receives the premiumd) pays the premium

7. You have purchased a $90.00 wheat CALL option. To offset this optionyou would:

a) sell a $90.00 wheat PUTb) sell a $90.00 wheat CALLc) buy a $90.00 wheat PUTd) exercise the optione) let the option expire

8. A wheat CALL has a strike price of $120.00. The underlying futures are at$130.00. This option is said to:

a) be out-of-the-money by $10.00b) have an intrinsic value of $2.00c) have an intrinsic value of $10.00d) be at the buyer’s break-even.


9. An option strike price is equal to the futures price of the underlyingcontract. The option is:

a) out-of-the-moneyb) at-the-moneyc) in-the-money d) deep in-the-money

10. A PUT option with a strike price of $400.00 while the underlyingfutures are at $370.00 has a premium of $36.00. The premium is madeup of:

a) all time valueb) all intrinsic valuec) $30.00 time value, $6.00 intrinsic valued) $30.00 intrinsic value, $6.00 time value


Options Exercise

CORN:

Consider the purchase of a PUT option (right to sell) on corn futures.

December corn futures $2.90 US/bu

PUT strike price $2.80 US/buPUT option price (premium) $0.10 US/bu

Futures floor price $2.70 US/bu (2.80 strike less $0.10 premium)

The producer obtains the right to sell futures at $2.80 US/bu by buying a PUToption with a strike price of $2.80.

1. What would the 2.80 PUT be worth if December corn futures fell to $1.85 US/bu byNovember 1?

Right to sell @ $2.80 US/bu - futures @ $1.85 US/bu = $0.95 US/bu.

= $0.95 US/bu * 1.35Cdn/US = $1.2825/buThe put will be worth $1.2825Cdn/bu on November 1.

2. Assuming the producer can receive $0.65 Cdn/bu (adjusted basis) OVER the December corn,what cash price would be realized on November 1?

$1.85 US/bu * 1.35 Cdn/US + $0.65/bu = $1.9325 Cdn/bu(The basis is over the futures so is added to the relevant futures price)

The producer will receive $1.9325Cdn/bu in the cash market.


3. What price would the producer actually realize for the corn, considering the profit onthe option and the returns from cash sales? Option premium value November 1: $0.95 US/bu less original option premium paid: (0.10) US/bu Profit $0.85 US/bu

Cdn value $0.85/bu * 1.35 = $1.1475Cdn/bu

Final Price = Cash price plus net premium profit/cost = $2.50 Cdn/bu + ($0.85 X 1.35 = 1.1475) = $3.6475 Cdn/bu

The producer will realize a price of $3.6475 Cdn/bu.

4. What would happen to the producer's PUT option and realized cash returns if the Decembercorn futures rose to $3.20US/bu by November?

A 2.80 PUT option gives the producer the right, but not the obligation, to sell at $2.80US/bu. However, futures are at $3.20 US/bu so the option would be worthless and left toexpire. The futures price in Cdn dollars is $4.32Cd/bu.

Assuming the producer can still receive $0.65 Cdn/bu OVER December futures for a cashbid, returns of $4.97 Cdn/bu should still be realized for the corn ($4.32/bu futures + $0.65/bubasis). However, since the producer paid $0.10 US/bu for the option, this premium cost mustbe deducted from cash returns. So $0.10 X 1.35 = $0.135 Cdn/bu must be deducted from theproducer's cash sale returns of $4.97 Cdn/bu. The producer's net realized return would be$4.835 Cdn/bu.

5. Was this effective price insurance?

Only you as the manager can decide which tool is the most effective.


- NOTES -

Chapter 5 - Hedging with Futures and Options Page 5-1

HEDGING WITH FUTURES AND OPTIONS


At the end of this Chapter, you will understand:

1. The mechanics of a hedge. How and why it is done.

2. The long hedge, a procurement strategy for the commodity buyer.

3. The short hedge, price protection for the commodity seller/producer.

4. The concept and importance of price risk management in your marketing plan.

5.1 Hedging with Futures & Options Markets

To Hedge with futures or options is to take an equal but opposite position to the cashposition to reduce the risk of adverse price movements. The actual hedge could be on allor a portion of the cash position. The amount of the cash position to actually hedge is anindividual business decision. Options give the hedger the alternative of having a right butnot the obligation to buy or sell a futures contract.

� A person who contracts to buy a cash commodity (already owns it or is in the process ofproducing it) is said to be long the cash commodity. Selling (short) futures establishes ahedge in this situation. In the case of an option, the risk can be hedged by purchasing a putoption. The put will give the buyer the right to sell a futures contract at the selected strikeprice.

� A person who does not now own the cash commodity, but will need it in the future, is saidto be short the cash commodity. Buying (long) futures or buying a call option provides ahedge in this situation. The call gives the buyer the right to buy a futures contract at theselected strike price.

�� The option examples assume the producer purchases an at-the-money option; the strike orlevel of protection is the same as the futures price at the time the hedge is placed by theproducer. Note that the strike prices of options are not always available at the samelevel as the futures price. For example, the option may only be available in 1, 2 or fivecent increments. For the purpose of illustration and comparison the strike prices used inthese examples will be equal to the initial futures price.


FUTURES AND OPTION HEDGE EXAMPLES

Example Futures Options

Elevator:

Buys cash for inventory - protect against lower price

Forward sale, selling cash - protect against higher price

sells futures

buys futures

buys a put

buys a call

Feedlot/Processor:

Short cash on barley - protect against higher price

buys futures buys a call

Producer:

Future sale of product (long cash) - protect against lower price

sells futures buys a put

� A hedger views a futures position as a temporary or tentative sale/purchase. It is placeduntil a similar transaction can be made in the cash market (delivery/acceptance of thephysical commodity). Any price changes that occur in the cash market during that periodwill be offset by either a gain or a loss on the futures position. Once the transaction in thecash market is completed, the hedger no longer requires the futures position and the positionis liquidated.

5.2 Examples

Look and work through the examples which are of interest to you or relevant to your operation.For the purposes of illustrating how a hedge is designed to work, the basis and exchangerate are assumed to be constant in each of the examples. In cases where there is not acorresponding futures contract for the expected sales month, the next available futures contractis used by the producer.

Adjusted basis ($US futures price is converted to $Cdn) is calculated for thepurpose of illustration. The impact of a change in the exchange rate on thehedge is discussed in Chapter 6.


5.2.1 Short Hedge - Live Cattle Example - Decline in Price:

A) Futures Hedge

February 1. The cattle feeder expects to sell cattle in late May at a price of $80.10 Cdn/cwt.The June cattle futures contract is currently trading at $89.10 Cdn/cwt ($66.00 US/cwt). Thecattle feeder sells June live cattle futures to protect against a decline in cattle prices.

May 20. Both the live cattle futures price and the cash prices have declined. The cattleproducer sells the cattle at a price of $75.04 Cdn/cwt. By buying back the June cattle futuresat $84.04 Cdn/cwt ($62.25 US/cwt), the cattle feeder realizes a return of $5.06 Cdn/cwt beforecommissions. The gain on the futures position of $5.06 offsets the lower than expected cashprice received for the cattle.

TRANSACTION MAY CASH (Physical) <BASIS> JUNE FUTURES*

FEBRUARY 1:Long CashSell (short) JUN futures

Expected Price$80.10 Cdn/cwt $9.00 Cdn/cwt Under $89.10 Cdn/cwt

MAY 20:Sell (short) CashBuy (long) JUN Futures

Actual Sale Price$75.04 Cdn/cwt $9.00 Cdn/cwt Under $84.04 Cdn/cwt

Profit (Loss) ($5.06) Cdn/cwt no change $5.06 Cdn/cwt

GAIN ON THE FUTURES OFFSETS LOSS ON THE CASH PRICE*The US futures price is converted to Cdn using the following exchange rate: US $ @ $1.35 Cdn, i.e., $66.00 US X 1.35 = $89.10 Cdn.


B) Options Hedge

The producer can lock in an expected price of $80.10 Cdn/cwt but feels there is enoughuncertainty in the market that prices could in fact rise. At the same time the risks of remainingunhedged are too high due to cash flow requirements. Equity is high and could be drawn uponbut the producer is also thinking of retirement within the next few years and doesn’t want to risklosing a portion of his retirement fund.

With a put option the producer can lock in an expected minimum price of $78.10 Cdn/cwt givenan at-the-money strike price, put option premium and expected basis ($89.10-$2.00-9.00). Bythe time the cattle are ready to be shipped for slaughter, prices have declined by $5.06 Cdn/cwtand the value of the put option rises to $5.06 Cdn/cwt. The final price for the producer is$78.10 Cdn/cwt.

At the time of sale the option has less no time value ( there are only a couple of weeks to expiry)and an intrinsic value of $5.06 Cdn/cwt. Using the put option the producer receives $2.00Cdn/cwt less versus the futures hedge due to the cost of the option. In this case the $2.00 Cdnwas the cost of not fixing the price in hopes of benefiting from a price increase.

TRANSACTIONMAY CASH

(Physical) <BASIS>Option Price Strike=

$89.10 Cdn/cwt

FEBRUARY 1:Long CashBuy JUN Put

Expected Price$80.10 Cdn/cwt $9.00 Cdn/cwt Under ($2.00 Cdn/cwt)

MAY 20:Sell (short) CashSell JUN Put


Profit (Loss) ($5.06) Cdn/cwt no change $3.06 Cdn/cwt

Sale of Put Less Initial Premium Partially Offsets Loss on Cash Sale*The US futures price is converted to Cdn using the following exchange rate: US $ @ $1.35 Cdn, i.e., $66.00 US X 1.35 = $89.10 Cdn.


5.2.2 Short Hedge - Live Cattle Example - Rise in Price:

A) Futures Hedge

In this example, the June live cattle futures contract is trading at $94.50 Cdn/cwt($70.00 US/cwt) on May 20. This means that the cattle feeder eventually realizes a loss on thefutures position of $5.40 Cdn/cwt. However, cash prices have increased by $5.40 Cdn/cwt to$85.50 Cdn/cwt.

The loss on the futures position offsets the higher cash price received for the cattle. Byhedging, the cattle feeder was protected against an adverse price move but forfeited anygains on cash prices.

TRANSACTIONMAY CASH

(Physical) <BASIS> JUNE FUTURES*

FEBRUARY 1:Long CashSell (short) JUN futures

Expected Price$80.10 Cdn/Cwt $9.00 Cdn/cwt

Under$89.10 Cdn/cwt

MAY 20:Sell (short) CashBuy (long) JUN Futures

Actual Sale Price$85.50 Cdn/cwt

$9.00 Cdn/cwtUnder

$94.50 Cdn/cwt

Profit (Loss) $5.40 Cdn/cwt no change ($5.40) Cdn/cwt

LOSS ON THE FUTURES OFFSETS GAIN ON THE CASH PRICE*The US futures price is converted to Cdn using the following exchange rate: US $ @ $1.35 Cdn, i.e., $66.00 US X 1.35 = $89.10 Cdn.


B) Options Hedge

The uncertainty in the market results in a price increase of $5.40 Cdn/cwt from the Februaryexpected price. The put option has no intrinsic or any significant time value remaining giventhe closeness of the sale date to the option expiry. The producer realizes the cash price of$85.50 Cdn/cwt minus the net cost of the put at $2.00 Cdn/bu.

The final price is $83.50 Cdn/cwt which is $3.40 Cdn/cwt higher than the return with the futureshedge. The cost of the option is more than offset by the price increase. If cash and futures hadrisen any higher the producer would have realized the additional increase as a result of using aput option.

TRANSACTION MAY CASH (Physical) <BASIS>OptionPriceStrike=

$89.10 Cdn/cwt

FEBRUARY 1:Long CashBuy JUN Put

Expected Price$80.10 Cdn/cwt $9.00 Cdn/cwt Under ($2.00 Cdn/cwt)

MAY 20:Sell (short) CashSell JUN Put


Profit (Loss) $5.40 Cdn/cwt no change ($2.00 Cdn/cwt)

Gain in Cash Sale Reduced by Option Premium Only*The US futures price is converted to Cdn using the following exchange rate: US $ @ $1.35 Cdn, i.e., $66.00 US X 1.35 = $89.10 Cdn.


5.2.3 Short Hedge - Hog Example - Decline in Price:

A) Futures Hedge

November 1. The hog producer is uncertain about prices for hogs to be delivered in lateJanuary. While the current February future price and exchange rate indicate the expected pricefor hogs will be $200 Cdn/ckg there are concerns that actual supplies may be higher and resultin lower prices. The February hog futures contract is trading at $215.00 Cdn/ckg ($159.26US/ckg). The hog producer sells February hog futures to protect against a decline in hog prices.

January 25. Hog futures and cash prices have declined. The return on the hogs in the week’scash pool is $180 Cdn/ckg. By buying back the February futures at $195.00 Cdn/ckg a returnof $20.00 Cdn/ckg is realized, before commissions. The gain on the futures position offsets thelower than expected pool price received for the hogs.

TRANSACTIONOCTOBER CASH

(Physical) <BASIS>FEBRUARYFUTURES*

NOVEMBER 1:Long CashSell (short) FEB futures

Expected Price$200.00 Cdn/ckg $15.00 Cdn/ckg

Under$215.00 Cdn/ckg

JANUARY 25:Sell (short) CashBuy (long) FEB Futures

Actual Sale Price$180.00 Cdn/ckg $15.00 Cdn/ckg

Under $195.00 Cdn/ckg

Profit (Loss) ($20.00) Cdn/ckg no change $20.00 Cdn/ckg



B) Options Hedge

While the producer can lock in an expected price of $200.00 Can/c.g. there is the possibility thatprices could in fact rise. Given the level of input costs, loan payments and investment in thefarm, this producer feels the risks of remaining unhedged are too high.

With a put option the producer can lock in an expected minimum price of $196.00 Can/c.g.given an at-the-money strike price, put option premium and expected basis ($215.00-$4.00-15.00). By the time the hogs are ready to be shipped for slaughter, prices have declined by$20.00 Can/c.g. and the value of the put option has risen to $20.10 Can/c.g.. The final price forthe producer is $196.10 Can/c.g..

At the time of sale the option has $0.10 Can/c.g. in time value ( there are a number of weeks toexpiry) and an intrinsic value of $20.00 Can/c.g.. Using the put option the producer receives$3.90 Can/c.g. less versus the futures hedge due to the cost of the option.



$215.00 Cdn/c.g.

NOVEMBER 1:Long CashBuy FEB Put

Expected Price$200.00 Can/c.g. $15.00 Can/c.g.

Under($4.00 Can/c.g.)

JANUARY 25:Sell (short) CashSell FEB Put

Actual Sale Price$180.00 Can/c.g. $15.00 Can/c.g.

Under$20.10 Can/c.g.

Profit (Loss) ($20.00) Can/c.g. no change $16.10 Can/c.g.

Sale of Put Less Initial Premium Partially Offsets Loss on Cash Sale*The US futures price is converted to Can using the following exchange rate: US $ @ $1.35 Can, i.e., $159.26 US X 1.35 = $215.00 Can.


5.2.4 Short Hedge - Hog Example - Rise in Price:

A) Futures Hedge

In this example, the February hog futures contract is trading at $215.00 Cdn/ckg($159.26 US/ckg) on November 1. By January 25 the price has risen by $25.00 Cdn/ckg. Thismeans that the hog producer eventually realizes a loss of $25.00 Cdn/ckg on the futuresposition. However, at the same time cash prices have increased by $25.00 Cdn/ckg to $225.00Cdn/ckg.

The loss on the futures position is offset by the higher cash price received for the hogs. Byhedging, the hog producer was protected against an adverse price move but forfeited anygains on cash prices. Effectively what the hog producer received, subject to changes in thebasis, was a fixed price of $200.00 Cdn/ckg.


(Physical) <BASIS>FEBRUARYFUTURES*

NOVEMBER 1:Long CashSell (short) FEB futures


Under$215.00 Cdn/ckg

JANUARY 25:Sell (short) CashBuy (long) FEB Futures

Actual Sale Price$225.00 Cdn/ckg

$15.00 Cdn/ckgUnder

$240.00 Cdn/ckg

Profit (Loss) $25.00 Cdn/ckg no change ($25.00) Cdn/ckg



B) Options Hedge

The uncertainty in the market in this example actually resulted in a price increase of $25.00Cdn/ckg from the expected February price. At the time of sale the option has $0.10 Cdn/ckgin time value ( there are a number of weeks to expiry). The producer realizes the cash price of$225.00 Cdn/ckg minus the net cost of the put at $3.90 Cdn/ckg.

The final price is $221.10 Cdn/ckg which is $21.10 Cdn/ckg higher than the return with thefutures hedge. The cost of the option is more than offset by the price increase. If cash andfutures had risen any higher the producer would have realized the additional increase as a resultof using the put option.



$215.00 Cdn/ckg

NOVEMBER 1:Long CashBuy FEB Put


Under($4.00 Cdn/ckg)

JANUARY 25:Sell (short) CashSell FEB Put

Actual Sale Price$225.00 Cdn/ckg $15.00 Cdn/ckg

Under $0.10 Cdn/ckg

Profit (Loss) $25.00 Cdn/ckg no change ($3.90 Cdn/ckg)



5.2.5 Long Hedge - Feeding Barley - Rise in Price:

A) Futures Hedge

In addition to lower prices for slaughter cattle, a western feeder has the risk of higher feed costs.Assume the cattle feeder expects to buy barley at $25.00 Cdn/mt under the futures, deliveredto the feedlot in December. There is enough grain in storage to feed the cattle until that time.The December barley futures contract is currently trading at $145.00 Cdn/mt.

The cattle feeder buys 1,000 feeders at an average cost of $850.00/feeder. Total barley inputusage is 50 bu/head over the feeding period to a final weight of 1,250 pounds. Break-even onthese cattle based on $120.00 Cdn/mt ($2.61 Cdn/bu) for barley is $78.44 Cdn/cwt. Theproducer is able to forward contract the cattle for late March delivery at $80.44 Cdn/cwt whichwill result in a profit margin of $2.00 Cdn/cwt.

The cattle feeder is long fat cattle and short cash barley when the feeders are purchased.However, by forward selling the fat cattle for $80.44 Cdn/cwt this cattle feeder offsets the longcash position and resulting price risk. The feeder now only has the risk of being short barley.

If the price of barley increases by $22.96 Cdn/mt ($0.50 Cdn/bu), the feeder’s costs increaseby $25.00 Cdn/animal or $2.00 Cdn/cwt which would wipe out the entire profit margin. If theprice increases by more than $22.96 Cdn/mt the producer would be in a loss position.

Because the cattle feeder is short cash barley, buying barley futures protects against rising barleyprices. This cattle feeder buys 55 December barley futures contracts at $145.00 Cdn/mt; the55 contracts which are 20 mt each will cover 50,512 bu, the volume of barley required to feed1000 cattle. By December 1 prices have risen by $30.00 Cdn/mt. With the long Decemberfutures position the feeder is able to make a profit of $30.00 Cdn/mt, before commission fees,which offsets the higher cost of the barley.

TRANSACTIONDEC CASH(Physical) <BASIS> DEC FUTURES

OCTOBER 1:Short CashBuy (long) DEC futures

Expected Price$120.00 Cdn/mt $25.00 Cdn/mt

Under

$145.00 Cdn/mt

DECEMBER 1:Buy (long) CashSell (short) Dec Futures

Actual Purchase Price$150.00 Cdn/mt $25.00 Cdn/mt

Under $175.00 Cdn/mt

Profit (Loss) ($30.00) Cdn/mt No change $30.00 Cdn/mt

LOSS ON THE FUTURES OFFSETS GAIN ON THE CASH PRICE*The December Western Barley futures price is denominated in Cdn dollars and traded on the Winnipeg CommodityExchange. The conversion factor is 45.92 bu = 1 mt.


B) Options Hedge

One alternative to a futures hedge to protect against rising costs is to purchase a call option.While there is a cost, the option allows the producer to benefit from any cash price decrease. In this case the producer buys 55 December options at the $145.00 Cdn/mt strike price onOctober 1 for $7.00 Cdn/mt.

When the barley is delivered on December 1 the cash and futures prices have risen by $30.00Cdn/mt. The producer sells the call for $30.00 Cdn/mt. The option has an intrinsic value of$30.00 Cdn/mt - the amount by which the futures price is above the call strike price. The timevalue remaining is $0.00 Cdn/mt, because of the December expiry.

TRANSACTIONDEC CASH(Physical) <BASIS>

Option Price Strike=$145 Cdn/mt

OCTOBER 1:Short CashBuy DEC call

Expected Price$120.00 Cdn/mt $25.00 Cdn/mt Under ($7.00 Cdn/mt)

DECEMBER 1:Buy (long) CashSell Dec call

Actual Purchase Price$150.00 Cdn/mt $25.00 Cdn/mt Under $30.00 Cdn/mt


Gain in Cash Sale Reduced by Option Premium Only*The December Western Barley futures price is denominated in Cdn dollars and traded on the Winnipeg CommodityExchange. The conversion factor is 45.92 bu = 1 mt.

The proceeds from the sale of the option help to offset the higher cost of the barley. The costof the barley is reduced by $23.00 Cdn/mt to $127.00 Cdn/mt. While the barley cost is $7.00higher than with the futures hedge, if in fact the barley price had decreased the producer couldstill have taken advantage of the lower price. With the futures hedge the barley price wouldremain fixed at $120.00 Cdn/mt.


5.2.6 Long Hedge - Feeding Corn - Rise in Price:

A) Futures Hedge

In addition to lower prices for slaughter cattle, this cattle feeder has the risk of higher cornprices. Assume the cattle feeder expects to buy corn at $0.13 Cdn/bu under the futures,delivered to the feedlot in May. There is enough grain in storage to feed the cattle until thattime. The July corn futures contract is currently trading at $3.51 Cdn/bu ($2.60 US/bu).

The cattle feeder buys 1,000 feeders at an average cost of $850.00/feeder. Total corn inputusage is 50 bu/head over the feeding period. Break-even on these cattle based on $3.51 Cdn/bufor corn is $82.04 Cdn/cwt. The producer is able to forward contract the cattle for late Augustdelivery at $84.04 Cdn/cwt which will result in a profit margin of $2.00 Cdn/cwt.

If the price of corn increases by $0.50 Cdn/bu, the feeder’s costs increase by $25.00 Cdn/animalwhich would wipe out the entire profit margin. If the price increases by more than $0.50 Cdn/buthe producer would be in a loss position. The cattle feeder is long fat cattle and short cashcorn when the feeders are purchased. However, by forward selling the fat cattle for $84.04Cdn/cwt this cattle feeder offsets the long cash position and the resulting risk. The feedernow only has the risk of being short grain (corn in this example).

Because the cattle feeder is short cash corn, buying corn futures would protect against risingcorn prices. This cattle feeder buys 10 July corn futures 5,000 bu contracts at $2.60 US/bu; the10 contracts will cover 50,000 bu, the volume required to feed 1000 cattle. The increase in priceof $1.35 Cdn/bu will have a negative impact on the feeder’s income. With the hedge this isoffset with a profit of $1.35 Cdn/bu, before commission fees, on the long July corn futurescontract.

TRANSACTION MAY CASH (Physical) <BASIS> JULY FUTURES*

FEBRUARY 1:Short CashBuy (long)JUL futures

Expected Price$3.38 Cdn/bu $0.13 Cdn/bu under $3.51 Cdn/bu

MAY 20:Buy (long) CashSell (short) JUL Futures

Actual Purchase Price$4.73 Cdn/bu

$0.13 Cdn/bu under $4.86 Cdn/bu

Profit (Loss) ($1.35) Cdn/bu no change $1.35 Cdn/bu



B) Options Hedge

One alternative to a futures hedge to protect against rising costs is the purchase of a call option.While there is a cost, the option allows the producer to benefit from any cash price decrease.In this case the producer buys 10 July call options at the $3.51 Cdn/bu strike price on February1 for $0.16 Cdn/bu.

When the corn is delivered on May 20 the cash and futures prices have risen by $1.35 Cdn/buto $4.86 Cdn/bu. The producer sells the call for $1.40 Cdn/bu. The option has an intrinsicvalue of $1.35 Cdn/bu - the amount by which the futures price is above the call strike price. Thetime value remaining is $0.05 Cdn/bu, over one month of time value on the July expiry.

TRANSACTION NOV. CASH (Physical) <BASIS> Option Price Strike=$3.51 Cdn/bu

February 1:Long Cashbuy July Call

Expected Price$3.38 Cdn/bu

$0.13 Cdn/bu Under ($0.16) Cdn/bu

May 20:Sell (Short) Cashsell July Call

Actual Purchase Price$4.73 Cdn/bu $0.13 Cdn/bu Under $1.40 Cdn/bu

Profit (Loss) ($1.35 Cdn/bu) no change $1.24 Cdn/bu

Sale of Call Less Initial Premium Partially Offsets Loss on Cash Sale*The US futures price is converted to Cdn using the exchange rate: US $ @ $1.35 Cdn, i.e., $3.60 US X 1.35 = $4.86 Cdn

The proceeds from the sale of the option help to offset the higher cost of the corn. The cost ofthe corn is reduced by $1.24 Cdn/bu to $3.49 Cdn/bu. While the cost is still higher than withthe futures hedge, if in fact the corn prices had decreased the producer could still have takenadvantage of the lower corn costs With the futures hedge the corn price would remain fixed at$3.38 Cdn/bu.


5.2.7 Short Hedge Corn Example - Decline in Price:

A) Futures Hedge

April 15. Given the traditional basis level for the November contract, the producer expects torealize a corn cash price of $3.50 Cdn/bu in November. The corresponding December futuresprice for this example is $3.85 Cdn/bu ($2.85 US/bu). The producer feels that this is a goodprice for corn and that it reflects a profitable return for the crop. To protect against a lower pricemove, the producer sells two (2) December corn futures contracts (2 X 5,000 bu = 10,000 bu)at $2.85 US/bu.

The producer, expecting to have an inventory of corn in the fall (long cash position) to selland having invested funds to produce that crop, sells futures to protect the investment.Therefore, the producer has taken an equal but opposite futures position from the cashposition (a short or sell position). The producer’s position is now hedged against a pricedecline.

TRANSACTION NOV. CASH (Physical) <BASIS> DEC FUTURES*

APRIL 15:Long CashSell (Short) DEC futures


$0.35 Cdn/bu Under $3.85 Cdn/bu

NOVEMBER 1:Sell (Short) CashBuy (Long) Dec Futures

Actual Sale Price$2.50 Cdn/bu $0.35 Cdn/bu Under $2.85 Cdn/bu

Profit (Loss) ($1.00) Cdn/bu No change $1.00 Cdn/bu

Gain on Futures offsets Loss on the Cash Price*The US futures price is converted to Cdn using the exchange rate: US $ @ $1.35 Cdn, i.e., $2.85 US X 1.35 = $3.85 Cdn

By November 1, the producer has harvested the corn and the local cash price is only$2.50 Cdn/bu. The producer sells 10,000 bushels of corn at $2.50 Cdn/bu in the local cashmarket and, at the same time, buys back the futures at $2.85 Cdn/bu ($2.11 US/bu), realizing a$10,000 (($3.85 Cdn/bu - $2.85 Cdn/bu) x 10,000) gain on the futures position before payingbrokerage commissions.

This offset the loss on the cash transaction side of the hedge equation and protected theproducer from the adverse price move. Had the producer not hedged in April, only the $2.50Cdn/bu would have been realized from the corn sale resulting in a negative cash flow. Byhedging, the producer realized the expected price of $3.50 Cdn/bu.


B) Options Hedge

Now consider an put option hedge which will establish an expected minimum price. On April15 the producer expects a minimum price of $3.34 Cdn/bu given the at-the-money strike price,put option premium and expected basis ($3.85-$.16-$.35). Upon the sale of the barley thefutures and cash prices have declined increasing the value of the put option to $1.01 Cdn/bu.The final price for the producer is $3.35 Cdn/bu.

At the time of sale the option has a time value of $0.01 Cdn/bu and an intrinsic value of $1.00Cdn/bu. The producer receives $0.15 Cdn/bu less using the option hedge versus a futureshedge. However, the producer did not fix the price but merely set a price floor. Unlike thefutures hedge, the producer is able to take advantage of any price increase as will be illustratedin the next example.


APRIL 15:Long Cashbuy DEC put



NOVEMBER 1:Sell (Short) Cashsell Dec put



Sale of Put Less Initial Premium Partially Offsets Loss on Cash Sale*The US futures price is converted to Cdn using the exchange rate: US $ @ $1.35 Cdn, i.e., $2.85 US X 1.35 = $3.85 Cdn


5.2.8 Short Hedge - Corn Example - Rise in Price:

A) Futures Hedge

April 15. The producer expects to realize a cash price of $3.50 Cdn/bu for the corn. SupposeDecember futures prices rises to $4.15 Cdn/bu ($3.07 US/bu) by November, perhaps due to asmall crop in the US. The producer realizes a loss on the futures position. However, at thesame time, the producer’s crop is worth more because cash corn values have risen as well.Since the basis is assumed to be constant, the producer is paid $3.80 Cdn/bu in the cash market.

By selling the corn for cash, the producer realizes a return of $0.30 Cdn/bu better than thatexpected in April. At the same time, buying back the futures position results in a $0.30 Cdn/buloss plus commissions. The loss on the futures position offsets the increased return. Theproducer will realize the expected April 15 cash price of $3.50 Cdn/bu.

TRANSACTION NOV. CASH (Physical) <BASIS>DEC

FUTURES*

APRIL 15:Long CashSell (short) DEC futures


$0.35 Cdn/bu UNDER $3.85 Cdn/bu

NOVEMBER 1:Sell (short) CashBuy (long) Dec Futures

Actual Sale Price$3.80 Cdn/bu $0.35 Cdn/bu UNDER $4.15 Cdn/bu

Profit (Loss) $0.30 Cdn/bu no change ($0.30) Cdn/bu


The hedge did not allow the producer to take advantage of the price improvement, but as wesaw in the earlier example when the price fell, the producer was protected from the adverseprice movement.


B) Options Hedge

The futures price has risen to $4.15 Cdn/bu ($3.07 US/bu). Since the futures price is greaterthan the strike price the put option has no intrinsic value. The option is sold back for $0.01Cdn/bu assuming it more than covers commission costs. If the time value does not covercommission fees it makes more sense to allow the option to expiry worthless.

The producer realizes the cash price of $3.80 Cdn/bu minus the net cost of the put at $0.15Cdn/bu. The final price is $3.65 Cdn/bu which is $0.15 Cdn/bu higher than the return with thefutures hedge. The cost of the option is more than offset by the price increase.


APRIL 15:Long Cashbuy DEC put



NOVEMBER 1:Sell (Short) Cashsell Dec put


Profit (Loss) $0.30 Cdn/bu No change ($0.15) Cdn/bu

Gain in Cash Sale Reduced by Option Premium Only*The US futures price is converted to Cdn using the exchange rate: US $ @ $1.35 Cdn, i.e., $2.85 US X 1.35 = $3.85 Cdn


5.2.9 Short Hedge - Beans Example - Decline in Price:

A) Futures Hedge

April 15. Given the traditional basis level for the November contract, the producer expects torealize a cash price of $8.00 Cdn/bu in October for the soybeans. The corresponding Novembersoybean futures price for this example is $9.10 Cdn/bu ($6.74 US/bu). The producer feels thatthis is a good price for soybeans and reflects a profitable return for the crop. To protect againstlower prices, the producer sells two (2) November soybean futures contracts (2 X 5,000 bu =10,000 bu) at $6.74 US/bu.

The producer sells futures to offset the expected fall inventory (long cash position) and thefunds invested to produce this crop. By taking an equal but opposite futures position fromthe expected cash position, the producer’s position is now hedged against an adverse pricemove.

TRANSACTION OCT CASH (Physical) <BASIS>NOV

FUTURES*

APRIL 15:Long CashSell (short) Nov futures

Expected Price$8.00 Cdn/bu $1.10 Cdn/bu UNDER $9.10 Cdn/bu

OCTOBER 20:Sell (short) CashBuy (long) Nov Futures




By October 20 the producer has harvested the beans and the best local cash bid is $6.00 Cdn/bu.In order to generate cash flow, the producer sells the 10,000 bushels and buys back the futuresat $7.10 Cdn/bu ($5.26 US/bu). The $2.00 Cdn/bu (before brokerage commission) gain on thefutures position will offset the decline in the cash price allowing the producer to realize theexpected April 15 price of $8.00 Cdn/bu. If the producer had not hedged in April, only $6.00Cdn/bu would have been realized from the soybeans and a negative cash flow could haveresulted.


B) Options Hedge

On April 15 the producer expects a minimum price of $6.58 Cdn/bu given the at-the-moneystrike price, put option premium and expected basis ($9.10-$1.42-$1.10). Upon the sale of thesoybeans prices have declined increasing the value of the put option to $2.05 Cdn/bu. The finalprice for the producer is $6.63 Cdn/bu.

At the time of sale the option has a time value of $0.05 Cdn/bu and an intrinsic value of $2.00Cdn/bu. The producer receives $1.37 Cdn/bu less using the option hedge versus a futureshedge due to the net cost of the option. The option cost is the price of not fixing the price yetestablishing a floor price.

TRANSACTION OCT CASH (Physical) <BASIS>Option Price Strike=

$9.10 Cdn/bu

APRIL 15:Long Cashbuy Nov put

Expected Price$8.00 Cdn/bu $1.10 Cdn/bu

UNDER($1.42) Cdn/bu

OCTOBER 20:Sell (short) Cashsell Nov put

Actual Sale Price$6.00 Cdn/bu $1.10 Cdn/bu

UNDER $2.05 Cdn/bu


Sale of Put Less Initial Premium Partially Offsets Loss on Cash Sale*The US futures price is converted to Cdn using the following exchange rate: US $ @ $1.35 Cdn, i.e., $6.74 US X 1.35 = $9.10 Cdn.


5.2.10 Short Hedge - Beans Example - Rise in Price:

A) Futures Hedge

April 15. The producer expects to realize a cash price of $8.00 Cdn/bu by selling (hedging)November bean futures at $9.10 Cdn/bu ($6.74 US/bu).

By late October, November soybean futures prices have risen to $10.85 Cdn/bu ($8.04 US/bu),perhaps due to a small crop in the US. The producer realizes a loss on the futures position of$1.75 Cdn/bu. However, the crop is worth more because cash soybean values increased at thesame time as the futures price increased. Assuming no change in the basis, the producer findsa cash bid of $9.75 Cdn/bu which is $1.75 Cdn/bu higher than expected.

The loss on the futures position offsets the return and the producer realizes the expected April15 price of $8.00 Cdn/bu.

The hedge did not allow the producer to take advantage of the price improvement, but aswe saw in the earlier example when the price fell, the producer was protected from anadverse price move.

TRANSACTIONNOV CASH

(Physical) <BASIS> Nov FUTURES*

APRIL 15:Long CashSell (short) Nov futures


$1.10 Cdn/bu UNDER$9.10 Cdn/bu

OCTOBER 20:Sell (short) CashBuy (long) Nov Futures



LOSS ON THE FUTURES OFFSETS GAIN ON THE CASH PRICE*The US futures price is converted to Cdn using the following exchange rate: US $ @ $1.35 Cdn,i.e., $6.74 US X 1.35 = $9.10 Cdn.


B) Options Hedge

Options are a good tool to use when there is uncertainty in the direction of prices and a fixedprice is unattractive to the hedger. If the soybean futures price rises to $10.85 Cdn/bu ($8.04US/bu) the original put option with a strike of $9.10 Cdn/bu has no intrinsic value. The optionis sold back for its time value of $0.05 Cdn/bu at the time of the cash sale.

The producer realizes the cash price of $9.75 Cdn/bu minus the net cost of the put at $1.37Cdn/bu. The final price is $8.38 Cdn/bu which is $0.38 Cdn/bu higher than the return with thefutures hedge. The cost of the option is more than offset by the price increase. If cash andfutures had risen any higher the producer would have realized the increase as a result of usinga put option.

TRANSACTION OCT CASH (Physical) <BASIS>Option Price Strike=

$9.10 Cdn/bu

APRIL 15:Long Cashbuy Nov put

Expected Price$8.00 Cdn/bu $1.10 Cdn/bu

UNDER($1.42) Cdn/bu

OCTOBER 20:Sell (short) Cashsell Nov put

Actual Sale Price$9.75 Cdn/bu $1.10 Cdn/bu

UNDER $0.05 Cdn/bu




5.2.11 Short Hedge - Barley Example - Decline in Price:

A) Futures Hedge

April 15. A barley producer feels that $120.00 Cdn/mt can be realized for barley next fall giventhat the December Western Barley futures contract is trading at $145.00 Cdn/mt and sells five(5) futures contracts (100 metric tonnes). Selling the futures offsets the expected long cashposition when the crop is harvested in the fall. By taking an equal but opposite futuresposition from the expected cash position, the producer’s position is now hedged and isprotected against an adverse price move.

October 20. The barley has been harvested and the best local cash price is $75.00 Cdn/mt. Theproducer sells the barley for cash and buys back the futures at $100.00 Cdn/mt. The $45.00/mtgain on the futures position offsets the decline in the expected barley price. The producer,between cash returns from the sale of the barley and the gain on the futures position will, beforepaying broker's commissions, realize the expected April 15 price of $120 Cdn/mt.

TRANSACTIONOCT CASH(Physical) <BASIS> DEC FUTURES


Expected Price$120.00 Cdn/mt $25.00 Cdn/mt Under $145.00 Cdn/mt

OCTOBER 20:Sell (short) CashBuy (long) Dec Futures

Actual Sale Price$75.00 Cdn/mt $25.00 Cdn/mt Under $100.00 Cdn/mt


GAIN ON THE FUTURES OFFSETS LOSS ON THE CASH PRICE*The December Western Barley futures price is denominated in Cdn dollars and traded on the Winnipeg CommodityExchange.


B) Options Hedge

On April 15 the producer expects a minimum price of $113.00 Cdn/mt given the at-the-moneystrike price, put option premium and expected basis. By October 20 barley futures have fallento $75.00 Cdn/mt while the put option value has risen to $46.00 Cdn/mt. Combining the cashprice sale with the profit from the option the producer nets $114.00 Cdn/mt.

The option has $1.00 Cdn/mt in time value remaining on the December expiry and an intrinsicvalue of $45.00 Cdn/mt. The producer receives $6.00 Cdn/mt less using the option hedgeversus a futures hedge due to the net cost of the option.

TRANSACTIONOCT CASH(Physical) <BASIS>


APRIL 15:Long CashBuy DEC put

Expected Price$120.00 Cdn/mt $25.00 Cdn/mt Under ($7.00) Cdn/mt

OCTOBER 20:Sell (short) CashSell Dec put



Sale of Put Less Initial Premium Partially Offsets Loss on Cash Sale*The December Western Barley futures price is denominated in Cdn dollars and traded on the Winnipeg CommodityExchange.


5.2.12 Short Hedge - Barley Example - Rise in Price:

A) Futures Hedge

April 15. The producer expects to realize a cash price of $120.00 Cdn/mt for the barley byselling (hedging) December Western Barley futures contracts at $145.00 Cdn/mt. By lateOctober, prices have risen to $175.00 Cdn/mt on December futures.

By selling the barley for cash, the producer realizes a return of $30.00 Cdn/mt better thanexpected in April. At the same time, buying back the futures position results in a$30.00 Cdn/mt loss before brokerage commissions. The producer will realize the expectedApril 15 price of $120.00 Cdn/mt (minus commissions) as the two positions offset one another.

The hedge did not allow the producer to take advantage of the price improvement, but aswe saw in the previous example when the price fell, the producer was protected from anadverse price move. While a positive cash flow was realized from the crop, it was less thanit would have been had the producer not hedged.

TRANSACTIONOCT CASH(Physical) <BASIS> DEC FUTURES



Under

$145.00 Cdn/mt

OCTOBER 20:Sell (short) CashBuy (long) Dec Futures

Actual Sale Price$150.00 Cdn/mt $25.00 Cdn/mt


Profit (Loss) $30.00 Cdn/mt No change ($30.00) Cdn/mt

LOSS ON THE FUTURES OFFSETS GAIN ON THE CASH PRICE*The December Western Barley futures price is denominated in Cdn dollars and traded on the Winnipeg CommodityExchange.


B) Options Hedge

The barley futures price has risen to $175.00 Cdn/mt. Since the futures price is greater than thestrike price the put option has no intrinsic value. The option is sold back for $1.00 Cdn/mt, theremaining time value. The producer realizes the cash price of $150.00 Cdn/mt minus the netcost of $6.00 Cdn/mt for the put. The final price of $144.00 Cdn/mt is $24.00 Cdn/mt higherthan the return with the futures hedge. The cost of the option is more than offset by the priceincrease.

TRANSACTIONOCT CASH(Physical) <BASIS>


APRIL 15:Long CashBuy DEC put

Expected Price$120.00 Cdn/mt $25.00 Cdn/mt Under ($7.00 Cdn/mt)

OCTOBER 20:Sell (short) CashSell Dec put


Profit (Loss) $30.00 Cdn/mt No change ($6.00 Cdn/mt)

Gain in Cash Sale Reduced by Option Premium Only*The December Western Barley futures price is denominated in Cdn dollars and traded on the Winnipeg CommodityExchange.


5.2.13 Short Hedge - Canola Example - Decline in Price:

A) Futures Hedge

April 15. A canola producer feels $353.00 Cdn/mt is realistic for next fall's crop since theNovember canola futures contract is trading at $365.00 Cdn/mt on the Winnipeg CommodityExchange. The producer sells five (5) November futures contracts or 100 mt (5 X 20 mt = 100mt) to equally offset the expected long cash position in the fall.

October 20. The canola is harvested and the local cash price is $270.00 Cdn/mt. The producersells the canola for cash and buys back the futures at $282.00 Cdn/mt realizing a gain on thefutures position of $ 83.00 Cdn/mt before commissions. This gain equally offsets the declinein the cash price. The producer realizes the expected price.

TRANSACTION CASH (Physical) <BASIS> NOV FUTURES

APRIL 15:Long CashSell (short) NOV futures

Expected Price$353.00 Cdn/mt

$12.00 Cdn/mtUnder $365.00 Cdn/mt

OCTOBER 20:Sell (short) CashBuy (long) NOV Futures




GAIN ON THE FUTURES OFFSETS LOSS ON THE CASH PRICE*The November canola futures price is denominated in Cdn dollars and traded on the Winnipeg Commodity Exchange.


B) Options Hedge

The minimum price expected on April 15 is $353.00 Cdn/mt given the at-the-money strikeprice, put option premium and expected basis. On October 20 canola futures had fallen to$282.00 Cdn/mt while the put option value has risen to $84.00 Cdn/mt. Combining the cashprice sale with the profit from the option the producer nets $340.00 Cdn/mt.

The option has $1.00 Cdn/mt in time value remaining on the December expiry and an intrinsicvalue of $83.00 Cdn/mt. The producer receives $13.00 Cdn/mt less using the option hedgeversus a futures hedge due to the net cost of the option.

TRANSACTION CASH (Physical) <BASIS>Option Price Strike=

$365 Cdn/mt

APRIL 15:Long CashBuy NOV Put


Under($14.00 Cdn/mt)

OCTOBER 20:Sell (short) CashSell NOV Put


Under $84.00 Cdn/mt


Sale of Put Less Initial Premium Partially Offsets Loss on Cash Sale*The November canola futures price is denominated in Cdn dollars and traded on the Winnipeg Commodity Exchange.


5.2.14 Short Hedge - Canola Example - Rise in Price:

A) Futures Hedge

April 15. The producer expects a cash price of $353.00 Cdn/mt for the canola after sellingNovember canola futures at $365.00 Cdn/mt.

By late October, November canola futures prices have risen to $400.00 Cdn/mt. The producerrealizes a loss on the futures position of $35.00 Cdn/mt. However, the crop is worth morebecause the cash price for canola increased as the futures price increased. Assuming nochange in the expected basis, the producer should be able to find a cash bid of at least $388.00Cdn/mt.

Selling the canola results in a return of $35.00 Cdn/mt more than expected in April, whilebuying back the futures results in a $35.00 Cdn/mt loss. The producer realizes the expectedprice of $353.00 Cdn/mt before brokerage commissions.

The hedge did not allow the producer to take advantage of the price improvement, but aswe saw in the earlier example when the price fell, the producer was protected from anadverse price move.

TRANSACTION OCT CASH (Physical) <BASIS> NOV FUTURES

APRIL 15:Long CashSell (short) NOV futures

Expected Price$353.00 Cdn/mt $12.00 Cdn/mt Under $365.00 Cdn/mt

OCTOBER 20:Sell (short) CashBuy (long) NOV Futures


Profit (Loss) $35.00 Cdn/mt No change ($35.00) Cdn/mt

GAIN IN CASH PRICE OFFSET BY DECLINE IN FUTURES*The November canola futures price is denominated in Cdn dollars and traded on the Winnipeg Commodity Exchange.


B) Options Hedge

By October 20 the canola futures price has risen to $388.00 Cdn/mt. Since the futures price isgreater than the strike price the put option has no intrinsic value. The option is sold back forthe remaining time value of $1.00 Cdn/mt. The producer realizes the cash price of $388.00Cdn/mt minus the net cost of $13.00 Cdn/mt for the put. The final price of $375.00 Cdn/mt is$22.00 Cdn/mt higher than the return with the futures hedge. The cost of the option is morethan offset by the price increase.

TRANSACTION CASH (Physical) <BASIS>Option Price Strike=

$365 Cdn/mt

APRIL 15:Long CashBuy NOV Put


Under($14.00 Cdn/mt)

OCTOBER 20:Sell (short) CashSell NOV Put


Under $1.00 Cdn/mt

Profit (Loss) $35.00 Cdn/mt No change ($13.00 Cdn/mt)

Gain in Cash Sale Reduced by Option Premium Only *The November canola futures price is denominated in Cdn dollars and traded on the Winnipeg Commodity Exchange.

Producers do not know with certainty that prices will rise or fall. When thepotential risk of price movement can have a far greater negative impact on thefinancial viability of the farming operation, hedging can be an effective riskmanagement tool.


5.3 Yield Risk and Hedging

Producers may initially decide to hedge only a portion of the expected yield with futures at orprior to seeding. Should the yield not be realized and at the same time the futures price rises aloss will be generated on the short futures position with no offsetting gain in the cash market.As the yield becomes more certain addition portions of the crop could be hedged by theproducer.

If futures prices are attractive to the producer it is possible to lock in a price on all the expectedproduction, despite the yield uncertainty, without the threat of unknown losses. With an optionthe maximum risk of loss on the hedge is the premium plus commissions. For producers whowish to hedge all the expected production, options do provide an advantage in that the potentialloss is limited.

5.4 Chapter Summary

� A short hedge is used to offset the risk of a price decline whereas a long hedge protectsagainst a price increase. A short hedge is entered into by selling futures or buying putoptions, while a long hedge means buying future contracts or buying call options.

� Short hedgers are long the cash commodity. This applies to farmers who are growing cropsor raising livestock, or have product in storage. It also applies to the farmer who has the riskthat the Canadian dollar may decline against the US dollar, raising the price of commoditiessuch as feed grains which are used as an input. This requires a short hedge in currencyfutures.

� A long hedger is short the cash market. In other words, their businesses require the actualphysical product at some later date. They do not currently own it and face the risk that priceswill rise. A long hedge in currency is used to protect against a decline in the local price ofa commodity because of an increase in the value of the Canadian dollar relative to the USdollar.

� With a short hedge, the farmer can buy back futures when the physical product is sold in thecash market. If prices fall, the hedger profits on the futures transaction which offsets thedecline on the cash position. Of course, if prices rise, then a loss on futures offsets the gainon the cash commodity.

� In the same way, a long hedger sells back the futures position when the cash commodity ispurchased. A rise in prices gives a profit on futures to offset the increased cash price, whilea decline in prices gives a loss on futures that offsets the decline in cash prices.

Hedging works as a result of the offset between futures and cash market. It is alwaysimportant to maintain that linkage. Any losses in futures will be related to gains inthe cash market and vice versa.


Hedging Quiz

1. A futures contract is defining quality, quantity, delivery locationand time of the specified contract. The buyer and seller are left to negotiate and .

a) fixed, lunch, who pays b) paper, price, quality c) standardized, price, number of contracts d) intangible, volume, open interest

2. A hedger is someone who . a) trims hedges for a living b) sells futures

c) has a financial interest in a physical commodity and uses some product (i.e.futures, options) to protect against an adverse price move.

d) has no financial interest in physical or cash commodities

3. A short hedger is typically a .

a) stock broker b) grain and oilseed processor

c) one who sells futures to protect inventory, current or expected, from a pricedecline.

d) a feed grain user

4. A person who buys futures to protect themselves against an adverse pricemove is a .

a) futures trader b) speculator

c) short hedger d) long hedger e) arbitrager


- NOTES -

Chapter 6 - Exchange Rate Risk Page 6-1

The US exchange rate can be quoted in two ways. When the Canadian dollar is trading at$1.3699 Cdn, it takes $1.3699 Cdn to buy $1.00 US. When we say the Canadian dollar istrading at $0.7300 US, it will take $0.7300 US to buy $1.00 Cdn. One exchange rate issimply the reciprocal of the other. Quotes are generally US$ per Cdn$.

MANAGING EXCHANGE RATE RISK


After completing this Chapter, you will understand:

1. The exchange rate risk for Canadian commodities priced and hedged in the US market.

2. How to hedge the dollar.

3. The size of the dollar position required to hedge a commodity position.

6.1 Introduction

The Canadian/US exchange rate has become more of a concern to Canadian buyers and sellersin recent years as a result of greater variability in the value of the Canadian dollar. This isimportant since many agricultural commodity prices are determined in the U.S. market. Attimes, a higher Canadian dollar can have a dramatic negative impact on the price of goodsproduced in Canada. Contrary to this is the risk buyers of inputs face of a depreciating Canadiandollar which results in higher prices. This Chapter provides an overview of how exchange raterisk can influence profits and how it can be managed effectively.

6.2 Exchange Rate and the Short Commodity Hedger

In September, a feedlot owner decides to hedge against a price decline for cattle to be sold inMarch, by selling April live cattle futures. At the time of the hedge, the April live cattle contractis trading at $94.50 Cdn/cwt ($70.00 US/cwt) while the Canadian dollar is trading at $0.74US,approximately $1.35Cdn. For the purpose of this example, we will assume that the adjustedlocal basis for the previous five years averaged $5.00 Cdn/cwt under the April futures price.This means the farmer would expect the hedge to net a target price for cattle of $89.50 Cdn/cwt.


This “expected price” is calculated as follows:On September 1 sell (short) April @ $70.00 US/cwt. At the expected exchange rateof $1.35Cdn, the target price is as follows:

$70.00US X $1.35 Cdn/US$= $94.50 Cdn/cwt average adjusted basis - ($5.00) Cdn/cwtExpected Price $89.50 Cdn/cwt

Note: The US price can also be converted to Cdn funds by dividing by the exchange rate inUS$, i.e. $70.00US/($0.74US/CDN$).

At this point, the farmer has no risk as long as the adjusted basis and exchange rate remainconstant. On March 15 the farmer sells the cattle in the local spot market and buys back thefutures contract. The following table shows the possible outcomes of the hedge if the April livecattle futures price rises to $114.75 Cdn/cwt ($85 US/cwt) or falls to $81.00 Cdn/cwt ($60.00US/cwt). In both instances, the producer has locked in a price of $89.50 Cdn/cwt and any loss(gain) in the cash market is offset by a gain (loss) in the futures market. Basis remains constantat $5.00 Cdn under.

Cattle Futures April Short Hedge at $70.00US(Exchange Rate = $1.35Cdn)

Price Increase Price Decrease

March 15:(a) Long April $114.75 Cdn/cwt $81.00 Cdn/cwt

(b) Basis = c-a ($5.00) Cdn/cwt ($5.00 Cdn/cwt)

(c) Cash Sale Price $109.75 Cdn/cwt $76.00 Cdn/cwt

(d) Futures Gain/(Loss)* ($20.25 Cdn)/cwt $13.50 Cdn/bu

(e) Net Price = c+d $89.50 Cdn/cwt $89.50 Cdn/cwt*Gain/(Loss)= ($70.00 US/cwt-April futures price ($US/cwt) in March) X $1.35Cdn/US$i.e. ($70.00-$85.00)x1.35=($20.25 Cdn)

Appreciation of Canadian Dollar - Short Hedge

Now consider the same example only now the Canadian dollar in March is stronger resultingin an exchange rate of $0.80US which is $1.25 Cdn. The local Canadian cattle price is lowerin both scenarios ($106.25 versus $114.75 and $75.00 versus $81.00) as it now takes fewerCanadian dollars to purchase $1.00 US. Remember the Canadian cattle price is based on an USprice denominated in US dollars. The adjusted basis stays the same. The change in the valueof the futures position from September to April, when converted to Canadian dollars, is nowsmaller as a result of the stronger Canadian dollar and does not fully offset any movement in thecash price.


Short Live Cattle April Futures Hedge(Exchange Rate = $1.25Cdn)

Price Increase Price Decrease

March 15:(a) Long Nov $106.25 Cdn/cwt $75.00 Cdn/cwt

(b) Basis = c-a $5.00 Cdn/cwt $5.00 Cdn/cwt

(c)Cash Price $101.25 Cdn/cwt $70.00 Cdn/cwt

(d) Futures Gain/(Loss)* ($18.75Cdn)/cwt $12.50 Cdn/cwt

(e) Net Price = c+d $82.50 Cdn/cwt $82.50 Cdn/cwt*Gain/(Loss)= ($70.00 US/cwt-April futures price ($US/cwt) in March) X 1.25i.e. ($70.00-$85.00)x1.25=($18.75 Cdn)

At the new exchange rate the farmer’s net realized price with the hedge is now $82.50 Cdn/cwt,provided the basis remains constant. The $7.00 Cdn/cwt drop in the net price from$89.50Cdn/cwt is the result of the higher exchange rate. This amounts to a loss of $2,800 Cdnfor every 40,000 lbs of cattle. As we have seen in past examples, this could be all or most ofthe farmer’s gross margin.

Take this information one step farther and summarize the effect of a change in the exchangerate by comparing price and basis levels when the futures price rises and falls. In each case, theadjusted basis remains at -$5.00 Cdn/cwt. The effects of the exchange rate are complex, butthey can be simplified if one begins with an adjusted basis and works through the effects of achange in the exchange rate

Futures and Basis Levels: Variable Exchange Rate

FuturesUS$

Exchange Cdn$/US$

FuturesCdn $

CashPrice Cdn

$Adjusted

Basis Cdn $

Price Rises 85.00 $1.350 114.75 109.75 -5.00

85.00 $1.250 106.25 101.25 -5.00

Price Falls 60.00 $1.350 81.00 76.00 -5.00

60.00 $1.250 75.00 70.00 -5.00

� In both cases, the lower Canadian price is due to the stronger Canadian dollar. The adjustedbasis has not changed.

� The advantage of looking at the adjusted basis is that the impact of the exchange rate is


removed and the producer can relate changes in the basis to actual market conditions.

� It is important to realize the potential impact of the exchange rate, a cash price lower by

$8.50 Cdn/cwt in the first instance and $6.00 Cdn/cwt in the second. In both cases it wouldhave been possible to hedge the exchange rate risk.

6.3 Canadian Exchange Rate Risk

� A Canadian producer who sells a product (short) at a price which is originally set in USdollars has the downside risk that the value of the Canadian dollar will rise. The short isholding the actual cash commodity and the risk is the cash price will fall if the Canadiandollar appreciates. Each US dollar will buy less Canadian dollars, $1.25 Cdn versus $1.35Cdn for example. This risk can be hedged by taking a long Canadian dollar futuresposition. This is true even if you don’t actually get paid in US$. The converted US pricedetermines the local Canadian price for many commodities.

� A Canadian processor or producer who buys a product (long) which is priced in the USmarket has the risk that the Canadian dollar will decrease in value. If this occurs, each US $will buy more Canadian dollars so the commodity price will be higher. Put another way, itwill now take more Canadian dollars to buy the product priced in U.S. dollars even throughthe U.S. price has remained the same. In the case of someone who buys a product (a longhedger) the exchange risk can be offset by taking a short Canadian dollar futuresposition. In the cash market the long hedger is holding or long Canadian dollars, hencethe need to go short.

� As is the case with a price hedge, any losses/gains on the exchange rate hedge will be offsetin the cash market. With a short Canadian dollar hedge, if the value of the Canadiandollar drops, the US price of the product converted into Canadian dollars will increase. Thehigher Canadian price paid by the producer for the product would be offset by a gain on theCanadian dollar futures position. One alternative to hedging with futures is to use optionsto hedge the exchange rate.

A Canadian dollar futures contract is $100,000 Cdn and is traded in US dollars. Sowhen we say the Canadian dollar is trading at $0.73 US, it means that it takes $1.3699 Cdn ($1.00Cdn ÷ $0.73US) to purchase $1.00 US. To convert an US priceto Canadian dollars multiply by the Canadian dollar value to purchase an US dollar.

6.3.1 Determining Your Canadian Dollar Hedge Requirement

Now, how many futures contracts are required to hedge your commodity risk? First determinethe expected value of the commodity in Canadian dollars. Using the cattle example, suppose


you hedge 80,000 lbs. at your expected net price of $89.50Cdn/cwt. The value of the cattle is$71,600 Cdn.

The number of Canadian dollars contracts needed to hedge a position can be approximated bydividing the face value of the commodity in Canadian funds by $100,000. So given a value of$71,600 Cdn the producer needs .716 of the dollar contract ($71,600 ÷ $100,000). Sincecommodity values are not measured in standard blocks of $100,000 Cdn there will be amismatch. It is up to the hedger to determine whether to round up or down when determiningthe number of currency contracts required to cover the currency risk. There are smallercontracts (mini-contracts) offered by the Mid America Exchange in the amount of $50,000 Cdn.

Currency contracts trade for different expiry months and may not match up with the actualsale/purchase date of the cash commodity or the relevant futures month (if the price risk ishedged as well). In most cases, the futures month trading after the relevant sale date is theappropriate expiry month to hedge the exchange rate risk.

6.4 Exchange Risk and a Short Commodity Hedge

The exchange rate risk faced by a short hedger is that the Canadian dollar will appreciate. Following are two examples where a producer with a commodity which will be sold is at riskof an appreciating Canadian dollar.

(i) Slaughter Cattle

Consider the following table which uses the previous short hedge example on live cattle (64head @ 1,250 lbs) with the same exchange rate of $.7408 US ($1.35 Cdn). The feedlot operatorsells April cattle futures at $.70US/cwt in September as the cattle are expected to be finishedin March. The expected net price remains at $89.50 Cdn/cwt. In March, cattle futures havefallen to $60.00 US/cwt while the exchange rate has increased to $0.80 US or $1.25 Cdn, whichresults in a futures price of $75.00 Cdn/cwt

The adjusted basis for cattle is the expected $5.00 Cdn under which results in the cash sellingprice of $70.00 Cdn/cwt. When the producer buys back the cattle futures contracts the net profitis $10.00 US/cwt which at the prevailing exchange rate of $1.25Cdn converts to $12.50Cdn/cwt. The net selling price to the producer is $82.50 Cdn/cwt instead of the expected $89.50Cdn/cwt. To prove to yourself that this shortfall of $7.00 Cdn/cwt is the result of the changein the exchange rate, review the previous example in the chapter.

By going long the Canadian dollar the producer will have a gain on any appreciation or a losson any depreciation in the value of the dollar. These gains or losses will offset those in the cashmarket and effectively lock in the exchange rate of $0.07408 US or $1.35 Cdn. In this case theproducer offsets the long position by going short in March. So for each Canadian dollar contractthe producer gains $0.0592US which on a contract of $10,000 Canadian dollars is $5,920 US.


The shortfall on the cattle hedge, due to the appreciation of the Canadian dollar, works out tobe $5,600 Cdn on the two cattle contracts. If the feedlot operator had hedged the exchange raterisk by buying one dollar contract, there would have been a profit of $7,400 Cdn on the currencyhedge. This profit on the dollar hedge more than offsets the $5,600 shortfall on the cattle hedgebecause the producer was over hedged on the Canadian dollar, the original expected value ofthe cattle was $71,600 Cdn and not $100,000 Cdn.

By hedging both the Canadian dollar and the cattle, the producer received $70.00 Cdn/cwt fromthe cash sale of the cattle plus, $12.50 Cdn/cwt on the cattle hedge plus, $9.25 Cdn/cwt ($7,400/800 cwt) on the dollar hedge for a total net selling price of $91.75 Cdn/cwt. This is more thanthe target price of $89.50 Cdn/cwt because the dollar was over hedged. However, the targetprice would have been lower than $89.50 Cdn if the Canadian dollar were to depreciate. Aportion of the loss in the Canadian dollar futures contract would not be offset by the higherCanadian cash cattle price since the hedge position is not equivalent to the value of the cattle.

Canadian $ and Short Cattle Hedge(Appreciating Cdn $)

April Cdn $ Futures April Cattle Futures

September: long Cdn $ short cattle

$1.00 US=$1.35Cdnor

$.7408 US = $1.00 Cdn

$70.00 US/cwt = $94.50 Cdn/cwt

Cattle:Expected adjusted basis

Expected net price

($5.00 Cdn)/cwt

$89.50 Cdn/cwt

March: short Cdn $ long cattle

$1.00 US=$1.25Cdn or

$.8000 US = 1.00 Cdn

$60.00 US/cwt = $75.00 Cdn/cwt

Cattle:Futures priceAdjusted basisSelling futures PriceCattle Hedge Result*

Final Net Price

$75.00 Cdn/cwt($5.00 Cdn)/cwt$70.00 Cdn/cwt $12.50 Cdn/cwt

$82.50 Cdn/cwt

Gain/loss $.0592 US ($7.00Cdn/cwt)

Contract size $100,000 800cwt (2 contracts)

Profit/loss $5,920 US

$7,400 Cdn ($5,600Cdn)

*Hedge result = ($70.00 US/cwt-$60.00 US/cwt)*$1.25 Cdn/US$


(ii) Soybeans

In April a soybean grower decides to hedge against a price decline for a crop to be harvested inOctober by selling November soybean futures. At the time that the hedge is initiated, theNovember soybean contract is trading at $9.45 Cdn/bu ($7.00 US/bu) and the Canadian dollaris trading at $0.7408 US/Cdn$ which converts to $1.35Cdn/US$. We will assume that for theprevious five years the October local adjusted basis has averaged $0.14 Cdn/bu under theNovember futures price. This means that the farmer expects the hedge to net a target price forthe beans of $9.31 Cdn/bu.

The following table contains the outcome of the hedge in Canadian dollars and a short hedgein soybeans futures. Since the risk is that the exchange rate will rise, the soybean growerhedges by buying (long position) Canadian dollar futures in December. In October, when thesoybean hedge is lifted, the producer sells back the long Canadian dollar futures contract.

The Canadian dollar increased from $0.7408 US to $0.8000 US during this period. Hence, thereis a profit on the Canadian dollar futures of $0.0592 US. The value of each currency $100,000Cdn dollar contract was $74,080 US in April and by October was $80,000 US, resulting in aprofit of $5,920 US. The profit on the currency hedge in Canadian funds is $7,400 Cdn.

In October, the November soybeans futures is trading at $5.40 US/bu. With the Canadian dollarnow trading at $0.80 US the futures price falls to $6.75 Cdn/bu. Since the basis remainsunchanged the grower can sell the soybeans in the cash market at a price of $6.61 Cdn/bu. Inaddition, the farmer has a profit on the hedge of $1.60 US/bu which, at the current exchange rateof $0.80US, converts to $2.00 Cdn/bu. This results in a final net selling price to the farmer of$8.61 Cdn/bu.

The effect of the increase in exchange rate on the soybean hedger was that the net price receivedwas $8.61 Cdn/bu instead of the expected $9.31 Cdn/bu. This is a difference of $0.70 Cdn/bu,a loss of $7,000 Cdn/contract on the two contracts. When the dollar was hedged with onecontract, the profit when the value of the Canadian dollar increased to $0.80 US was $7,400Cdn/dollar contract.

The profit on the dollar position more than compensated for the loss on the 10,000 bu ofsoybeans that resulted from a change in the exchange rate. By hedging both the Canadian dollarand the soybeans, the grower received $6.61 Cdn/bu from the cash sale of the beans plus, $2.00Cdn/bu on the soybean hedge plus, $0.74 Cdn/cwt ($7,400 / 10,000 bu) on the dollar hedge fora total net selling price of $9.35 Cdn/bu. This is more than the target price of $9.31 Cdn/bubecause the dollar was over hedged. As in the previous example the currency hedge did notexactly match the cash position and if the Canadian dollar were to depreciate the target pricecould have been lower.


Canadian $ and Short Soybean Hedge(Appreciating Cdn $)

Dec Cdn $ Futures Nov Soybean Futures

April: short soybeans long Cdn$

$1.00 US=$1.35Cdn or

$.7408 US = 1.00 Cdn

$7.00 US/bu = $9.45 Cdn/bu

Soybeans:Expected adjusted basisExpected Net Selling price

($0.14) Cdn/bu $9.31 Cdn/bu

October: long soybeans short Cdn$

$1.00 US =$1.25Cdnor

$0.80 US=$1.00 Cdn

$5.40 US/bu = $6.75 Cdn/bu

Soybeans:Selling Futures PriceAdjusted basisFinal Cash PriceSoybeans Hedge ResultFinal Net Selling Price

$6.75 Cdn/bu($0.14) Cdn/bu $6.61 Cdn/bu $2.00 Cdn/bu $8.61 Cdn/bu

Gain/loss $.0592 US ($.70 Cdn/bu)

Contract size $100,000 10,000bu (2 contracts)


$7,400 Cdn ($7,000Cdn)

*Hedge result = ($7.00 US/bu-$5.40 US/bu)*$1.25 Cdn/US$.

6.5 Exchange Rate and the Long Commodity Hedger

Assume that you are a livestock producer who will need corn in the future. Your risk is that theprice of corn will rise before you actually buy or price the corn and/or that the Canadian dollarexchange rate will fall. As shown in the table below, the corn futures price increases from $3.00US/bu to $3.60 US/bu and the exchange rate falls from $0.7408 US to $0.6993 US.


Canadian $ and Long Corn Hedge(Depreciating Cdn $)June Cdn $ Futures May Corn Futures

January: short Cdn $long corn

$1.00 US=$1.35Cdnor

$.7408 US = 1.00 Cdn

$3.00 US/bu = $4.05 Cdn/bu

Corn:Expected adjusted basisExpected Purchase price

+$0.20 Cdn/bu $4.25 Cdn/bu

April: long Cdn $short corn

$1.00 US =$1.43Cdnor

$0.6993 US=$1.00 Cdn

$3.60 US/bu = $5.15 Cdn/bu

Corn:Futures PriceAdjusted basisFinal Cash PriceCorn Hedge ResultFinal Net Purchase Price

$5.15 Cdn/bu+$0.20 Cdn/bu $5.35 Cdn/bu ($.858 Cdn)/bu $4.492 Cdn/bu

Gain/loss $.0415 US ($.242 Cdn/bu)

Contract size $100,000 20,000bu (4 contracts)


$5,934.50 Cdn ($4,840Cdn)

*Hedge result = ($3.00 US/bu-$3.60 US/bu)*$1.43 Cdn/US$.

The livestock producer takes a long (buy) May corn position in January to protect against a priceincrease for the 20,000 bu of corn which will be required in April. The expected adjusted basisin April is $0.20 Cdn/bu over the Canadian price of May corn futures. The expected price forthe corn is $3.85 Cdn/bu. In April, the producer buys the physical corn at $5.35 Cdn/bu. Thefinal adjusted basis is $0.20 Cdn/bu over the Cdn $ price of the May corn futures.

The value of the Canadian dollar has declined relative to the US dollar. The net cash price is$4.492 Cdn/bu after the producer sells (short) the corn futures for a $.858 Cdn/bu profit. Thegain on the corn hedge effectively reduces the cost of the corn to the livestock producer.Subtracting the profit on the futures position from the cash price gives a net price for corn of$4.492 Cdn/bu which is $0.242 Cdn/bu higher than the expected cost of $4.25 Cdn/bu inJanuary. In this case the higher cost of the corn is a result of the lower Canadian dollar exchangerate.


The livestock producer hedged the dollar by going short (selling) one Canadian dollar futurescontract and made $0.0415 US per Canadian dollar from the depreciation, $4,150 US/contract.At the April exchange rate of $0.6993 US, this translates into $5,934.50 Cdn.

Previously, we determined that the cash loss due to the exchange rate change was $0.242 Cdn/bu.This results in an additional cost of $1,210 Cdn/contract or $4,840 on 20,000 bu of corn for thecorn hedger which is more than offset by the $5,934.50 profit on the exchange rate hedge.

6.6 Hedging Exchange Rate Risk With Options

� Options can be used to manage exchange rate risk. The advantage of the option is that isprotects against an adverse movement in the exchange rate while at the same time anybeneficial currency change due to the exchange rate is not given up by the holder of theoption.

� For a short commodity hedger the exchange rate risk can be offset by purchasing a calloption. As the Canadian dollar appreciates the US dollar value of a Canadian dollar futurescontract increases as well as the value or premium for the call. The increased value of theCanadian dollar option helps to offset the lower Canadian cash price resulting from thechange in the exchange rate.

� The long commodity hedger can use a put option to offset the risk of a decline in the valueof the Canadian dollar. The increase in the value of the put option will help offset theincreased cost of inputs due to the weaker Canadian dollar.

Options on the Canadian Exchange Rate ($0.73 US)

Canadian dollar $US per $1.00 Cdn Option Expiry Value (strike = $0.73US)

put option call option

weaker dollar 0.70 in-the-money no value

stronger dollar 0.75 no value in-the-money


6.7 Chapter Summary

� Exchange rate risk has become increasingly important given the uncertainty in the value ofthe Canadian dollar, especially for goods produced and bought in Canada but priced in theUS. To alleviate this risk producers can hedge with futures or option contracts.

� Basis becomes more complicated when the commodity’s futures contract is traded in USdollars and the cash is traded in Canadian dollars which is the case for corn, soybeans,soybean meal (and oil), wheat (other than feed wheat), oats, live cattle, feeder cattle and livehogs.

� Basis may be expressed as the cash price in Canadian funds minus the futures price in USfunds. This expression of basis, which we term “unadjusted,” reflects both the normalfactors that affect basis as well as the factors that affect the exchange rate.

� To separate these factors, the concept of “adjusted” basis was introduced which is simply thecash price in Canadian funds minus the futures price in Canadian funds. The adjusted basisprovides a better measure of the underlying local market condition versus the futurescontract. With the unadjusted basis the impact of a change in the exchange rate can lead toconfusion over the actual commodity market signals.

� Those who have risk that the commodity’s price may fall have the risk that the Canadiandollar may rise. This risk can be hedged by buying dollar futures or call options.

� When the risk is that prices will rise, the exchange rate risk is that the value of the Canadiandollar will fall. This risk can be hedged by selling dollar futures or put options.

� One difficulty in hedging currency risk is the size of the dollar contract, which is $100,000Canadian. The way to match the dollar and futures positions is to divide the size of thedollar contract ($100,000) into the value of the commodity in Canadian funds.


Exchange Rate Risk Quiz

A feedlot operator hedges by selling four live cattle contracts at $75.00 US/cwt andbuying four corn contracts at $3.00 US/bu. The corn will be purchased in April, atwhich time the corn hedge will be liquidated. The cattle will be sold in September,at which time the cattle hedge will be liquidated. The Canadian dollar is currentlytrading at $0.72 US. Based on the above information:

a) What is the nature of the exchange rate risk on the cattle hedge?That exchange rate will rise.

b) What is the nature of the exchange rate risk on the corn hedge?That exchange rate will fall.

c) How much net exchange rate exposure does the feedlot operator have?$83, 333.33

(4 cattle contracts X 40,000 lbs ea. X 0.75) ÷ $0.72 = $166,666.66(4 corn contracts X 5,000 bu ea. X $3.00/bu) ÷ $0.72 = ($83,333.33)

$83,333.33d) How can the feedlot operator hedge it?

By buying one futures contract of dollars or one mini contract. In the firstcase, the hedge position will be greater than the exposure. In the second case,the hedge position will be less than the exposure.

e) Does the exchange rate exposure change in April when the corn hedge isliquidated? If it does, how does the feedlot operator hedge this newposition? Yes, because the short dollar risk will no longer exist. The amountof the exposure will depend upon the cattle futures price and the exchange ratewhen the corn hedge is lifted. The new position would be hedged by adding amini contract or a full dollar contract.


- NOTES -

Chapter 7 - Cash Market Contracts Page 7-1

CASH MARKET CONTRACTS


At the end of this Chapter, you will recognize:

1. Key business events that take place in a cash marketing transaction.

2. Various methods of reducing risk within each of the key cash market events.

This Chapter will provide a brief examination of the key business events that take placeduring the sale of a commodity including: delivery, pricing, title transfer and settlement.Contracting methods used to reduce the risk associated with each element of the transactionwill be reviewed and the merits compared with alternatives. Consideration will also bemade for the fact that parallel business events are occurring in the futures marketssimultaneously. The potential linkage with the futures market will be discussed as well.

7.1 Key Business Events

� Delivery: physical transfer of a commodity from seller to buyer.� Pricing: agreement on an acceptable price by buyer and seller.� Title transfer: actual transfer of ownership.� Settlement: payment from buyer to seller.

Cash market contracts can be an effective tool in managing price risk for the farm business.Many cash contracts have ties to the futures market with the buyer (elevator, packer)responsible for the management of the futures position. The producer gives a deliverycommitment or the user gives delivery acceptance or assurance, either immediately orin the future.

Successful marketing and risk management requires separating pricing and delivery of thecommodity. By separating the pricing decision from the delivery decision, a producer canprotect against potential or anticipated price declines while managing the timing of delivery(title transfer) to match the operation's cash flow, tax management or storage requirements.The user of the commodity can, by separating the timing of the pricing decision fromreceipt of the product, manage inventory to facility requirements and utilization over time.

While the contracts below are tools the farm manager can use, remember the deliverycommitment involved. This may limit utilization of these contracts unless production orutilization is known.


� All contracts specify quantity, quality and delivery period. If any of these conditionscannot be met, financial damages may be assessed. For example, if the quantitycontracted cannot be delivered and the price has increased, there may be “underfill”charges in a fixed price contract. These charges are the difference between the currentfutures price and the fixed contracted price times the delivery shortfall.

�� Due to production risk (reduced yield, hail, etc.), one cannot expect to make useof these contracts on 100% of expected production. In the case of grain and oilseedproduction, use of cash market contracts for seeded production, should be limited to nomore than 33% to 50% of the expected production Once in the bin and quantity aremore certain, they can be utilized to a higher degree. Caution is required by the userof a commodity as actual expected demand for the commodity may not be known withcertainty.

� Quality can vary from what was expected. Many grain companies/packers will acceptlesser grades at a discount. These discounts may be specified in the contract or the cashmarket discount at the time of delivery may apply. Premiums may be applicable if thequality delivered is higher than specified. This is often the case for oats in westernCanada and sometimes for canola if oil yield is above a specified level.

� Quality discounts reduce the effectiveness of a hedge. They also reduce the returns tothe farm even if the producer has not hedged. Except in severe cases of deterioratedquality (i.e., heated), disease, toxicity or excessive moisture, quality is rarely used toreject compliance on a cash grain contract. Instead, it is simply discounted.

As the production becomes more certain, additional cash contracts could be used by theproducer.

7.2 Overview and Evaluation of Main Types of Contracts

7.2.1 Deferred Delivery/Forward Contract (Sale)

� Quantity, quality and delivery period specified. Discounts for lower quality, orpremiums for higher quality may be specified in the contract. The buyer does not haveto accept out of condition or diseased grain/carcass.

� Price is calculated as basis ± futures when contract signed.� Grain company/packer enters short futures position.� No margin calls for producer.� Price is “locked in” regardless of final cash or futures prices.� Producer forfeits any opportunity of a price gain or basis improvement.� The producer can forward price in smaller increments than futures contracts:

< 5,000 bushel increments for corn and beans< 20 metric tonne increments for canola, barley and feed wheat< 40,000 lbs for fat cattle


� Similar to short futures position.� Many benefits associated with short futures position can be realized through this type

of cash contracts.� Has some of the risks/disadvantages associated with short futures position.

Example - Forward Contract (Sale):

In January a canola producer wants to protect the price of a portion of the farm’s expectednew crop production. The November futures are currently trading at $350.00 Cdn/mt. Alocal crusher has bid $340.00 Cdn/mt ($10 Cdn/mt UNDER Nov.) for next Octoberdelivery. The producer feels this is a good return and signs a deferred delivery contractwith the crusher for 100 mt of #1 Canada canola at $340.00 Cdn/mt for next Octoberdelivery. The crusher now sells (goes short) November futures to protect the value of theirfuture inventory. The producer, regardless of whether prices go higher or lower than thecontract price, is expected to deliver 100 mt of canola.

� If prices fall, the balance of the producer’s canola crop will return less. If prices rise,the balance of the producer’s canola crop will be worth more than the contract price.

� If delivery cannot be made and prices have moved higher, the crusher will expect to bepaid in cash, the sum of money equal to the margin calls and may require paymentrelated to any adverse change in the basis.

� If prices have fallen and delivery cannot be made due to circumstances beyond yourcontrol, some companies will give you cash equal to any realized gains in futures lessan administration fee and less any unfavourable basis changes. Not all companieshandle these contracts in the same manner so be sure you know the companypolicy before you sign!

� When you sign these contracts, you have made a legal commitment to deliver aspecified commodity and quality in a given time period.

7.2.1.1 Deferred Delivery/Forward Contract (Procurement)

� Price of the input is fixed in advance of the delivery period. � The quantity, basis, delivery period and quality are established.� It is similar to a long futures position.� The user agrees to a fixed price, and the company establishes a long futures position.� There are no margin calls for the buyer. � The user can purchase in smaller increments than futures contracts.


7.2.2 Basis Contracts

� Delivery period, quantity and quality are established. � Basis is fixed relative to a futures contract price.� The producer can lock in the futures price level at a later date. � The producer speculates on the price level but not the basis level.� Allows the producer to split the pricing decision into basis and price.� No final price is established initially.� The futures month for the delivery period is specified.� Can be for selling a commodity or for purchase of a commodity.� The quantity contracted can be in smaller increments than futures contracts.� Best used when adverse basis changes are expected.� A delivery commitment by buyer and seller.

Basis contract example:

An Alberta canola producer in January is considering pricing a portion of this year’sproduction. The producer believes that the current tight world supply situation will providebetter pricing opportunities in the fall. The quoted basis level for October delivery isattractive at $5.00 Cdn/mt UNDER the November futures, delivered to the local elevator.Typical fall basis levels have ranged between $5.00 and $15.00 Cdn/mt UNDER thefutures. The producer believes prices for November could still climb but feels the basiswill widen for November because of an expected increase in canola plantings this spring.

In order to ensure cash flow in the fall, the producer decides to sign a basis contract for100 metric tonnes at $5.00 Cdn/mt UNDER the November futures for October delivery.The producer still has the larger risk of price uncovered, but plans to establish the finalprice during an expected spring rally.

7.2.3 Grain Pricing Order

� Similar to a limit or contingent order on a futures contract except the basis is includedin the calculation.

� Used primarily to determine selling level.� The net cash price desired by producer is selected. � The company’s basis for the delivery period specified is added (if basis under futures);

or deducted (if basis over futures) to determine the futures price to be sold by aspecified date.

� If the actual futures price meets the specified contract target price before the contractexpiry date, a corresponding number of futures contracts are sold (based on quantityspecified) and either a Deferred Delivery contract is issued for future delivery, or acheque is issued if the grain has already been delivered.

� The quantity can usually be in smaller increments than those specified in futurescontracts.

� If the price is not met by the expiry date, there is no delivery commitment.


� This contract is usually used to target higher prices but provides no protection againstdeclining prices.

� If the selling basis improves before the expiry, the producer forfeits any opportunity togain from the basis change.

� A useful tool during seeding, harvest and holidays when you can’t watch the marketclosely.

All Grain Pricing Orders specify:

� quantity, quality, commodity;� a specific basis;� delivery period, futures month and price;� an expiry date, and� signature of both parties.

7.2.4 Delayed or Deferred Pricing (90 day tickets in Western Canada)

� The delivery and title transfer occurs now, while pricing and payment are delayed.� No basis or price is established.� No payment is made until the price is established (or 90 days expire).� Producer is at risk of an adverse change in the basis.� Producer is at risk of an adverse futures price movements.� Not usually a good strategy if going into a period where traditionally seasonal basis

levels are wide or will widen.

7.2.5 Hedge to Arrive/Futures Only Contracts

� It is usually done for short hedges.� There is no basis determined.� The delivery period is usually specified - some contracts allow rolling into another

contract month.� The futures price is established.� The company pays any margin calls.� Delivery is expected.

7.2.6 Deferred Payment

� Delivery, title exchange and pricing transactions are completed.� The settlement (payment) is deferred until a later date, usually for tax purposes.� It can be used in conjunction with other cash market contracts at the time of the

settlement.


7.2.7 Bank Swaps - Managing Foreign Exchange Risk

� Forward exchange contracts are arranged by a bank or foreign currency broker to offsetthe risk of conducting business in foreign currencies.

� An offsetting balance is established, in the same foreign currency as that expected bythe producer.

7.3 Chapter Summary

� For grains and oilseeds, and increasingly for livestock, it is possible for producers tomanage risk with instruments available from merchants and processors.

� Producers who are selling commodities and face the risk of a price decline in the cashmarket can often set up a forward sales contract with a buyer at a fixed price.

� When the cash market risk is an increase in the price, farmers can often set up a forwardpurchase contract with a supplier.

� Basis contracts are contracts that establish the price relationship in a local area. Afarmer makes a contract with a buyer or supplier which fixes the premium or discountfor a cash product relative to a futures price.

� Cash contracts can be used by the producer to hedge all of the components of the localprice (basis, futures prices and the exchange rate, where applicable) or one or more ofthe components separately.

� Cash contracts are legally binding agreements so it is important to understand the termsof the contract.


Discuss and list the reasons why buyers might choose to contracttheir inputs.

Cash Market Quiz

� security of supply�� concerned about rising prices which may reduce their

profitability�� to meet sales commitments, i.e., feed, ethanol, flour, oil, meal, etc.

�� US buyers are offering $100 US/mt for corn delivered to northernMinnesota elevators for a two month period, November 1 throughDecember 31.

�� During that time, the value of the Canadian dollar moves from $0.728US to $0.75 US.

What impact would the change in the Canadian dollar have on the cornproducer’s returns during this period if the exchange rate was unhedged?

Returns in Canadian dollars from sale would be less than originally anticipatedwhen entered into sale.

If the producer had a bank swap that assured an exchange or conversion rateof $0.728 US?The producer would have received in Canadian dollars what was expected whenthe sale was made.

$100 US/mt ÷ $0.728 = $137.36 NOT $100 US/mt ÷ $0.750 = $133.33


- NOTES -

Chapter 8 - Concluding Comments Page 8-1

Acrobat Distiller 4.0.lnk

SUMMARY COMMENTS

8.0 Futures, Options and Cash Market Tools

The focus of this course has been on the use of futures, options and cash contracts tolimit risk as it relates to price, cash flow, gross margin and ultimately the financialviability of an operation. The effectiveness of any of these contracts is dependent ona number of factors which the producer should always keep in mind. The specificationsof the contract must be similar to the physical commodity being considered under anyof the contracts. Basis fluctuations, delivery obligations, grades and exchange rate risk can allimpact on the effectiveness of any hedge.

8.1 Protecting Against Lower Commodity Prices

The previous chapters covered a number of tools which can be used to protect against a pricedecline, alone or in combination, on any proportion of the commodity up to 100%. Followingis a brief summary of the tools.

a) taking a short position in the futures marketb) buy a put optionc) deferred deliveryd) minimum price contracts

(i) deferred delivery plus buy a call option(ii) basis contract plus buy a put option

Assume the commodity in question is trading at $3.85 on some futures contract with a historicalbasis of $0.35 under so the expected local price is $3.50. The currency rate is not consideredto be a problem. There is an equal likelihood of the price rising or falling by $0.50 and the priceof both. An at-the-money call and option are $0.10.

a) Short the futures. The final sale price of the commodity is essentially fixed, subject to basisfluctuations. Any gains (losses) on the physical commodity price will be offset by losses (gains)on the futures contract so the producer is assured a return of $3.50 whether price rises or falls.

Should the basis increase or widen, to say $0.40 under, the producer’s net price falls by $0.05to $3.45. At the same time if the basis were to narrow to $0.25 the producer’s net price wouldbe $0.10 higher at $3.60. Basis risk remains a concern of the producer under this alternative.

b) Buy a put option. The minimum price sale price of the commodity is fixed, subject to basisfluctuations, at $3.50 minus the $0.10 premium. The producer must pay the premium up-frontbut is not subject to margin calls. As the futures price falls the value of the option will increaseand can be recouped by selling the put to offset the cash loss.


If prices increase there is no offset, save the initial cost of the premium, so the producer benefitsfrom the higher futures prices. The producer can choose the level of protection desired and theresulting premium which would be paid.

c) Deferred Delivery. Price and basis are fixed and the producer is expected to deliver thecontracted tonnage regardless of whether prices are lower or higher in the fall. As with futures,the producer receives the contract price whether prices are higher or lower when the deliveryperiod arrives. The producer must be confident of being able to deliver the agreed upon gradeand quantity.

d) Minimum Price Contracts

These cash contracts, commonly issued by grain companies, reduce the price the producerreceives under a deferred delivery contract by the amount of the option premium. However, theproducer can now take advantage of price improvements while still being protected against pricedeclines.

The floor price: futures less basis (if negative) less premium OR futures plus basis (if positiveor over) less premium, is the lowest price the producer will receive. In this case the minimumprice will be $3.40.

(i) Deferred Delivery Plus Buy a Call The producer is expected to make delivery of thecommodity within the agreed delivery period. However, the producer's minimum returns arereduced by the cost of the call option, in this case to $3.40. By contracting at a fixed price(delivery commitment) and buying the call option, costs are increased by the amount of thepremium. However, the producer can sell the call option and should futures prices improve,take advantage of the price increase.

ii) Basis contract (Unpriced) plus buy a put This is similar to the previous scenario. Thecost of the put reduces the producer's expected returns but allows the producer to delay fixingthe futures price under the basis contract. If futures prices rise, the producer will be able to pricethe basis contract at higher levels and let the put expire worthless (or sell it to recoup anyoutstanding time value). If futures prices fall, the basis contract will be priced at lower levelsbut the put value will have increased to offset the price decline and will be sold.


Hedging Versus Cash Markets

Low er Price Breakeven Price Higher Price

Net

Pro

fit

Option Futures Cash

8.1.1 A Comparison with Cash Markets

Essentially hedging sets a minimum or fixed price for the commodity. How does this comparewith the cash market prices at the time of the sale? Consider the following graph. Assume thatat $3.48 the producer is at break-even. At present futures prices and a constant basis andexchange rate a profit of $0.02 per unit can be assured. Now look at the consequences of eachcourse of action given a price increase or decrease.

Depending on the volumes of the commodity the financial implications could make or break afarm. As the farm manager it is important to assess the implications of each possible priceoutcome, the tolerance to risky outcomes, the preferred hedging tool and the timing of anyhedge.


8.2 Protecting Against Higher Input Costs

Similar strategies may be used to limit the risk of higher input costs. For example a cattle feedercould protect against higher barley or corn prices by using a variety of tools such as:

a) taking a long position in the futures marketb) buy a call optionc) forward purchased) maximum price contracts

(i) forward purchase plus buy a put option(ii) basis contract plus buy a call option

Again, assume the commodity in question is trading at $3.85 on some futures contract with anhistorical basis of $0.35 under so the expected local price is $3.50. As before, the currency rateis not considered to be a problem. The price of an at-the-money call and option are both $0.10and there is an equal probability of the price rising or falling by $0.50.

a) Go long the futures. The final purchase price of the commodity is essentially fixed, subjectto basis fluctuations. Any gains (losses) on the physical commodity price will be offset bylosses (gains) on the futures contract so that the producer is assured a cost of $3.40 whetherprice rises or falls.

Basis risk remains a concern for the buyer of the commodity. Should the basis increase orwiden, to say $0.40 under, the producer’s net cost falls by $0.05 to $3.45. At the same time ifthe basis were to narrow to $0.25 the producer’s net cost would be $0.10 higher at $3.60.

b) Buy a call option. The maximum purchase price of the commodity is fixed, subject to basisfluctuations, at $3.50 plus the $0.10 premium. The producer must pay the premium upfront butis not subject to margin calls. As the futures price rises the value of the option will increase andcan be recouped by selling the call to offset the higher cash cost. If futures and cash pricesdecrease there is no offset, save the initial premium, so the producer benefits. The producer canchoose the level of protection desired and the resulting premium which would be paid.

c) Forward purchase: This is a cash contract which fixes the basis and the price for futuredelivery. In this case, regardless of whether futures prices rise or fall, the cost is locked in at$3.40.

d) Maximum Price or Price Ceiling Contracts Another alternative is to enter into amaximum price or ceiling price contract. The option premium increases the buyer's cost whencompared to the forward purchase contract but establishes a maximum price. A strike price isselected and the buyer has the opportunity to fix a lower price, should prices decline, by somespecified date. The disadvantage of this contract is that delivery must be accepted for thecontracted amount and quality.


Hedging Versus Cash Markets

Higher Price Breakeven Price Low er Price

Net

Pro

fit

Option Futures Cash

i) Forward Purchase Plus Buy a Put Option: With a forward purchase contract and a putoption the initial cost is increased by the put premium. If prices rise or remain unchanged, thebarley price is locked in at $3.60, the forward purchase contract price plus the premium. However if the price declines the put becomes more value and can be sold, thereby reducing thecost from $3.60, the forward price plus the initial put premium.

ii) Basis Contract (Unpriced Forward Purchase Contract) Plus Buy Call. The buyerestablishes a basis through a contract or agreement with a grain company or local producer. Thefutures price will be established at some later date prior to delivery by the buyer. In the interim,the call allows the buyer to take advantage of lower prices while still maintaining protectionfrom rising prices. The call becomes more valuable if price rise to offset the greater cost in thecash input market for the buyer. When the futures price is selected the call is sold.

8.2.1 A Comparison with Cash Markets

Essentially hedging sets a maximum or fixed price for the commodity. Consider the followinggraph which compares costs under cash, fixed and maximum price scenarios. Assume that theproducer can lock in a profit of $0.02 per unit when the cost is fixed at $3.50. This assumesthere is no risk on the output price.


8.3 Risk Management - The First Steps

Applying these tools to your own operation will take some time and effort but will make youa better farm manager. As a first step calculate your break-even and examine the results of eachhedge with prices rising and falling. This will give you an indication of the price risk the operation is facing and the degree to which it should be limited. While break-even is an important concept, it should not be the basis for all hedge decisions. Marketing thecommodity at the highest price or buying at the lowest price should override any break-evenconsiderations. Consider the following; at the start of the production cycle expectations on both the output andinput price may only indicate a break-even or even a loss. In many instances an individualwould ask why hedge? Well, any loss can get larger and a bad situation can quickly becomeworse and potentially effect the viability of the operation. In these cases be aware of the break-even but do not let it over shadow the risk of being unhedged in the market place.

Which tool is appropriate will depend on market expectations and the desire to decrease thelevel of risk exposure. Recognize that some of the tools discussed here will not be appropriatedue to basis problems, contract specifications or availability. The best course of action is toestablish a marketing plan which should establish some discipline in the way the product is soldor inputs purchased, in terms of expected prices and returns.

8.4 Summary

As is evident from the preceding sections there are numerous ways to reduce price risk in themarket. Each tool will have its own advantages and disadvantages. As a result of this courseyou are now better informed on how these products work and where available, how they mightfit in your own risk management plan. One key for any plan to be successful is to follow itthrough to completion. By altering your plan during the production cycle you could very wellend up speculating rather than hedging. Establish your goals early and ensure they are realistic. Today’s marketing environment is continually changing and there is an increasing emphasis onrisk management at the farm level. There are various tools which can be used to manageincome risk ranging from government programs to futures markets to individual productionmanagement decisions. The degree to which any of these tools are used is largely dependenton each individual’s financial situation and risk attitudes. The material presented in this coursewill help you to make some of these decisions.

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Exercise/Quiz Answers Page EQ-1

EXERCISE/QUIZ ANSWERS

Chapter 1 - Understanding Market Risk on the Farm

1. Will the management of market risk be less or more important in the future thanin the past? Explain.

Individual risk management will be more important in the future. Governments havereduced the level of funding for direct income support as a result of budgetary constraintsand in response to an increased emphasis on global trade liberalization. For sectors suchas livestock this has reduced the risk of countervail action which would be detrimental toCanadian producers.

Chapter 2 - Futures

1. b) price, liquid2. b) chaos caused by erratic supply, poor storage facilities and large price swings3. b) auction, open outcry4. a) good faith, earnest money

Hedge Exercises

Short Hedges:Barley

TRANSACTION NOV. CASH (Physical) DEC. FUTURES

APRIL 15:Long Cash

Sell (Short) DEC.futures


$145.00/mt.

NOVEMBER 1:Sell (Short) Cash Buy (Long) Dec.

Futures

Actual Sale Price$90.00/mt. $115.00 /mt.

Profit (Loss) ($30.00/mt.) $30.00/mt.

Gain on FUTURES offsets Loss on the CASH PriceThe gain on the futures offset the loss on the cash transaction side of the hedge equation. The producerrealized the expected price of $120.00/mt.


CornTRANSACTION NOV. CASH (Physical) DEC. FUTURES

APRIL 15:Long Cash



$3.85/bu

NOVEMBER 1:Sell (Short) Cash

Buy (Long) Dec.Futures



Gain on FUTURES offsets Loss on the CASH PriceThe gain on the futures offset the loss on the cash transaction side of the hedge equation. The producerrealized the expected price of $3.50/bu.

HogsTRANSACTION NOV. CASH (Physical) DEC. FUTURES

APRIL 15:Long Cash


Expected Price$150.00/ckg

$160.00/ckg



Actual Sale Price$120.00/ckg $130.00/ckg

Profit (Loss) ($30.00/ckg) $30.00/ckg

Gain on FUTURES offsets Loss on the CASH PriceThe gain on the futures offset the loss on the cash transaction side of the hedge equation. The producerrealized the expected price of $150.00/ckg.


CanolaTRANSACTION NOV. CASH (Physical) FUTURES

APRIL 15:Long Cash



$360.00/mt.



Actual Sale Price$378.00/mt. $385.00 /mt.

Profit (Loss) $25.00/mt. ($25.00/mt.)

Gain on Cash offsets Loss on the Futures PriceThe gain on the futures offset the loss on the cash transaction side of the hedge equation. The producerrealized the expected price of $353.00/mt.

Slaughter CattleTRANSACTION NOV. CASH (Physical) FUTURES

APRIL 15:Long Cash


Expected Price$88.00/cwt.

$96.00/cwt.



Actual Sale Price$95.00/cwt. $103.00/cwt.

Profit (Loss) $7.00/cwt. ($7.00/cwt.)

Gain on Cash offsets Loss on the FUTURES PriceThe gain on the cash offsets the loss on the futures transaction side of the hedge equation. The producerrealized the expected price of $88.00/mt.


Long Hedges: Barley

TRANSACTION NOV. CASH (Physical) FUTURES

APRIL 15:Short CashBuy (Long) Jul.futures

Expected Price$100.00/mt. $125.00/mt.

May 20:Buy (Long) CashSell (Short) Jul.Futures

Actual Sale Price$130.00/mt. $155.00/mt.

Profit (Loss) ($30.00/mt.) $30.00/mt.

Gain on FUTURES offsets Loss on the CASH PriceThe gain on the futures offset the loss on the cash transaction side of the hedge equation. The producerrealized the expected cost of $130.00/mt.

CORNTRANSACTION NOV. CASH (Physical) FUTURES

APRIL 15:Short CashBuy (Long) Jul.futures


$3.25/bu

May 20:Buy (Long) CashSell(Short) Jul.Futures



Gain on FUTURES offsets Loss on the CASH PriceThe gain on the futures offset the loss on the cash transaction side of the hedge equation. The producerrealized the expected cost of $3.00/bu.


Chapter 3 - Basis

Basis Widens - Short Hedge

Cash Futures

Feb.: Position long short

Price $400 $420

Oct.: Position short long

Price $410 $440

NET $10 ($20)

Basis Narrows - Short Hedge

Cash Futures

Feb.: Position long short

Price $400 $420

Oct.: Position short long

Price $425 $440

NET $25 ($20)

Quiz

1. c) basis in Canada calculated after converting US futures prices to Canadian funds

2. d) all of the above

3. c) $6.35 Cdn/cwt under

$75 US futures ÷ $0.74 US exchange rate = $101.35 Cdn;$101.35 Cdn - $95 Cdn cash price = adjusted basis minus $6.35

4. $410.00 Cdn/mt ($425.00 futures less $15 “under” basis = $410.00).


L ive C a ttle B a s is C a lcu la tio n - O n ta rio (1 9 9 7 )W eek O n ta rio C ash F u tu res P rice O n ta rio B as is

E nd ing ($C dn /cw t) ($C dn /cw t) ($C dn /cw t)3 -Jan -97 87 .88 89 .17 -1 .29

10 -Jan -97 86 .46 87 .97 -1 .5117 -Jan -97 85 .00 88 .35 -3 .3524 -Jan -97 83 .84 87 .62 -3 .7831 -Jan -97 83 .93 86 .80 -2 .877 -F eb -97 81 .86 88 .38 -6 .52

14 -F eb -97 81 .84 89 .14 -7 .3021 -F eb -97 84 .91 92 .56 -7 .6528 -F eb -97 86 .94 95 .39 -8 .45

7 -M ar-97 88 .27 94 .02 -5 .7514 -M ar-97 87 .73 93 .47 -5 .7421 -M ar-97 87 .23 94 .07 -6 .8428 -M ar-97 87 .77 93 .91 -6 .14

4 -A p r-97 89 .13 90 .43 -1 .3011 -A p r-97 87 .94 89 .33 -1 .3918 -A p r-97 90 .28 90 .38 -0 .1025 -A p r-97 90 .13 89 .81 0 .322 -M ay-97 89 .26 90 .22 -0 .969 -M ay-97 91 .27 90 .38 0 .89

16 -M ay-97 91 .20 90 .71 0 .4923 -M ay-97 89 .80 89 .69 0 .1130 -M ay-97 89 .80 90 .09 -0 .29

6 -Jun -97 88 .58 88 .15 0 .4313 -Jun -97 86 .63 88 .17 -1 .5420 -Jun -97 89 .99 89 .00 0 .9927 -Jun -97 89 .73 88 .62 1 .11

4 -Ju l-97 88 .44 88 .50 -0 .0611 -Ju l-97 88 .85 88 .15 0 .7018 -Ju l-97 89 .28 90 .69 -1 .4125 -Ju l-97 90 .88 92 .15 -1 .271 -A ug -97 92 .73 94 .35 -1 .628 -A ug -97 93 .32 96 .84 -3 .52

15 -A ug -97 91 .05 97 .25 -6 .2022 -A ug -97 90 .22 95 .83 -5 .6129 -A ug -97 89 .74 94 .88 -5 .14

5 -S ep -97 88 .94 93 .40 -4 .4612 -S ep -97 88 .21 95 .85 -7 .6419 -S ep -97 87 .71 94 .94 -7 .2326 -S ep -97 86 .89 94 .34 -7 .45

3 -O ct-97 85 .82 91 .57 -5 .7510 -O ct-97 83 .36 91 .53 -8 .1717 -O ct-97 85 .13 92 .14 -7 .0124 -O ct-97 86 .18 93 .19 -7 .0131 -O ct-97 86 .73 94 .55 -7 .827 -N ov-97 85 .98 94 .07 -8 .09

14 -N ov-97 86 .88 94 .07 -7 .1921 -N ov-97 86 .90 95 .39 -8 .4928 -N ov-97 87 .39 95 .78 -8 .39

5 -D ec-97 87 .90 96 .52 -8 .6212 -D ec-97 87 .97 95 .63 -7 .6619 -D ec-97 88 .82 94 .00 -5 .1826 -D ec-97 90 .62 94 .49 -3 .87


Chapter 4 - Options

� Who is the holder of the right?Real estate broker representing foreign interest

� Who is the issuer or grantor of the right?Pension fund

� What is the underlying asset of the option?Office building

� At what price will the deal be struck or the right exercised?$50 million

� What premium did the buyer or holder of the option pay?$100,000

� When does the buyer's right (option) expire?May 31

� What happens to the premium money if the option expires without being exercised?Seller of the option (pension fund) keeps the premium

� What happens to the premium money if the option is exercised before or on the expirydate?

Seller keeps the premium, but must sell the building for $50 million. Thepremium is not a partial payment.

� What happens to the office building if the option expires without being exercised?The ownership stays with the pension fund.

� What happens to the office building if the option is exercised before or on the expirydate?

The pension fund must sell the building to the real estate broker’s clients for $50million.

� When can the buyer exercise the right provided by the option?Anytime up to and including May 31

The above bold and underscored words or terms make up the components of an option.All must be present and included for an option to exist.


CALCULATING TIME VALUE AND INTRINSIC VALUEANSWER SHEET

REMEMBER, time value plus intrinsic value must equal the option premium given.P = PUTC = CALLTIME VALUE = Premium - IntrinsicINTRINSIC = Strike price versus futures and profitable to exercise (in-the-money)

OPTIONS ON SCOOBIESScoobie Futures= $188.00

STRIKE PRICE PREMIUM INTRINSIC VALUE TIME VALUE

200 P $15.00 $12.00 $3.00

200 C $8.00 -- $8.00

195 P $14.00 $7.00 $7.00

195 C $10.00 -- $10.00

190 P $12.50 $2.00 $10.50

190 C $10.50 -- $10.50

185 P $9.00 -- $9.00

185 C $12.00 $3.00 $9.00

180 P $6.00 -- $6.00

180 C $16.00 $8.00 $8.00


CONDITION CLASSIFICATION

NOV 5.75 C, futures @ $6.00 (ITM)

DEC 2.70 P, futures @ $2.80 (OTM)

NOV 4.00 P, futures @ $3.60 (ITM)ITM — in-the-money

DEC 110 C, futures @ $110 (ATM)OTM — out-of-the-money

DEC 140 P, futures @ $110 (ITM)ATM — At-the-money



DEC 2.60 C, futures @ $2.50 (OTM)

DEC 2.70 P, futures @ $2.70 (ATM)

OPTIONS CLASSIFICATION EXERCISEANSWER SHEET


Option Quiz

1. d) negotiated by open outcry2. c) the right, but not the obligation, to buy a futures contract3. d) in-the-money

- The holder has the right to buy futures at $95 and could sell them back todayfor $105 realizing a $10 profit. The option has intrinsic value so therefore isin the money.

4. c) a price decline5. a) buy the underlying futures at $1006. a) receives a short futures position7. b) sell a $90 wheat CALL8. c) have intrinsic value of $109. b) at-the-money10. d) $30 intrinsic value, $6 time value

Options Exercise

1. What would the 2.80 PUT be worth if December corn futures fell to $1.85 US/buby November 1?

Right to sell @ $2.80 US/bu - futures @ $1.85 US/bu = $0.95 US/bu.

= $0.95 US/bu * 1.35Cdn/US = $1.2825/bu

The put will be worth $1.2825Cdn/bu on November 1.

2. Assuming the producer can still receive $0.65 Cdn/bu (adjusted basis) OVER theDecember corn, what cash price would be realized on November 1?

$1.85 US/bu * 1.35 Cdn/US + $0.65/bu = $3.15 Cdn/bu(The basis is over the futures so is added to the relevant futures price)

The producer will receive $3.15Cdn/bu in the cash market.


3. What price would the producer actually realize for the corn, considering theprofit on the option and the returns from cash sales?

Option premium value November 1: $0.95 US/bu less original option premium paid: (0.10) US/bu Profit $0.85 US/bu

Cdn value $0.85/bu * 1.35 = $1.1475Cdn/bu

Final Price = Cash price plus net premium profit/cost = $3.15 Cdn/bu + ($0.85 X 1.35 = 1.1475) = $4.2975 Cdn/bu

The producer will realize a price of $4.2975 Cdn/bu.

4. What would happen to the producer's PUT option and realized cash returns ifthe December corn futures rose to $3.20US/bu by November?

A 2.80 PUT option gives the producer the right, but not the obligation, to sell at$2.80 US/bu. However, futures are at $3.20 US/bu so the option would be worthlessand left to expire. The futures price in Cdn dollars is $4.32Cd/bu.

Assuming the producer can still receive $0.65 Cdn/bu OVER December futures for acash bid, returns of $4.97 Cdn/bu should still be realized for the corn ($4.32/bufutures + $0.65/bu basis). However, since the producer paid $0.10 US/bu for the option, this premium cost must be deducted from cash returns. So $0.10 X 1.35 =$0.135 Cdn/bu must be deducted from the producer's cash sale returns of $4.97Cdn/bu. The producer's net realized return would be $4.835 Cdn/bu.

5. Was this effective price insurance?

Only you as the manager can decide which tool is the most effective.

Chapter 5 - Hedging

1. c) standardized, price, number of contracts2. c) has a financial interest in a physical commodity and uses futures to

protect against an adverse price move.3. c) one who sells futures to protect inventory, current or expected, from a

price decline.4. d) long hedger


Chapter 6 - Exchange Rate Risk

a) That exchange rate will rise.b) That exchange rate will fall.c) $83, 333.33

(4 cattle contracts X 40,000 lbs ea. X 0.75) ÷ $0.72 = $166,666.66(4 corn contracts X 5,000 bu ea. X $3.00/bu) ÷ $0.72 = ($83,333.33)

$83,333.33

d) By buying one futures contract of dollars or one mini contract. In the firstcase, the hedge position will be greater than the exposure. In the secondcase, the hedge position will be less than the exposure.

e) Yes, because the short dollar risk will no longer exist. The amount of theexposure will depend upon the cattle futures price and the exchange ratewhen the corn hedge is lifted. The new position would be hedged by addinga mini contract or a full dollar contract.

Chapter 7 - Cash Market Contracts

Discuss and list the reasons why buyers might choose to contract their inputs?

� security of supply� concerned about rising prices which may reduce their profitability� to meet sales commitments, i.e., feed, ethanol, flour, oil, meal, etc.

US buyers are offering $100 US/mt for corn delivered to northern Minnesotaelevators for two month period, November 1 through December 31. During thattime, the value of the Canadian dollar moves from $0.728 US to $0.75 US.

What impact would the change in the Canadian dollar have on the cornproducer’s returns during this period if the exchange rate was unhedged?

Returns in Canadian dollars from sale would be less than originallyanticipated when entered into sale.


If the producer had a bank swap that assured an exchange or conversion rate of$0.728 US?

The producer would have received in Canadian dollars what was expected when thesale was made.$100 US/mt ÷ $0.728 = $137.36 NOT $100 US/mt ÷ $0.750 = $133.33

Glossary Page G -1

GLOSSARY

ABBREVIATIONS LIST

APR April

AUG August

bu bushel

CBOT Chicago Board of Trade

Cdn Canadian

CME Chicago Mercantile Exchange

cwt hundred weight

DEC December

FCM Futures Commission Merchant

FEB February

JAN January

JUL July

JUN June

MAR March

mt metric tonnes

NOV November

OCT October

SEP September

US United States

WCE Winnipeg Commodity Exchange

Glossary Page G -2

ADJUSTED BASIS: Basis expressed in a single (usually Canadian) currency. For example,

if corn is trading in Canada at $3.00 Canadian per bushel, and thenearby future is trading in Chicago at $2.50 US, and the Canadiandollar is worth $0.75 US, then the futures price equates to$3.333 Canadian. In this case the adjusted basis is $0.333 under thefutures price.

ARBITRAGE: Simultaneous purchase of cash commodities or futures in one marketagainst the sale of cash commodities or futures in the same or differentmarkets or time periods with the intention of profiting from adiscrepancy in prices.

BASIS: The difference between the local cash price and the futures price. Itdefines the terms of sale or purchase at a local point relative to futures. For example, if the basis is $0.10 per bushel under the nearby, thismeans that the cash product is being traded at a price $0.10 per bushelless than the price at which the nearby future is trading.

BASIS CONTRACT: A forward cash contract that establishes the basis, quantity and

delivery period for a commodity to be delivered at a future date. Thefinal price is established when the holder of the contract, at some laterdate prior to delivery, locks in the futures price at that time.

Backwardation: Prices in defferred delivery months are pr0ogressively lower thannearby months for storable commodities (inverted market).

BEAR: One who expects a decline in prices.

BEARISH: Conditions exist that suggest lower prices are warranted are said to be“bearish.”

BEAR MARKET: Declining, sluggish, depressed markets.

BID: An offer to buy at a quoted price.

BREAK: A rapid or sharp decline.

BROKER: A person executing buy and sell orders for customers for a fee orcommission.

Glossary Page G -3

BROKERAGE: The fee charged by a broker for execution of transactions as instructedby the customer. The fee may be a percentage of the transaction valueor a fixed dollar amount.

BULL: One who expects prices to rise.

BULL MARKET: A market that is rising.

BULLISH: Conditions or events that suggest higher prices are warranted are saidto be bullish.

BUY IN: Buying to cover a previous sale or short position.

BUYER/LONG HEDGE: A hedging transaction of buying futures or call options to protect

against a possible price increase in the cost of a commodity.

CALL: An option which gives the buyer the right but not the obligation to buyan underlying asset (commodity futures contract, stocks, etc.) at anagreed upon price (strike price) within a specified period of time.

CARRYING CHARGES: Cost of storing a physical commodity (i.e., grain) over a period of

time. Costs include insurance, storage and interest.

CASH MARKET: Generally the market where the exchange of the physical commodity

takes place for cash between buyer and seller.

CASH PRICE: The price in the cash market for the physical or actual commodity.

CLEARING: The procedure by which the clearing house of an exchange acts as thebuyer to every seller of a futures contract and the seller to every buyer.

CLEARING HOUSE: A separate division or corporation of a commodity exchange through

which all transactions executed on the floor of the exchange aresettled. The clearing house assures proper conduct of the exchange’sdelivery procedures and the adequate financing of the trading(margining) protecting both parties from financial loss.

Glossary Page G -4

CLEARING MEMBER: A member of the clearing house or association. All trades by non-

clearing members must be registered and eventually settled through aclearing member.

CLOSE: A point in time officially designated by the exchange at the end of thetrading session when trading must cease..

COMMERCIAL: Any company that merchandises or processes cash grain and othercommodities.

COMMISSION HOUSE: A brokerage company that buys and sells futures on behalf of its

customers. The company’s income is generated by the commissionthat it charges its customers.

CONTANGO: Prices ibn deferred delivery months are progressively higher than thenearby months for storable commodities (carrying charge market).

CFTC: The Commodity Futures Trading Commission, the US FederalRegulatory Agency which regulates commodity futures and optionmarkets in the United States.

CONTRACT GRADES: Those grades of a commodity that have been approved by an exchange

as deliverable in settlement of a short futures position.

CONTRACT MONTH: The month in which delivery is to be made in accordance with a

futures contract.

CROSS-HEDGE: Hedging a commodity’s cash market risk in a futures contract of adifferent commodity which has some price relationship to thatcommodity.

CURRENT DELIVERY MONTH: The nearby futures contract which matures and becomes deliverable

during that present month. This is also referred to as a spot month.

Glossary Page G -5

DAY ORDER: An order that exists with a broker to buy or sell a futures contract that

automatically expires at the end of each day’s trading session if notfulfilled. Many orders given to futures brokers will be treated as dayorders only unless otherwise specified.

DAY TRADING: Refers to establishing and off-setting a futures position within the

same trading session.

DAY TRADERS: Commodity traders that conduct day trades. Typically these traders

are active members of the exchange and are on the floor of theexchange.

DEFERRED FUTURES: Of the futures contracts currently traded those that expire in the more

distant months. Sometimes referred to as “forward” months.

DELIVERABLE STOCKS: That inventory of a commodity, located in exchange-approved storage,

that satisfies the deliverable grade specifications for which receipts,warrants, etc., may be used in making delivery on futures contracts.

DELIVERY: The tender and receipt of the actual commodity or the deliveryinstrument (warrant, delivery certificate, warehouse receipt) coveringsuch commodity in the settlement of a short futures contract asoutlined in the exchange by-laws.

DELIVERY NOTICE: Written notice given by the seller of a futures contract of his intention

to make delivery against an open short futures position on a specificdate.

DELIVERY POINTS: Locations designated by the commodity exchange where stocks of a

commodity, as described by a futures contract, may be delivered tosatisfy a short futures position.

DELIVERY PRICE: The price established by the clearing house at which deliveries on

futures contracts will be made when delivery has been initiated.

Glossary Page G -6

ELASTICITY: Refers to the sensitivity of the quantity supplied or demanded of acommodity as the price of that commodity changes. A commoditydemand or supply that is elastic will change in response to pricemovements while an inelastic demand or supply is relativelyunresponsive to changes in price.

EVENING UP: When traders execute transactions that offset an existing marketposition.

EXCHANGE OF FUTURES FOR CASH: A futures transaction made between a buyer of a cash commodity and

a seller of a cash commodity at an agreed upon price outside the pit onthe floor of the exchange. The buyer of the cash commodity transfersto the seller a set number of futures contracts at the agreed price. Thistype of transaction is also referred to as an EFP (Exchange forPhysical) or AA (Against Actuals).

EXCESS MARGIN: The amount of equity in a futures account that exceeds original margin

requirements. These funds may be withdrawn or used to establishnew futures positions.

EXECUTION BY OUTCRY: The practice on many exchange floors that allows all transactions to

be fulfilled by auction, open outcry (verbally and publicly).

EXERCISE: To elect to buy or sell an underlying futures contract as defined by anoption contract.

EXPIRATION DATE: The date on which an option contract expires. The last day an option

can be exercised.

EXPIRATION TIME: The exact date and time specified in an option contract that the option

expires and the obligation to the seller and the rights of the buyerexpire.

FIRST NOTICE DATE: The first day on which notice of intention to deliver against a short

futures position can be made as described by the futures contract.

Glossary Page G -7

FIXED PRICE: A price determined for a specified amount of a given commodity in

which both the basis and futures prices have been established or fixed.

FLOORBROKER: A broker that works on the floor of the exchange and executes orders

on behalf of others for the purchase or sale of any commodity forfuture delivery.

FLOOR TRADER: Member of an exchange that may execute personal trades by being

physically present on the floor of the exchange. These traders areoften referred to as locals.

FOREIGN EXCHANGE RATE: Foreign exchange is the price you pay in one currency to buy a unit of

another currency. If the exchange rate of the Canadian dollar is $0.75US, this means it costs $0.75 US to buy one Canadian dollar or theinverse, $1.333Cdn to buy one US dollar.

FORWARD CONTRACT: A cash transaction where buyer and seller bilaterally agree upon a

specified quality and quantity of goods to be delivered at a specifiedfuture date.

FORWARD PRICE: An agreement made between a buyer and seller that establishes the

price of a commodity prior to delivery.

FORWARD PURCHASE OR SALE: A purchase or sale of a cash commodity for delivery in the future

(deferred delivery).

FUNDAMENTAL ANALYSIS: Study of market factors affecting the supply and the demand of a

commodity. Such factors include production, imports, domesticusage, exports, spoilage, etc.

FUTURESCONTRACT: Refers to standardized contracts covering the sale of commodities for

future delivery on a commodity exchange. .

Glossary Page G -8

FCM: Futures Commission merchant; individuals, associations, partnershipsor corporations registered with a commodity exchange to trade for thepublic.

FUTURES PRICE: The price determined for a given commodity by auction, open outcry

on a futures exchange.

GRANTOR: Name given to the maker, writer or issuer of an option contract.

GROSS MARGIN: Gross margin is the difference between the direct input costs and the

selling price of the final product. .

HEDGE WITH FUTURES: A position held in the futures market that is equal and opposite to a

position held in the cash market so as to minimize the risk of financialloss as a result of an adverse price change.

HOLDER: Name given to buyer of an option. .

INITIAL MARGIN: Funds deposited by a customer as security at the time a futures market

position is established to guarantee contract fulfillment.

IN-THE-MONEY: An option that would realize a profit if exercised. A CALL (PUT)

option is in-the-money when the strike price is below (above) thecurrent futures market.

INTRINSIC VALUE: Value of the option if it were exercised and in the money.

INVERTED MARKET: A futures market in which the nearby months are trading at prices

higher than the deferred months.

JOB LOT: A trading unit smaller than a full contract unit, i.e., 20 metric tonnes inWinnipeg.

LAST NOTICE DAY: The final day on which the short can give notice of their intent to

Glossary Page G -9

deliver on a futures contract.

LAST TRADING DAY: The day on which trading ceases for the current (maturing) delivery

month.

LIFE OF CONTRACT: Period from the beginning of trading in a particular futures contract to

present, i.e., life of contract high, life of contract low.

LIMITED ORDER: An order in which the customer sets some restriction as to its

execution i.e., price and/or time.

LIMIT (up or down): The maximum price advance or decline permitted in one trading

session versus the previous day’s closing price.

LIMIT MOVE: A price that has moved the allowable limit as set out in the rules of thefutures contract.

LONG: The buy side of a futures contract. A promise to take delivery.

MAINTENANCE MARGIN: Level of funds that must be maintained per contract in a margin

account at all times. .

MARGIN: The amount of money or collateral deposited by a client with hisbroker or by a broker to the clearing house for the purpose of insuringperformance on an open futures contract or short option position.

MARGIN CALL: A request from a brokerage firm to a customer or from the clearing

house to a clearing member to bring account equity up to minimumlevels.

MARKET IF TOUCHED: An order that becomes a market order when a specified price is

reached. A sell MIT is placed above the market. A buy MIT is placedbelow the market.

MARKED TO

Glossary Page G -10

MARKET: The process whereby a margin account is debited or credited on adaily basis given the closing futures price.

MARKET ORDER: An order to buy or sell a futures contract at the prevailing price when

the order enters the pit.

MATURITY: Refers to the delivery month of the maturing contract. The period inwhich the futures contract obligation can be fulfilled by the delivery ofthe actual commodity.

MAXIMUM PRICE FLUCTUATION: See “Limit Move”.

MINIMUM PRICE FLUCTUATION: Smallest increment of price movement allowed in trading a specific

futures contract.

NEARBYS: The nearest or closest delivery months of a futures market as opposedto the deferreds.

NOTICE DAY: Any day on which an intent to deliver on a futures contract may beissued.

OCO: An order that has two (2) parameters. If one order is filled first, theother order is cancelled.

OFFER: An indication of willingness to sell at a given price. The opposite of abid.

OFFSET: The liquidation of an existing futures position by performing theopposite transaction for an equal number of contracts in the samedelivery month. For an option an opposite transaction at the samestrike level and contract month.

OPEN INTEREST: The sum of either all short or long futures contracts in one delivery

month or in all delivery months that are outstanding (have not beenoffset).

OPEN ORDER: A buy or sell order from a customer that remains in force until

cancelled by the customer or when the futures contract expires.

Glossary Page G -11

OPEN OUTCRY: Vocal bids and offers made in the trading pits or rings of commodity

exchanges - public auction.

OPENING: Refers to the beginning of a trading session officially designated by anexchange when transactions of futures contracts can commence.

OPENINGPRICE (range): The price at which futures contracts were traded at the daily opening.

OPTION: A contract that gives the buyer the right but not the obligation to buyor sell a specified quantity of an underlying asset (futures contract,stock, etc.) at a specific price (strike price) within a specified period oftime.

OUT-OF-THE-MONEY: Refers to an call (put) option whose strike price is currently higher

(lower) than the current market price of the underlying asset. Theoption would not be profitable to exercise.

OVER BOUGHT: A technical opinion of the market place. Typically a market that has

moved higher and faster than the underlying fundamental factorswarrant.

OVER SOLD: Opposite to over bought. A market that has moved lower further, andperhaps faster, than can be warranted by underlying fundamentalfactors.

PAR: Refers to the current futures price for a standard delivery point and/orgrade of a commodity represented by a futures contract that can bedelivered at the contract price. Serves as a benchmark upon which tobase discounts and/or premiums for varying quality.

PIT: A specially constructed or designated area on the trading floor wheretrading in a futures contract is conducted. Some exchanges refer tothese areas as “rings.”

POINT: The minimum price fluctuation of a futures contract.

POSITION: An interest or existing obligation in a market that can be either long(to have bought) or short (to have sold) one or more futures contracts.

PREMIUM: The amount of money a buyer of an option must pay the option writer

Glossary Page G -12

for the rights granted under the option.

PUT: An option which gives the buyer the right but not the obligation to sellan underlying asset (commodity futures contract, stocks, etc.) at anagreed upon price (strike price) within a specified period of time.

RANGE: The difference between the highest and lowest prices of a futurescontract price within a specified time period, i.e., weekly range, dailyrange.

SELLER’S MARKET: A condition in a marketplace where sellers are hard to find or the

goods or commodity are scarce. Therefore, sellers can draw priceshigher.

SELLING/SHORTHEDGE: Selling futures contracts or buying put options to protect against a

possible decrease in the price of a given commodity.

SETTLEMENT PRICE: The daily price used by clearing houses to clear all trades and settle all

accounts between clearing members of each contract month.

SHORT: The sell side of a futures contract. A promise to make delivery.

SPECULATOR: An individual who trades in stocks and/or futures markets with theobjective of realizing a profit by successfully anticipating pricechanges. A necessary player in a futures market as the speculatorprovides liquidity.

SPREAD: The word “spread” refers to the price relationship or differencebetween two futures contract month prices for the same or relatedcommodity.

STOP ORDER: An order issued by the customer that becomes a market order when a

particular price level is reached with the objective to reduce loss (stoploss order) or initiate positions. A sell stop is placed below themarket, a buy stop above the market.

STRIKE PRICE: The price at which the BUYER of a put (call) can sell (purchase) the

Glossary Page G -13

underlying asset during the life of the option.

SWITCH: Offsetting a futures position in one month while simultaneouslyestablishing a similar position in another delivery month of the samecommodity.

TECHNICAL ANALYSIS: The study of price changes, rates of change, averages, volume, and

open interest of futures markets and trends.

TO ARRIVE CONTRACT: Typically a contract calling for the delivery of an actual commodity

within a specific time period for a specified grade and quantity.

TRADER: A merchant involved in the merchandising of a cash commodity or aspeculator that trades for his/her own account.

UNADJUSTED BASIS: The simple difference between the local cash price and a futures price

in another currency. If the local cash price is $3.00 Cdn and the USfutures is $2.50 the “unadjusted basis” is $0.50 OVER.

UNDERLYING COMMODITY: The actual or cash commodity that a futures contract is based upon

which must be accepted or delivered when delivery against thecontract is made.

VARIATION MARGIN: Additional margin deposited as a result of greater market volatility.

WRITER: The issuer, grantor, underwriter of an option contract.

Appendix -Future/Option Contract Specs Page A-1

This information was taken from sources which were believed to be accurate at the time of printing. However, thisinformation may have changed and it is the responsibility of the reader to contact the exchange and obtain the mostcurrent contract specifications.

APPENDIX - FUTURE/OPTION CONTRACT SPECS

CHICAGO BOARD OF TRADE (CBOT) CORN FUTURES

CONTRACT UNIT: 5,000 bushels

DELIVERY MONTHS: March, May, July, September, December

TICKER SYMBOL: C

PRICE QUOTATION: US cents per bushel (quarter-cents per bushel)

MINIMUM PRICEFLUCTUATION: 1/4 cent per bushel ($12.50 per contract)

MAXIMUMDAILY LIMIT: 12 cents per bushel ($600 per contract) above or below

the previous day’s settlement price. Limits can beexpanded to 18 cents per bushel. No limit in the spotmonth (delivery month)

LAST TRADING DAY: Seven business days before the last business day of thedelivery month.

FIRST NOTICE DAY: Last business day of month preceding the delivery month.

DELIVERABLE GRADES: No. 2 US Yellow corn AT PAR and substitutions atdifferentials as established by the Exchange.

DELIVERY: In warehouses listed as “regular” within the ChicagoSwitching District or the Burns Harbor, IndianaSwitching District at the contract price. “Regular”warehouses located in Toledo, Ohio Switching Districtdeliverable at a three (3) cent per bushel discount to thecontract price. Corn in regular warehouses locatedwithin the St. Louis - East St. Louis and AltonSwitching Districts may be delivered at a (7) seven centper bushel premium to the contract price.



CHICAGO BOARD OF TRADE (CBOT) SOYBEANS FUTURES

EXCHANGE: CHICAGO BOARD OF TRADE (CBOT)

CONTRACT UNIT: 5,000 bushels

DELIVERY MONTHS: January, March, May, July, August, September,November

TICKER SYMBOL: S

PRICE QUOTATION: US cents per bushel (quarter-cents per bushel)

MINIMUM PRICE 1/4 cent per bushel ($12.50 per contract)

FLUCTUATION:MAXIMUM 30 cents per bushel ($1,500 per contract) above or belowDAILY LIMIT: the previous day’s settlement price. Limits can be

expanded to 45 cents per bushel. No limit in the spotmonth (delivery month).

LAST TRADING DAY: Seven business days before the last business day of thedelivery month.

FIRST NOTICE DAY: Last business day of the month preceding the deliverymonth.

DELIVERABLE GRADES: No. 2 Yellow soybeans at par and substitutions atdifferentials established by the Exchange.

DELIVERY: In warehouses listed as “regular” within the ChicagoSwitching District or the Burns Harbor, IndianaSwitching District at the contract price. “Regular”warehouses located in the Toledo, Ohio SwitchingDistrict deliverable at an eight (8) cent per busheldiscount to the contract price. Soybeans in regularwarehouses located within the St. Louis - East St. Louisand Alton Switching Districts may be delivered at an (8)eight cent per bushel premium to the contract price.



CHICAGO MERCANTILE EXCHANGE (CME) CANADIAN DOLLAR FUTURES

CONTRACT UNIT: 100,000 Canadian dollars

DELIVERY MONTHS: January, March, April, June, July, September, October,December and spot month. (Typically, trading occurs onlyin March, June, September and December contract months).

TICKER SYMBOL: CD

PRICE QUOTATION: US dollars per $10,000 Canadian dollars

MINIMUM PRICEFLUCTUATION: $1 US per $10,000 Canadian dollars (1 point)

($10.00 per contract)MAXIMUMDAILY LIMIT: No price limits for the first 15 minutes of Regular Trading

Hours (RTH) from 7:20 a.m. to 7:35 a.m. Afterwards aschedule of sequential expanding price limits based on thesame day’s Opening Range is effective. Once the primaryfutures contract (lead month) is limit bid or offered at anexpanding price limit, such expanding price limit will beeffective for 5 minutes, after which it will expire and the nextlarger (“expanding”) price limit will be effective. Thissequential schedule continues until the last 15 minutes oftrading when there will be no price limits. Also, on the lastday of trading for a contract month, there will be noexpanding price limits. The schedule of price limits is asfollows: no price limits for first 15 minutes, first expandinglimit = 400 points, second expanding price limit = 800points, third expanding price limit = 1200 points, fourthexpanding price limit = 1600 points, and so forth. For moredetails, please contact the CME.

LAST TRADING DAY: 9:16 a.m. on the business day immediately preceding thethird Wednesday of the contract month.

FIRST NOTICE DAY: Last day of trading. Any contracts which are open at thetermination of trading are cash settled.

DELIVERY: Third Wednesday of the contract month. In the country ofissuance at a bank designated by the Clearing House.



CHICAGO MERCANTILE EXCHANGE (CME)FEEDER CATTLE FUTURES

CONTRACT UNIT: 50,000 pounds of 700 to 799 pound Medium Frame#1 and Medium and Large Frame #1 feeder steers

CONTRACT MONTHS: January, March, April, May, August, September,October and November

TICKER SYMBOL/QUOTATION SYMBOL: FC

PRICE QUOTATION: US cents per pound

MINIMUM PRICE FLUCTUATION: $.00025 per pound ($12.50 per contract)

MAXIMUM DAILY PRICE FLUCTUATION: 1 1/2 cents per pound ($750 per contract) above or

below the previous day’s settlement price.

LAST TRADING DAY: The last Thursday of the contract month, except in thecase of the November contract which terminates onthe Thursday prior to Thanksgiving Day.

FINAL SETTLEMENT: This contract is cash settled. It is calculated as 50,000times the CME Composite Weighted Average Priceper pound for 700 to 799 pound Medium Frame #1and Medium and Large Frame #1 feeder steers for theseven days ending on the Thursday on which tradingterminates.



CHICAGO MERCANTILE EXCHANGE (CME) LEAN HOG FUTURES

CONTRACT UNIT: 40,000 lbs

DELIVERY MONTHS: February, April, June, July, August, October, December

TICKER SYMBOL: LH

PRICE QUOTATION: US cents per pound

MINIMUM PRICEFLUCTUATION: .025 cents per pound ($10 per contract)

MAXIMUMDAILY LIMIT: 1.50 cents per pound ($600 per contract). No price limit

on last two days.

LAST TRADING DAY: Tenth business day of the contract month.

FIRST NOTICE DAY: Last day of trading. Any contracts which are open at thetermination of trading are cash settled.

FINAL SETTLEMENT: Cash-settled to the CME Lean Hog Index, a two (2) dayweighted average of USDA Lean Value Direct Hog Tradeprices from the Western Corn Belt, Eastern Corn Belt andMid-south regions.

CONVERSION: The US measures the carcass with the head off and withdifferent internal trim. The US measures and pays on animperial basis, Canada on metric and, of course, both aretraded in their own currency. The following is anapproximation of a US futures price in Canadianequivalents:

1. Multiply the lean hog futures price by 0.74 to calculatea live hog equivalent.

2. Divide the live hog equivalent by 0.80 to calculate aCanadian specific hog carcass price.

3. Divide by the expected exchange rate as measured byUS$ per dollar Canadian.

4. Multiply by 2.2046 to convert to price per ckg.



CHICAGO MERCANTILE EXCHANGE (CME) LIVE CATTLE FUTURES

CONTRACT UNIT: 40,000 pounds of 55% choice, 45% select grade live steers

DELIVERY MONTHS: February, April, June, August, October, December

TICKER SYMBOL: LC

PRICE QUOTATION: US cents per pound (thousands of cents)

MINIMUM PRICE 0.025 cents per pound ($10 per contract)FLUCTUATION:

MAXIMUM 1-1/2 cents per pound ($600 per contract) above or below theDAILY LIMIT: previous day’s settlement price.

LAST TRADING DAY: The business day immediately preceding the last 5 business days ofthe contract month.

FIRST NOTICE DAY: The first business day following the first Friday of the contractmonth.

DELIVERY: Delivery may be made on any business day of the contract monthprovided a certificate has been tendered as follows: A certificatetendered before the termination of trading requires delivery on thesixth business day following the tender of that certificate, if thebuyer elects live grading. If the buyer elects carcass grading, thecertificate delivery is at the option of the buyer on any day theslaughter plant is in operation between the third business day andthe sixth business day, inclusive, following tender of thatcertificate. A certificate tendered on or after the day tradingterminates requires delivery on the fourth business day thatfollowing the tender of that certificate, if the buyer elects livegrading. If the buyer elects carcass grading, the certificate requiresdelivery at the option of the buyer on the third business day orfourth business day following tender of that certificate, or on anintervening slaughter day that the plant is in operation. Live gradeddeliveries may not be made prior to the seventh business dayfollowing the first Friday of the contract month.

TRANSFER OF Innovations in delivery include a tenderable and retenderableNOTICES: certificate of delivery, demand notices, and reclaims. The contract

allows the cattle to be delivered to a slaughter plant (rather than astockyard) with final grading in carcass form.



WINNIPEG COMMODITY EXCHANGE (WCE) CANOLAFUTURES

CONTRACT UNIT: 20 metric tonnes (Job Lot). A minimum of 5 contracts(Board Lot) is required to register a quote.

DELIVERY MONTHS: January, March, May, July, August, November

TICKER SYMBOL: RS

PRICE QUOTATION: Dollars per metric tonne

MINIMUM PRICEFLUCTUATION: 10 cents per metric tonne

MAXIMUMDAILY LIMIT: $10.00 per metric tonne above or below the previous

day’s settlement price. If two of the three nearestcontract months close limit up (bid or traded) or down(offered or traded), the daily limit shall expand to150% of normal for the next three successive businessdays. If two of the three nearest contract months closelimit up (bid or traded) or down (offered or traded) onthe third day of that period, the limit shall remain at150% of normal for another three day period. Thedaily limit will return to normal if limit moveconditions are not met in two of the three nearestcontracts on the third day of any such three day period.

LAST TRADING DAY: Seven business days prior to the end of the deliverymonth.

FIRST NOTICE DAY: Last business day of month preceding the deliverymonth.

DELIVERABLE GRADES: Non-commercially clean Canadian canola withmaximum dockage of 8%; all other specifications tomeet No. 1 Canada Canola, with the privilege ofdelivering:

a. commercially clean No. 1 Canada Canola at apremium of $5.00 per net tonne; OR



b. commercially clean No. 2 Canada Canola at adiscount of $8.00 per net tonne; OR

c. non-commercially clean Canadian Canola withmaximum dockage of 8%, all other specificationsto meet No. 2 Canada Canola, at a discount of$13.00 per tonne.

Canola varieties that are derived from geneticallymodified organisms (GMOs), sometimes referred to as“transgenic” canola, are not deliverable against WCECanola Futures Contracts until such time as approvedfor delivery by the WCE Board of Governors.

DELIVERY: PAR PAR area in Saskatchewan(approximately 150km radius from themidpoint between North Saskatoonand Aberdeen)

CENTRAL Non-PAR locations in Saskatchewanwith a differential currently at a $2.00per tonne discount.

EASTERN Non-PAR locations in Manitoba with adifferential currently at a $2.00 pertonne discount

WESTERN Non-PAR locations in Alberta with adifferential currently at a $6.00 pertonne premium

PACIFIC Non-PAR Vancouver, BritishColumbia with a differential currentlyat a $30.00 per tonne premium



WINNIPEG COMMODITY EXCHANGE (WCE) WESTERN BARLEY FUTURES

CONTRACT UNIT: 20 metric tonnes (Job Lot). A minimum of 5 contracts(Board Lot) is required to register a quote.

DELIVERY MONTHS: March, May, July, October and December

TICKER SYMBOL: AB

PRICE QUOTATION: Dollars per metric tonne at the buyer’s facility inLethbridge, Alberta

MINIMUM PRICEFLUCTUATION: 10 cents per metric tonne

MAXIMUM $5.00 per metric tonne above or below the previous day’sDAILY LIMIT: settlement price. If two of the three nearest contract

months close limit up (bid or traded) or down (offered ortraded), the daily limit shall expand to 150% of normal forthe next three successive business days. If two of the threenearest contract months close limit up (bid or traded) ordown (offered or traded) on the third day of that period,the limit shall remain at 150% of normal for another threeday period. The daily limit will return to normal if limitmove conditions are not met in two of the three nearestcontracts on the third day of any such three day period.

LAST TRADING DAY: Seven business days prior to the end of the delivery month.

FIRST NOTICE DAY: Last business day of month preceding the delivery month.

DELIVERABLE GRADES: Deliverable at PAR:Weight: 48 lbs per bushelMaximum Moisture: 14.8%Maximum Dockage: 2%

All other specifications to meet standards of #1 CWBarley.

Deliverable at $5.00 per metric tonne DISCOUNTWeight: 46 lbs per bushelMaximum Moisture: 14.8%Maximum Dockage: 2%

All other specifications to meet standards of #1 CWBarley.



CHICAGO BOARD OF TRADE (CBOT) OPTIONS ON CORN FUTURES

STRIKE PRICEINCREMENTS: 10 cent increments

CONTRACT MONTHS: December, March, May, July, September

LAST TRADING DAY: Last Friday preceding the first notice day of the underlyingfutures contract by at least five (5) business days

EXPIRATION: Unexercised options expire at 10:00 a.m. (Chicago time) onthe first Saturday following the last day of trading.

AUTOMATIC EXERCISE: Options in-the-money on the last trading day are automaticallyexercised.

EXERCISE: The option can be exercised by the buyer on any business dayprior to expiration by giving notice to the Board of TradeClearing Corporation by 1800 Chicago Time.

CHICAGO BOARD OF TRADE (CBOT) OPTIONS ON SOYBEAN FUTURES

STRIKE PRICEINCREMENTS: 25 cent increments

CONTRACT MONTHS: September, November, January, March, May, July, August

LAST TRADING DAY: The last Friday preceding the first notice day of thecorresponding underlying futures contract by at least five (5)business days.

EXPIRATION: Unexercised options expire at 10:00 a.m. (Chicago time) onthe first Saturday following the last day of trading.

AUTOMATIC EXERCISE: Options in-the-money on the last trading day are automaticallyexercised.




WINNIPEG COMMODITY EXCHANGE (WCE) OPTIONS ON WESTERN BARLEY FUTURES

STRIKE PRICEINCREMENTS: $5.00 per metric tonne increments

CONTRACT MONTHS: September, November, January, March, May, July, August

LAST TRADING DAY: The third Friday of the month immediately preceding thedelivery month of the underlying futures contract.

EXPIRATION: Unexercised options expire at 2:00 p.m. (central time) on thethird (3rd) Friday in the month immediately preceding thedelivery month of the underlying futures contract.

AUTOMATIC EXERCISE: Options that are in-the-money by at least the equivalent of oneregular daily price move ($5) shall be automatically exercisedat expiry by Winnipeg Commodity Clearing Ltd.


WINNIPEG COMMODITY EXCHANGE (WCE) OPTIONS ON CANOLA FUTURES

STRIKE PRICEINCREMENTS: $10.00 per metric tonne increments

CONTRACT MONTHS: January, March, May, July, August, September, November

LAST TRADING DAY: The third Friday of the month immediately preceding thedelivery month of the underlying futures contract.

EXPIRATION: Unexercised options expire at 2:00 p.m. (central time) on thethird (3rd) Friday in the month immediately preceding thedelivery month of the underlying futures contract.

AUTOMATIC EXERCISE: Options that are in-the-money by at least the equivalent of oneregular daily price move ($10) shall be automatically exercisedat expiry by Winnipeg Commodity Clearing Ltd.



CHICAGO MERCANTILE EXCHANGE (CME)OPTIONS ON LIVE CATTLE FUTURES

STRIKE PRICEINCREMENTS: Even intervals of 2 cents per pound except on front three

(3) months where intervals are every 1 cent increment.

CONTRACT MONTHS: February, April, June, August, October, December andserial months. Serial months, listed only one at a timeare: January, March, May, July, September andNovember. The next serial month is listed once thecurrent serial month expires. The underlying futurescontract for the serial options is the next nearby futures.

LAST TRADING DAY: • Non-Serial Options: The first Friday of the deliverymonth of the underlying futures contract. If that Friday isnot a business day, then trading shall terminate on thepreceding business day.

• Serial Options: The first Friday of the contract monthwhich is also a business day.

EXPIRATION: Unexercised options expire at 1:00 p.m. (Chicago time)on the last trading day.

AUTOMATIC EXERCISE: An option that is in-the-money at the termination oftrading is automatically exercised.

EXERCISE: The option can be exercised by the buyer on any businessday that the option is traded.



CHICAGO MERCANTILE EXCHANGE (CME)OPTIONS ON CANADIAN DOLLAR FUTURES

STRIKE PRICEINCREMENTS: $0.005 per Canadian dollar, i.e., $0.700, $0.705, $0.710

CONTRACT MONTHS: Three option contracts per quarterly cycle (March, June,September, December) and two option contracts not in thequarterly cycle know as serial months (January, February,April, May, July, August, October, November) plus fourweekly expirations.

LAST TRADING DAY: Quarterly and serial options close on the second Fridayimmediately preceding the third Wednesday of the contractmonth.

Weekly options close out trading on Fridays that are notterminations for the quarterly and serial options.

EXPIRATION: Unexercised options expire at 2:00 p.m. (Chicago time) on thelast trading day.

AUTOMATIC EXERCISE: Automatic exercise applies to in-the-money options followingthe termination of trading unless buyer’s clearing membergives clear instructions to the Clearing House to the contrary.

EXERCISE: Options can be exercised any trading day.



CHICAGO MERCANTILE EXCHANGE (CME)OPTIONS ON LEAN HOG FUTURES

Strike Price Increments: First two nearby contracts are one cent (e.g., 62, 63, 64) otherwise, every two cents (e.g., 62, 64)

Contract Months: February, April, June, July, August, October, December. Alsoserial options of January, March, November with only oneserial month posted at a time. Serial options expire on the firstFriday of month prior to underlying futures contract month(nearby or next futures preceding serial option month).

LAST TRADING DAY: The last trading date is the same date and time as theunderlying futures contract.

EXPIRATION: Same day and time as underlying futures contract.

AUTOMATIC EXERCISE: An option that is in-the-money at the termination of trading isautomatically exercised.

EXERCISE: The option can be exercised by the buyer on any business daythat the option is traded.

CHICAGO MERCANTILE EXCHANGE (CME)OPTIONS ON FEEDER CATTLE FUTURES

STRIKE PRICE: Even intervals of two cents per pound except on the nearestINCREMENTS: contract month where the intervals are one cent.

CONTRACT MONTHS: January, March, April, May, August, September, October andNovember

LAST TRADING DAY: The last trading date is the same date and time as theunderlying futures contract.

EXPIRATION: Same day and time as underlying futures contract.

AUTOMATIC EXERCISE: An option which is in-the-money on the settlement date isautomatically exercised.

EXERCISE: The option can be exercised on any business day that theoption is traded.

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