Education

Basis is the price difference between the cash price and the futures price for a particular commodity. Basis varies from one location to another, so it is specific to a particular cash market. Freight, handling, storage and quality, as well as local supply and demand factors typically affect the basis price.

Local Cash Price – Futures Price = Basis

If a spot corn price is $2.42 and nearby futures are $2.52, the prevailing basis level is then -$0.10.

The “cash” market represents the specific, local marketplace in which suppliers sell and users buy a physical commodity based on negotiated terms including quality, quantity, delivery time, and location. The prices of cash commodity market transactions are typically quoted for either “spot” or “forward” contracts.

Spot Cash Contract

A spot cash contract involves a prompt or near-term delivery of a commodity. The negotiated grade, quantity, and delivery location is specified, and price is set based on a relationship to the nearby futures contract, that is, the contract closest to expiration.

Forward Cash Contract

A forward cash contract calls for the future delivery of a commodity. The negotiated grade, quantity, delivery location, and time are specified, and the price is set based on a relationship to the appropriate deferred futures contract. This would represent the contract which would be the nearby month during the scheduled delivery period. In contrast to cash contracts, futures contracts are highly standardized with respect to quality, quantity, delivery time, and location. They are considered “benchmark” prices for the commodity because they represent the broad value at large, independent of local supply and demand factors.

Coverage in the risk management process refers to the scope of protection, usually measured in percent of the operational risk, provided by a marketing strategy.

For example, if the operation will be marketing 10,000 bushels of corn, and has already signed a contract to physically sell 5,000 bushels of corn, they are covered on 50% of the production. This operation can consider various strategies to lock-in coverage on the remaining 50% of the corn.

Futures Market

The futures market is a centralized exchange where buyers and sellers from around the world trade standardized futures contracts. Prices are driven by global supply and demand, and reflect a broad consensus. In that way, the futures market can provide estimates of future commodity prices.

Futures Contract

A standardized contract to buy or sell a commodity:

• in a fixed quantity
• of a fixed quality
• to a fixed place
• in a fixed time period

The buyer of a futures contract has right and obligation to buy the commodity.

The seller of a futures contract has right and obligation to sell the commodity.

A practice that reduces the risk of holding one asset, by taking a position in a related asset. Hedging is based on the principle that cash market prices and futures market prices tend to move up and down together. This movement is not necessarily identical, but it usually is close enough that it is possible to lessen the risk of a loss in the cash market by taking an opposite position in the futures market.

A hedge is the buying or selling of a futures contract for protection against the possibility of a price change in the physical commodity that the business is planning to buy or sell. There are two types of hedges: a long hedge and a short hedge.

Short Hedge

A short hedge is the selling of a futures contract to protect the sale price of a commodity the business is planning to sell.

Long Hedge

A long hedge is the buying of a futures contract to protect the purchase price of a commodity the business is planning to buy. Most hedges are liquidated or offset prior to delivery or expiration. The long hedger can offset their futures contract by subsequently selling a contract with the same delivery month.

While most contracts entered into do not result in delivery, the threat of delivery still tends to serve the purpose of keeping the prices of futures contracts and their underlying cash market in reasonable alignment with one another. The cash market is where physical commodities are bought and sold.

A margin or profit margin represents the profit left behind after you take out costs. In our risk management models, the margin represents a forward looking calculation that takes into account the estimated cost of production, the projected cost of feed and finally the projected earnings from sales. We offer two unique margin calculations:

Net Margin based on Inputs and Positions

In the CIH risk management model, the “net margin based on inputs and positions” is calculated by first projecting revenues:

• quantify how much the operation expects to produce and project sales revenue using the current commodity futures contract price
• incorporate any gains or losses from cash or futures and options positions in the commodity that the operation sells

The following projected costs are then subtracted from projected revenues to arrive at a profit margin dollar amount:

• calculate the projected cost of any inputs that can be hedged (priced using the current commodity futures contract price)
• incorporate gains or losses from these hedges
• combine all of the other projected costs to produce the commodity, including inputs that cannot be hedged using the futures market

Open Market Margin

The open market margin is a similar calculation but does not factor in gains and losses from cash or futures and options positions. It reflects the profit margin projected independent of any contracting or risk management. Comparing the net margin to the open margin therefore allows one to evaluate the effectiveness of their risk management strategy at any given point in time.

Margin as a Percentage

In traditional finance, margin is calculated as a percentage and reflects three different sets of costs on an income statement: Gross Margin, Operating Margin, and Net Margin.¹

Gross Margin

Subtract raw material cost (“cost of goods sold”) from revenue and you get the gross profit amount. Dividing the gross profit by the gross revenue yields the gross margin.

Operating Margin

A second measurement includes staff salaries, rent, utility bills, and countless other expenses with the cost of goods sold. Subtract these costs from the gross profit to calculate the operating profit. Divide this figure by the gross revenue, and you’ll get the operating margin.

Operating margin expresses how well a company’s holding up against its own previous results. A lower operating margin year over year may mean a company’s becoming less efficient in its internal operations.

Net Margin

Finally, after items such as taxes and interest payments are accounted for, you’re left with net profit (more commonly known as net income), near the bottom of the statement. Dividing a companies’ net profit by its gross revenue yields a net profit margin. This number reflects how much of every dollar of sales a company keeps as profit — the rock-bottom fundamental view of its fiscal strength.

Source: 1.Selena Maranjian, The Motley Fool

In financial and commodities markets, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk represented by his position to his counterparty (most often his broker). This risk can arise if the holder has done any of the following:

• borrowed cash from the counterparty to buy securities or options
• sold securities or options short, or
• entered into a futures contract

The collateral can be in the form of cash or securities, and it is deposited in a margin account. On U.S. futures exchanges, “margin” was formally called a performance bond.

Keep in mind that gains in futures trading result in credits to your futures margin account. Futures margin and the margining process ensure the financial integrity of the marketplace – a vital function. All buyers and sellers of futures are required to post and maintain margin as a performance bond which virtually eliminates counterparty risk for all participants. Many people like to get a bid bond. What is a bid bond? A bid bond is issued as part of a bid by a surety bond company to the project owner. The owner is then assured that the winning bidder will undertake the contract under the terms at which they bid.

The dollar level of margin required to trade a CME agricultural contract varies based on the value and volatility of the underlying commodity. Typically the amount of margin required is only 5-10% of the contract’s notional value, creating significant financial leverage.

As an example, one can trade a corn futures contract with a notional value of $20,000 for an initial margin deposit of approximately $1,500 or a soybean contract with a notional value of $50,000 for an initial margin deposit of roughly $3,700.

Marketing can be defined as the commercial functions involved in transferring goods from producer to consumer. Agricultural marketing is where the producer, the processor, the distributor, and the consumer meet.

An important step in the marketing process is understanding and managing risk. Successful agricultural producers and consumers understand that risk is part of their business and take a deliberate and knowledgeable approach to managing it.

Successful market planners are constantly learning new skills such as using market options or basis contracts. They take advantage of marketing professionals who help them find ways of dealing with market risk.

Marketing decisions should be made based on their impact on long-term profitability not short term “windfalls”. The impact of marketing decisions on production, finances, and human resources should be accounted for. Managing market risk begins with a marketing plan. This plan should be based on the goals of your business, the level of profit needed, and your ability to accept risk.

The three keys to a successful marketing plan are:

• An accurate account of production costs
• An understanding of the appropriate marketing and risk management tools available
• A decision plan

Source: University of Pennsylvania College of Agricultural Sciences

The following lists common contracts that are used by suppliers and end-users to market commodities.

Basis Contract

A basis contract allows marketers to specify or “lock in” the value of the basis or difference between the local cash price and the futures price for a commodity, delivered to a specific location, on a particular date. A basis contract is also known as a “Fix Price Later (FPL)” contract.1 This is because the futures price portion of the full delivered price remains open to fluctuate until its value is fixed either at or ahead of delivery.

Cash Contract

An agreement between suppliers and users of a physical commodity based on negotiated terms including quality, quantity, delivery time, and location. The prices of cash commodity market transactions are typically quoted for either “spot” or “forward” delivery, and hence, referred to as spot or forward contracts.

A spot cash contract involves a prompt or near term delivery of a commodity. The negotiated grade, quantity, and delivery, location are specified and price is set based off a relationship to the nearby futures contract, that is, the contract closest to expiration.

A forward cash contract calls for future delivery of a commodity. The negotiated grade, quantity, delivery location and time are specified and price is set based off a relationship to the appropriate deferred futures contract. This would represent the contract which would be the nearby month during the scheduled delivery period. In contrast to cash contracts, futures contracts are highly standardized with respect to quality, quantity, delivery time, and location. They are considered “benchmark” prices for the particular commodity because they represent the broad value at large, independent of local supply and demand factors.

Futures Contract

A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a commodity at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.²

Option Contract

A contract that gives its owner the right, but not the obligation, to either buy or sell a commodity at a specified price, or strike price, for a specified period of time. There are two types:

• a call option contract gives its owner the right, but not the obligation, to buy a commodity at a price for a specified time.
• a put option contract gives its owner the right, but not the obligation, to sell a commodity at a price for a specified time.

Physical Contract

Physical contract is another way to describe a cash contract, or an agreement between suppliers and users for a physical commodity based on negotiated terms including quality, quantity, delivery time, and location.

Price + Basis Contract

Price + Basis contract is another way to describe a cash contract that emphasizes the two, distinct risk components within the contract: futures price and the basis price.

Price Only Contract

A price only contract is one that specifies quality, quantity, delivery time and location for the physical commodity and sets price relative to a specific futures contract, without committing to the basis price. This is also referred to as a “hedge to arrive” contract, as it is an agreement in the cash market between two counterparties to the futures price associated with the specific delivery period.

Window Contract

Window contract describes a class of cash contracts that set a minimum and maximum commodity price for the duration of the contract.

Sources: 1. United States Department of Agriculture Risk Management

Agency. 2. University of Pennsylvania College of Agricultural Sciences.

To liquidate a position by entering an equivalent but opposite transaction in the same delivery month. Offsetting cancels the obligation of making (or taking) physical delivery of the underlying commodity.

To offset an initial purchase, a sale is made; to offset an initial sale, a purchase is made.

This effectively closes out the position, resulting in a realized profit or loss (P & L) from the transaction.

A contract that gives its owner the right, but not the obligation, to either buy or sell a specified underlying asset at a specified price for a specified period of time.

Call Option

An option contract giving its owner the right, but not the obligation, to buy the underlying asset at the strike price for a specified time.

Put Option

An option contract giving its owner the right, but not the obligation, to sell the underlying asset at the strike price for a specified time.

Premium is another word for the price of an option. The value is primarily affected by:

• the difference between the underlying futures contract price and the strike price
• the time remaining for the option to be exercised
• and the volatility of the underlying futures contract price

These factors affect the option premium to a lesser degree:

• interest rates
• market conditions

Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and impact of them.

Risk has many forms, but in the business of food and agriculture, shifts in supply or demand and natural causes like weather or disease create significant risk.

Who Has Risk?

Many participants in the food and agriculture industry have risk. Corn growers are impacted by rainfall and the cost of fuel, while grain millers are at risk of securing enough corn to fulfill their contracts with corn chip manufacturers. Meanwhile the chip manufacturers are at risk of lower demand for snacks. Common to all of these businesses is price risk.

Price risk naturally transfers other risks. If demand is low, price will fall. If disease strikes and supplies fall, prices rise. Since profits and sustainability depend on whether you sell or buy at or above break-even values, price risk management is a crucial discipline in any successful business.

In futures trading, the settlement price is an official price established at the end of each trading day that uses the range of closing prices for a particular contract.

It is computed based on:

• the closing offer and bid price
• last actual traded price
• and weighted average of prices traded during the closing minutes of the trading day

This price is used to settle accounts with open positions and determine margin requirements as well as the following day’s price limits.

Commodity speculators have no inherent cash market price exposure and simply buy or sell futures contracts in an effort to make a profit. Simply put, speculators buy futures or options if they believe prices will increase or they can sell futures or options if they believe prices will fall. They may realize a profit if their expectations occur or a loss if they don’t occur.

A speculator could be a trader on the exchange trading floor known as a local, an individual investor, or a commodity fund. Speculators provide a very important role in adding liquidity to the markets. This liquidity enhances the markets’ efficiency for all participants.

A spread involves two transactions that simultaneously take one long position (buying) and one short position (selling) on two different contracts. Gains occur with a positive price change in one position more than offsetting a negative price change in the other. In rare situations, both “legs” of the spread may simultaneously be reflecting a gain.

• Long position is a position resulting from ownership of an asset
• short position is a position resulting from selling an asset that is not owned. There is a future obligation to repurchase.
• Leg refers to part of the position, either long or short. Spreads are initiated and offset as a package, but alternatively can be “legged”. This means that the long or short position is initiated (or offset) independently of the other contract. This introduces additional risk and is typically avoided.

Futures Spread

A futures spread simply refers to the difference in value between two futures contracts. There are two basic types:

• Intra-market spread
  An intra-market spread reflects the difference in value between two contracts of different expiration months within the same commodity. As an example, if July corn futures are trading at $3.75 per bushel and September corn futures are trading at $3.85 per bushel, the spread between July and September futures is equal to 10 cents (September over July).
• Inter-market spread
  An inter-market spread reflects the difference in value between two contracts of different commodities. As another example, if Chicago July wheat futures are trading at $5.25 per bushel and Kansas City July wheat futures are trading at $5.75 per bushel, the spread between the Chicago and Kansas City July contracts is equal to 50 cents (Kansas City over Chicago). Here, even though we are comparing two wheat contracts, they are different markets and hence an inter-market spread. We could also compare the difference in value between two totally different markets such as wheat vs. corn, which would be an example of another type of inter-market spread.

Futures Spread to Manage Basis Risk

In managing the risk of an adverse change in cash prices, there are essentially two risks exposed to this change in price. A cash price consists of both a futures component or benchmark price, as well as a basis differential that relates that futures value or benchmark to a local cash market in which the commodity will be priced. By definition:

• cash = futures + basis
• basis = cash – futures

Often, futures are used as a hedge against an adverse move in cash prices. If futures are priced as a substitute to a cash purchase or sale, then this element of price is covered or hedged; however, the basis differential remains a floating variable to the final determinant price and is itself exposed to adverse variation in its value between the time the futures are hedged and the time the hedge is removed and the cash price is set in the local market.

• As a long hedger (someone who is short the physical commodity in the cash market), one is exposed to a stronger basis
• As a short hedger (someone who is long the physical commodity in the cash market), one is exposed to a weaker basis

As an alternative to forward pricing basis, futures spreads can be used to hedge the basis element of a cash price. The reasoning behind this is that basis and spreads tend to move together. For example, in situations where the cash market is very strong, basis tends to be increasing. This typically is reflected in the spot futures contract gaining relative to deferred contracts. In the opposite case where the cash market is very weak, basis tends to be decreasing and this usually corresponds with spot futures declining relative to deferred contracts.

• bull spreads are used to hedge against the risk of a stronger basis
• bear spreads are used to hedge against the risk of a weaker basis

Bull Spread

A bull spread is a position that includes an order to buy a nearby futures contract and sell a deferred futures contract. A bull spread can gain in value when nearby futures are increasing at a faster rate or decreasing at a slower rate relative as compared to deferred futures. Bull spreads are commonly used to assist in managing the risk of a strengthening basis – ahead of actually buying the basis with a supplier.

Bear Spread

A bear spread is a position that includes an order to sell a nearby futures contract and buy a deferred futures contract. A bear spread can gain in value when nearby futures are decreasing at a faster rate or increasing at a slower rate relative to deferred futures. Bear spreads are commonly used to assist in managing the risk of a weakening basis – after buying the basis with a supplier.

A strike price is the fixed price at which the owner of an option can purchase, in the case of a call, or sell, in the case of a put, the underlying commodity. The strike price is often called the exercise price. The strike price is a standardized feature of the contract and is set by the exchange.

Examples

A May Corn Call Option with a strike price of $4 per bushel might cost $0.25 per bushel to buy. When the option is exercised the owner of the option will have a long May corn futures position at $4 per bushel.

Similarly a May Corn Put Option with a strike price of $3.50 per bushel might cost $0.18 per bushel to buy. If and when the option is exercised the owner of the put option will have a short May corn futures position at $3.50 per bushel.

Volatility measures the relative rate at which price moves up and down. Volatility is measured by calculating the annualized standard deviation of daily change in price. If the price moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility.

Option Volatility

Volatility is an essential element in an option’s price level, called premium.

• If volatility is high, the premium on the option tends to be relatively high
• If volatility is low, the premium on the option tends to be relatively low

Premium is the cost or value of an option. This is discovered on an exchange through competitive bids and offers, and constitutes the consensus value of what the rights to buy or sell the underlying commodity at various strike prices is worth at any given point in time.