Chad Hart Assoc. Professor

of Economics, Iowa State University

Steve JohnsonISU Extension

Farm Management Specialist

Ed Kordick Commodity Services

Manager,Iowa Farm Bureau

Presentation Objectives:

• Education on basic marketing tools

• Introduction to the Marketing Tools Workbook

• Invitation to continue learning by experience with Iowa Commodity Challenge after this session.

Marketing Tools Workbook

Crop Marketing

• Unpredictable events, emotions, volatility• Back to the basics: know the tools,

have revenue perspective, realistic goals • Price is not an adequate measure of success

• How do you define success? hitting revenue goals, reducing risk, . . . . . .

Decide what success means to you

Futures and Basis Movement

Futures Hedging

• Hedging: taking an equal and opposite position in the futures market than you have in the cash market.

• When a farmer hedges they take an action now in the futures market that they will take later in the cash market. – If the farmer will sell bushels later in the cash

market, the bushels can be sold now in the futures market to protect downside price risk.

Why Hedging Works:5

Hedging Example

DATE CASH FUTURES BASIS

Results

Start date

End date

Hedging Example

DATE CASH FUTURES BASIS

Results

In this presentation, T diagrams are used in examples to track three market components: Cash Futures Basisover the time period that the hedge is in place.

• The difference between the cash price and futures price. Many factors influence basis:

local supply/demand, etc.

• The calculation for basis is: Cash Price – Futures Price = Basis $4.80 – $5.10 = - $0.30

$14.20 – $14.70 = - $0.50

Basis

Example futures hedge story

• It’s November: the goal is to sell 5000 bushels of cash corn in late Feb. at $4.30.

• Estimated basis for late February is -30¢ (cash under March futures).

• March corn futures are sold at $4.60

• Let’s see what happens if the market goes either way !

Hedging Example (market lower)

DATE CASH FUTURES BASIS

Sell 1 March Corn

@ $4.60

Buy 1 March Corn

@ $4.15

Late February

November

Results

Goal: $4.30 Cash Corn

Sell Cash Corn

@ $3.85

- 45¢

Estimated: - 30¢

0.00+ 45¢

Actual: - 30¢

6

Hedging Example (market lower)

Net Hedge (without commissions and interest cost)

1.Original futures less actual basis = net hedge $4.60 – 0.30 = $4.302. Cash sale to buyer +/– futures gain/loss = net hedge $3.85 + 0.45 = $4.30

Hedging Example (market higher)

DATE CASH FUTURES BASIS

Sell 1 March Corn

@ $4.60

Buy 1 March Corn

@ $5.00

Late February

November

Results

Goal: $4.30 Cash Corn

Sell Cash Corn

@ $4.70

+ 40¢

Estimated: - 30¢

0.00- 40¢

Actual: - 30¢

7

Hedging Example (market higher)

Net Hedge (without commissions and interest cost)

1.Original futures less actual basis = net hedge $4.60 – 0.30 = $4.302. Cash sale to buyer +/– futures gain/loss = net hedge $4.70 – 0.40 = $4.30

Example futures hedge story

• Story begins the same: November, the goal is to sell 5000 bu. cash corn at $4.30.

• Estimated basis for late February is -30¢,

March corn futures are sold at $4.60

• Let’s see what happens if basis is different than expected !

Hedging Example (market lower)

DATE CASH FUTURES BASIS

Sell 1 March Corn

@ $4.60

Buy 1 March Corn

@ $4.10

Late February

November

Results

Goal: $4.30 Cash

Corn

Sell Cash Corn @

$4.00

- 30¢

Estimated: - 30¢

+ 20¢+ 50¢

Actual: - 10¢

9

Hedging Example (market lower)

Net Hedge (without commissions and interest cost)

1.Original futures less actual basis = net hedge $4.60 – 0.10 = $4.502. Cash sale to buyer +/– futures gain/loss = net hedge $4.00 + 0.50 = $4.50

Hedging Example (market higher)

DATE CASH FUTURES BASIS

Sell 1 March Corn

@ $4.60

Buy 1 March Corn

@ $5.20

Late February

November

Results

Goal: $4.30 Cash

Corn

Sell Cash Corn

@ $4.80

+ 50¢

Estimated: - 30¢

- 10¢- 60¢

Actual: - 40¢

10

Net Hedge (without commissions and interest cost)

1.Original futures less actual basis = net hedge $4.60 – 0.40 = $4.202. Cash sale to buyer +/– futures gain/loss = net hedge $4.80 – 0.60 = $4.20

Hedging Example (market higher)

Key points:

• Price does not define marketing success, hitting revenue goals, reducing risk, . . . . . .

• The cash market, futures market and basis can be tracked in futures hedges

• A futures hedge works in up & down markets• Basis is key to result of futures hedge:

Stronger basis than expected = Higher price Weaker basis than expected = Lower price

Carry and Cost of Ownership

Defined: The difference in price between the nearby contact and the more distant delivery months (deferred). Compare the carry offered by the market to the costs of storing grain for the various delivery months.

Carry Market

In a year like 2012, the limited supply has reduced demand. There is little to no carry in the futures markets. The nearby futures contract is actually higher than the deferred futures. The market provides little incentive for storing the crop.

Inverted Market

Corn Futures Inverse Soybean Futures Inverse

Source: www.cmegroup.com

Example Corn Futures

Date: Oct. 16th, 2013

$4.43Dec.

$4.55Mar.

$4.63May

$4.71July

Source: www.cmegroup.com

Example Soybean Futures

Date: Oct. 16th, 2013

$12.75Jan.

$12.63Mar.

$12.49May$12.47July

Corn On-Farm: Monthly Charge = 3¢/bushel Commercial: Monthly Charge = 6¢/bushel

Cost of Ownership

Soybeans On-Farm: Monthly Charge = 4¢/bushel Commercial: Monthly Charge = 6¢/bushel

Key points:

• Compare the carry offered by the market to the costs of storing grain for the various delivery months

• The Cost of Ownership will accrue Commercially for both corn and soybeans at 6¢/bushel/month.

Forward Cash Contracts

Forward Cash Contract

Defined: An agreement between a buyer and seller covering a quantity and quality of grain to be delivered at a specified location and time in exchange for a specific price.

Example: 5,000 bushel of #2 yellow corn delivered

to Local Co-op the last half of February The cash price at delivery will be -$.40

under the March corn futures contract that closed at $4.60/bu.

14

Forward Cash Contract

A Forward Cash Contract is a binding transaction between the seller and buyer for a later delivery date. Conditions are set including the quantity of bushels, the quality, delivery time and cash price.

Quantity Quality Delivery Location Cash

Price

5,000 bu. #2 Yellow Corn

Last Half February

Local

Co-op

$4.20

/bu

Forward Cash Contract

Forward Cash Contracts are widely used and:

Set the cash price and delivery terms Are available both before and after

harvest Don’t require margin deposits or

premiums.

DisadvantagesPenalties if cannot deliver the contracted amountLocked in price (can’t go higher)Often receive a wider basis.

Forward Cash Contract

AdvantagesNo margin deposit requiredLock in price and delivery terms

Hedge-to-Arrive Contract

Hedge-to-Arrive (HTA) Contracts are similar to Forward Cash Contracts. The binding transaction sets the:

Delivery Date and Location Amount of Bushels to Deliver Quality of those Bushels The Basis is typically not set when the

transaction is initiated, however the Futures Price is established. The Seller sets the Basis prior to Delivery.

Hedge-to-Arrive Contract

Similar to a Forward Cash Contract, an HTA Contract is a binding transaction between the seller and buyer for a later delivery date. Conditions are set including the quantity of bushels, the quality, delivery time but the cash price is not known until the Basis is set.

Quantity Quality Delivery Location Cash

Price

5,000 bu. #2 Yellow Corn

Last Half February

Local

Co-op

?

Margin Flows

DisadvantageMust understand margin callsCommissionsBasis risk

Futures ContractsAdvantages

Flexibility, ease of entry and exitReduces price riskCan improve basis

Margin money is “good faith” money that is deposited into the futures account.

Performance bond Money that covers changes in the value

of the contract position Minimum margins are set by the

exchange Additional margin can be collected if the

futures contract is losing value for the user

Margin Account

There are two key margin levels: Initial margin Maintenance margin

Key Margin Levels

The initial margin is the amount you have to deposit to participate in the futures market.

The maintenance margin is the amount you have to keep as a minimum balance.

Key Margin Levels

Corn Soybeans

Initial $1,650 $3,300

Maintenance $1,500 $3,000$ per contract

Let’s go through an example

Margin Example

Sold 1 corn futures contract at $5.00 per bushel17

Day Price Change in Value

Computed Balance

Margin Call

Ending Balance

1 $5.00 $1,650

2 $5.10 –$ 500 $1,150 $ 500 $1,650

3 $5.30 –$1,000 $ 650 $1,000 $1,650

4 $4.90 +$2,000 $3,650 $3,650

5 $5.00 –$ 500 $3,863 $3,150

Basic Options, Intrinsic and Time Value

An option is the right, but not the obligation, to buy or sell a futures contract.

Options Contracts

Farmers can buy and sell options. When you buy an option, you get the right.When you sell an option, you face the obligation.

Options are tied to specific futures contracts.

The strike price is the price in the option at which you may buy (or sell) futures contracts.

Types of OptionsThere are two types of options:

PutsCalls

A put option gives you the right to sell futures.Put options are often used to set price floors.

A call option gives you the right to buy futures.Call options are often used to replace cash bushels.

ExamplesLet’s say you buy a $4.50 put on July corn futures.

That put gives you the right to sell July corn futures for $4.50 per bushel.

If you had bought a $4.50 call, that would give you the right to buy July corn futures for $4.50 per bushel.

Example Put

Put options pay out when futures prices fall. Here’s the payout schedule for a $4.50 put on July 2014 corn.

Example Call

Call options pay out when futures prices rise. Here’s the payout schedule for a $4.50 call on July 2014 corn.

Premium vs. Margin

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

3/3/

2008

3/10

/200

8

3/17

/200

8

3/24

/200

8

3/31

/200

8

4/7/

2008

4/14

/200

8

4/21

/200

8

4/28

/200

8

5/5/

2008

5/12

/200

8

5/19

/200

8

5/26

/200

8

6/2/

2008

6/9/

2008

6/16

/200

8

6/23

/200

8

6/30

/200

8

$ p

er b

ush

el

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

$ p

er c

on

trac

t

Futures Cumul. Margin Calls Option Cost

22

Options PremiumsCan be divided into two sections:

Intrinsic value What is the option worth today?

Time valueHow much time is left on the option?

Intrinsic value depends on the futures price and the strike price of the option.

Time value depends on the length of time in the option and the price volatility in the market.

Example

Day Futures Price

Option Premium

Intrinsic Value

Time Value

1 $12.00 $0.60 $0.00 $0.60

2 $12.20 $0.56 $0.00 $0.56

3 $11.70 $0.83 $0.30 $0.53

4 $11.55 $0.95 $0.45 $0.50

5 $11.90 $0.67 $0.10 $0.57

Start with an soy put option @ $12.00 per bushel29

Options FeaturesAdvantages

Options can establish price floors or ceilingsNot locked in to a particular buyerFlexibleNo margin requirements

DisadvantagesSpecific size of contractCommissions and option premiums

Store Cash Bushelsand Buy Put Option

Put Option

• A put option is the right, but not the obligation to sell futures. The buyer of the option pays a premium for “price insurance” to the downside.

• Market Lower: Put option gains value to offset cash loss.

• Market Higher: Put premium is only cost.

Store cash bushels and buy put option strategy

• A combination of a cash position (owning the cash bushels) and a risk management position (buying the put).

• The put option gains value as market goes lower (as cash bushels lose value).

• If market moves higher, the cash position gains value and the put option is limited to the loss of the option premium.

Estimated Floor Price Calculation

July Corn Put Strike Price less Premium Paid less estimated basis = Est. Floor Price*

$4.60

- 26¢ premium

- 30¢ est. basis

= $4.04

*Option examples do not include commissions and interest

Store Cash & Buy Put OptionFutures Put equals less equalsMarket Option less Net Basis Cash

Outcome Worth Premium Futures Estimate Estimate

+ 1.00

+ 0.75

+ 0.50

+ 0.25

- 0.25

- 0.50

- 0.75

- 1.00

Today'sfutures

$5.60

$5.35

$5.10

$4.85

$4.60

$4.10

$3.85

$3.60

$4.35

0.00

0.00

0.00

0.00

+0.25

+0.50

+0.75

0.00

+1.00

-0.26

$4.60

-0.26

-0.26

-0.26

-0.26

-0.26

-0.26

-0.26

-0.26

$5.34

$5.09

$4.84

$4.59

$4.34

$4.34

$4.34

$4.34

$4.34

-0.30

-0.30

-0.30

-0.30

-0.30

-0.30

-0.30

-0.30

-0.30

$5.04

$4.79

$4.54

$4.29

$4.04

$4.04

$4.04

$4.04

$4.04

Initial Futures

24

Key points: Store cash bushels & buy put option strategy

• The put option gains as market goes lower (as cash bushels lose value).

• Market higher: cash position gains value and the put option loses only the premium paid.

• Strike Price – Premium – Est. Basis = Est. Floor Price

• Basis is key to the net result of the strategy.

Sell Cash Bushels and Buy Call Option

Call Option

• A call option is the right, but not the obligation to buy futures. The buyer of the option pays a premium for “price insurance” to the upside.

• Market Lower: Call premium is the only cost• Market Higher: Call option gains value.

Sell cash bushels and buy call option strategy

• This is a re-ownership strategy.

• This is price risk management since the cash bushels are sold and the limited risk is the call option premium.

• Call option “replaces” cash ownership Strategy is not considered hedging by IRS.

• The call option tends to gain value as the market moves higher.

• Similar to minimum price strategy of buying put

options and can be reasonable if conditions are right (avoid storage costs, good basis at harvest, lack of carrying charge).

Sell cash bushels and buy call option strategy

Estimated Floor Price Calculation

Cash Sale Price less Premium Paid (to buy July Soy $12.80 call)

= Est. Floor Price*

$12.20

- 55¢ premium

= $11.65

*Option examples do not include commissions and interest

Sell Cash & Buy Call OptionFutures Cash Call equalsMarket Sale Option less Cash

Outcome Price Worth Premium Estimate

+ 2.00

+ 1.50

+ 1.00

+ 0.50

- 0.50

- 1.00

- 1.50

- 2.00

Today'sfutures

$14.30

$13.80

$13.30

$12.80

$11.80

$11.30

$10.80

$12.30

$14.80

$12.20

$12.20

$12.20

$12.20

$12.20

$12.20

$12.20

$12.20

$12.20 +2.00

+1.00

0.00

0.00

+0.50

0.00

0.00

0.00

+1.50

-0.55

-0.55

-0.55

-0.55

-0.55

-0.55

-0.55

-0.55

-0.55

$13.15

$12.65

$12.15

$11.65

$11.65

$11.65

$11.65

$11.65

$13.65

$12.80

Initial Futures

27

Key points: Sell cash bushels & buy call option strategy

• Re-ownership strategy: price risk transferred from cash market to call option.

• Minimum price: cash price is set and the call option has the limited risk of the premium.

• Cash Sale Price – Premium = Floor Price• Consider when: want to avoid storage costs,

basis is acceptable, lack of carrying charge.

Marketing New Crop

• The 5-year seasonal crop price patterns favor new crop futures to peak during the spring and summer months.

Seasonal Patterns

31

• Historically, corn prices don’t exceed estimated costs of crop production for long periods of time. Consider sales – even before harvest when profit margins are available.

Crop Margins - Corn

Price = $4.20/bu

Cost = $4.46/bu

• Soybean prices don’t exceed estimated costs of production for long periods, but note the trend in recent years. That opportunity to make sales before harvest is especially attractive in 2012.

Crop Margins - Soybeans

Price = $10.75/bu

Cost = $11.13/bu

2014 Costs Annual estimates from ISU Extension

Publication A1-20, January 2014

Cost of Production

Corn following Soybeans = $4.29/buCorn following Corn = $4.97/buSoybeans = $11.13/bu

Harvest Delivery

Reduced Storage/Drying Costs Bushels that can be sold and moved to

market at harvest will result in less bushels to store and perhaps reduce corn drying costs.

10,000 bu. of soybeans valued @ $13/bu8 cent in/out charge + 3 months of 4% interest

8¢ + 12¢ = 20¢ per bushel

20¢ X 10,000 bu = $2,000 savings!

Key points:

• Keep good records to determine your cost of crop production; estimate your profit margin and compare to harvest delivery prices.

• Seasonal crop price patterns favor new crop futures to peak during the spring and summer months.

• Bushels that can be sold and moved to market at harvest will result in fewer bushels to store, perhaps reduced corn drying costs and an opportunity to generate cash flow needs.

Conquer Marketing Concerns38

Revenue Protection = Over 90% of Iowa’s Insured Acres

Crop Insurance Coverage

Marketing Strategy• Pre-Harvest Sell for

Delivery up to 136 Bu/A

• Price Guarantee is Higher of the Projected Price vs. Harvest Price

• Slight Basis Risk

• Must Plant the Crop

(Prevented Planting = 60%)

170 Bu/AActual

Production History(APH)

RP @ 80% Level of Coverage

136 Bu/AGuarantee X

$4.62/bu Projected Price

Deductible20% = 34 Bu/A

= $628/A Revenue Guarantee

Selling Insurance Bushels

• Corn Actual Production History (APH) of 170 bu/A• Revenue Protection @ 80%(170 X .80 = 136 bu/A)• Revenue Guarantee:136 bu/A X $4.62/bu = $628/A• Drought: Actual yield is 100 bu/A, price = $7.50/bu• New Revenue Guarantee: 136 bu/A X $7.50/bu =

$1,020/A• Revenue to Count: Harvests 100 bu/A X $7.50/bu =

$750/A• Indemnity Payment: $1,020 - $750 = $270/A• Shortfall of Delivery Bushels: Settle by Nov. 1st

Corn Indemnity Payments

Corn Insurance Prices

Soybean Insurance Prices

Key points:• Revenue Protection (RP) can easily be used in

combination with a pre-harvest sales strategy that commits guaranteed insurance bushels to delivery.

• Use of forward contracts and/or HTA contracts are common tools for selling crop insurance bushels committed to delivery.

• Bushels that you prefer not to commit to delivery, consider protecting prices using futures hedges and/or buying put options.

• .

Marketing New Crop

• The 5-year seasonal crop price patterns favor new crop futures to peak during the spring and summer months.

Seasonal Patterns

31

• The traditional 5-year seasonal crop price pattern favored new crop futures peaking during spring & summer months.

• Recently, it appears the seasonals have flattened. Market with revenue margins as the objective!

Seasonal Patterns

31

Crop Marketing Matrix

Futu

res

Pric

eFu

ture

s Pr

ice

Basis Basis

1. Store & wait2. Delayed price contract3. Minimum price contract

(open basis)

1. Basis contract2. Sell Cash Bushels and

Buy Futures or Call Option3. Minimum price contract (fixed basis)

1. Hedge2. Non-roll hedge to arrive3. Buy put option

1. Cash sale now2. Forward Contract

43

Corn and soybean marketing simulation

Practice with forward contracts, futures & options

Periodic e-mails to support learning

The simulation will end in October, 2014.

Participants are invited to play the Commodity Challenge simulation

to experiment with marketing tools and planning.

The plan is to market the insurance guaranteed bushels before harvest:

Corn APH of 180 bpa X 600 acres = 108,000 bushels; 75% is 81,000 bu. available to market.

Soybean APH of 50 bpa X 600 acres = 30,000 bushels; 75% is 22,500 bu. available to market.

2014 New Crop Iowa Commodity Challenge

Click Click JoinJoin

Go to www.commoditychallenge.comGo to www.commoditychallenge.com

Click Click JoinJoin

Fill out Fill out the formthe form

Including Including password password you createyou create

Click Find a Click Find a Game, select the Game, select the 2014 New Crop Iowa Commodity Challenge and click joinand click join

Enter the Enter the game game passwordpassword

www.extension.iastate.edu/agdm/info/icc.html

Web address on page #47

Written Plan to manage emotions

Marketing Tools Workbook

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Updated Weekly Tracking Table and Charts on: www.extension.iastate. edu/agdm/info/icc.html

Online Curriculumwww.extension.iastate.edu/agdm/info/icc.html

Marketing Tools Workbook

For Questions about this program, please contact:

Chad Hart Assoc. Professor

of Economics, Iowa State University

chart@iastate.edu

Steve JohnsonISU Extension

Farm Management Specialist

sdjohns@iastate.edu

Ed Kordick Commodity Services

Manager,Iowa Farm Bureauekordick@ifbf.org