Hedging Against Falling Live Cattle Prices using Live Cattle Futures

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Hedging Against Falling Live Cattle Prices using Live Cattle Futures

Live Cattle producers can hedge against falling live cattle price by taking up a position in the live cattle futures market.

Live Cattle producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of live cattle that is only ready for sale sometime in the future.

To implement the short hedge, live cattle producers sell (short) enough live cattle futures contracts in the futures market to cover the quantity of live cattle to be produced.

Live Cattle Futures Short Hedge Example

A feedlot operator has just entered into a contract to sell 4.00 million pounds of live cattle, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of live cattle on the day of delivery. At the time of signing the agreement, spot price for live cattle is USD 0.8445/lb while the price of live cattle futures for delivery in 3 months’ time is USD 0.8400/lb.

To lock in the selling price at USD 0.8400/lb, the feedlot operator can enter a short position in an appropriate number of CME Live Cattle futures contracts. With each CME Live Cattle futures contract covering 40,000 pounds of live cattle, the feedlot operator will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the feedlot operator will be able to sell the 4.00 million pounds of live cattle at USD 0.8400/lb for a total amount of USD 3,360,000. Let’s see how this is achieved by looking at scenarios in which the price of live cattle makes a significant move either upwards or downwards by delivery date.

Scenario #1: Live Cattle Spot Price Fell by 10% to USD 0.7601/lb on Delivery Date

As per the sales contract, the feedlot operator will have to sell the live cattle at only USD 0.7601/lb, resulting in a net sales proceeds of USD 3,040,200.

By delivery date, the live cattle futures price will have converged with the live cattle spot price and will be equal to USD 0.7601/lb. As the short futures position was entered at USD 0.8400/lb, it will have gained USD 0.8400 – USD 0.7601 = USD 0.0800 per pound. With 100 contracts covering a total of 4000000 pounds, the total gain from the short futures position is USD 319,800

Together, the gain in the live cattle futures market and the amount realised from the sales contract will total USD 319,800 + USD 3,040,200 = USD 3,360,000. This amount is equivalent to selling 4.00 million pounds of live cattle at USD 0.8400/lb.

Scenario #2: Live Cattle Spot Price Rose by 10% to USD 0.9290/lb on Delivery Date

With the increase in live cattle price to USD 0.9290/lb, the live cattle producer will be able to sell the 4.00 million pounds of live cattle for a higher net sales proceeds of USD 3,715,800.

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However, as the short futures position was entered at a lower price of USD 0.8400/lb, it will have lost USD 0.9290 – USD 0.8400 = USD 0.0890 per pound. With 100 contracts covering a total of 4.00 million pounds of live cattle, the total loss from the short futures position is USD 355,800.

In the end, the higher sales proceeds is offset by the loss in the live cattle futures market, resulting in a net proceeds of USD 3,715,800 – USD 355,800 = USD 3,360,000. Again, this is the same amount that would be received by selling 4.00 million pounds of live cattle at USD 0.8400/lb.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the live cattle seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling live cattle prices while still be able to benefit from a rise in live cattle price is to buy live cattle put options.

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Hedging Against Rising Live Cattle Prices using Live Cattle Futures

Businesses that need to buy significant quantities of live cattle can hedge against rising live cattle price by taking up a position in the live cattle futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of live cattle that they will require sometime in the future.

To implement the long hedge, enough live cattle futures are to be purchased to cover the quantity of live cattle required by the business operator.

Live Cattle Futures Long Hedge Example

A meat packer will need to procure 4.00 million pounds of live cattle in 3 months’ time. The prevailing spot price for live cattle is USD 0.8445/lb while the price of live cattle futures for delivery in 3 months’ time is USD 0.8400/lb. To hedge against a rise in live cattle price, the meat packer decided to lock in a future purchase price of USD 0.8400/lb by taking a long position in an appropriate number of CME Live Cattle futures contracts. With each CME Live Cattle futures contract covering 40000 pounds of live cattle, the meat packer will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the meat packer will be able to purchase the 4.00 million pounds of live cattle at USD 0.8400/lb for a total amount of USD 3,360,000. Let’s see how this is achieved by looking at scenarios in which the price of live cattle makes a significant move either upwards or downwards by delivery date.

Scenario #1: Live Cattle Spot Price Rose by 10% to USD 0.9290/lb on Delivery Date

With the increase in live cattle price to USD 0.9290/lb, the meat packer will now have to pay USD 3,715,800 for the 4.00 million pounds of live cattle. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the live cattle futures price will have converged with the live cattle spot price and will be equal to USD 0.9290/lb. As the long futures position was entered at a lower price of USD 0.8400/lb, it will have gained USD 0.9290 – USD 0.8400 = USD 0.0890 per pound. With 100 contracts covering a total of 4.00 million pounds of live cattle, the total gain from the long futures position is USD 355,800.

In the end, the higher purchase price is offset by the gain in the live cattle futures market, resulting in a net payment amount of USD 3,715,800 – USD 355,800 = USD 3,360,000. This amount is equivalent to the amount payable when buying the 4.00 million pounds of live cattle at USD 0.8400/lb.

Scenario #2: Live Cattle Spot Price Fell by 10% to USD 0.7601/lb on Delivery Date

With the spot price having fallen to USD 0.7601/lb, the meat packer will only need to pay USD 3,040,200 for the live cattle. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the live cattle futures price will have converged with the live cattle spot price and will be equal to USD 0.7601/lb. As the long futures position was entered at USD 0.8400/lb, it will have lost USD 0.8400 – USD 0.7601 = USD 0.0800 per pound. With 100 contracts covering a total of 4.00 million pounds, the total loss from the long futures position is USD 319,800

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the live cattle futures market and the net amount payable will be USD 3,040,200 + USD 319,800 = USD 3,360,000. Once again, this amount is equivalent to buying 4.00 million pounds of live cattle at USD 0.8400/lb.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the live cattle buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising live cattle prices while still be able to benefit from a fall in live cattle price is to buy live cattle call options.

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Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

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Understanding Put-Call Parity

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Valuing Common Stock using Discounted Cash Flow Analysis

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Hedging Against Falling Live Cattle Prices using Live Cattle Futures

Hedging with futures is one of the marketing tools that can be used to forward price a commodity to protect against a price movement.

This article reviews the basics of hedging using a Chicago Mercantile Exchange (CME) live cattle futures contract as a short hedge (selling) for protection against a potential price decline. This discussion only considers the hedging of cattle and not the value of the Canadian dollar versus the American dollar.

A good starting point is to become familiar with some of the common futures trading terms.

  • Short – is to sell a futures contract when participating in the futures market
  • Long – is to buy a futures contract when participating in the futures market
  • Hedge – taking a futures market position that is equal and opposite a cash market position
  • Short Hedge – is to sell a futures contract. This is to protect against the risk of a decrease in the commodity price to be sold in the cash market in the future.
  • Long Hedge – is to buy a futures contract. This is to protect against the risk of an increase in the commodity price to be purchased in the cash market in the future.
  • Offset – is to take the opposite position of the original futures contract for the same delivery month. i.e. a seller of a futures contract (short position) offsets by purchasing (long position) the same number of contracts for the same delivery month
  • Basis – the difference between the local cash price and a nearby futures price
  • Nearby Futures – is the next delivery month or sometimes called the spot month
  • Margin – money deposited by both the sellers and buyers of futures contracts as a performance bond to ensure the terms of the contract are met.

The OMAFRA factsheet, “Managing Commodity Price Risk Using Hedging and Options” available at www.omafra.gov.on.ca/english/busdev/facts/08-053.pdf provides further explanations.

What is a futures contract?

A futures contract is a standardized agreement that states the commodity, quantity, quality, expiry date and whether it is deliverable or cash settled. Futures contracts are traded (sold and purchased) on regulated exchanges (i.e. CME) to establish a price.

A CME live cattle contract is for 40,000 pounds. Therefore the number of head it represents will depend on the live market weight of cattle. For example, for cattle marketed at 1,450 pounds a futures contract would represent approximately 27 head. Contracts are available for the months of February, April, June, August, October, and December. They expire the last business day of the contract month. For example, the December 2020 live cattle contract will expire on December 30, 2020. Live cattle futures contracts are deliverable upon expiry. To remove the obligation to make or take delivery of cattle, the futures contract needs to be offset prior to expiry. In fact, very few futures contracts are delivered upon, they are offset. Generally, the trading in futures contracts is not for the exchange of the physical commodity, but rather it is the trading of obligations. Complete contract specifications for live cattle (and other futures contracts) are provided on the CME Group website (www.cmegroup.com).

Who trades futures contracts?

There are basically two types of traders who participate in the futures market, hedgers and speculators. Hedgers produce or use (i.e. farmers and packers) the physical commodity (i.e. live cattle) and trade futures with the goal to reduce price risk or establish prices for a commodity. Speculators generally do not trade or use the physical commodity. They trade futures to profit from the price movement in the futures market. Remember, for every seller there is a buyer and for every buyer there is a seller.

There are two types of hedgers, a short hedger who wants to protect against a price decline and a long hedger who wants to protect against a price rise. An example of a short hedger would be a cattle producer finishing cattle who wants to protect a future price against a potential decline. To start the hedge they would sell a live cattle futures contract. An example of a long hedger would be a cattle producer who needs corn for feed and who wants to protect a future corn price against a potential increase. To start the hedge he would buy a corn futures contract.

What is hedging with futures?

To hedge is to take a futures position that is equal and opposite to a position held in the cash market. The objective is to manage the risk of an adverse move in prices. Hedging works because futures and cash prices both respond to the underlying forces of supply and demand. This means they both tend to move together and in the same direction over time. Also, the futures contract delivery provision (or threat of delivery) helps to ensure the futures and cash prices eventually move together.

Example of a cattle short hedge

  • Cattle were purchased at the end of March 2020 and fed to be marketed the end of September 2020.
  • At the end of March the October 2020, live cattle futures were valued at US$125 per cwt. The risk was that cattle prices could fall prior to the cattle being ready to market. Also, a potential profit could be realized at this price level.
  • To protect against declining prices, a short hedge was put in place by selling one CME live cattle futures October 2020 contract for US$125 per cwt. The estimated market price was C$111.35 per cwt. This was based on a Canadian dollar being worth $1.03 U.S. and a historical basis of minus C$10 per cwt. for cattle being marketed the end of September (US$125 ÷ 1.03 – $10).
  • The cattle were fed and sold to a packer at the end of September for C$106.66 per cwt weighing 1,450 pounds. At the same time the CME live cattle futures October 2020 contract was offset by purchasing one October 2020 contract for US$120 per cwt.
  • The futures contract was sold for US$125 and purchased for US$120 for a gain of US$5 per cwt. The value of the Canadian dollar was 97 cents U.S. making a futures contract gain of $5.15 per cwt. Canadian.
  • By hedging, a price of C$111.81 per cwt was realized. This was made up of the $106.66 per cwt from the cash market and $5.15 per cwt from the futures. This was based on the futures contract representing approximately 27 head of cattle at 1,450 pounds (i.e. 40,000 pounds per contract ÷ 1450 per head).
  • The other costs that need to be accounted for are the brokerage fees (i.e. 12.5 cents per cwt. assuming a $50 fee/contract) and carrying costs (cost to carry the margin account, for this example would have been minimal to zero).

A short hedge provides protection against declining prices. If prices had gone up in the above example, the value realized from the futures hedge would have declined but the cash price should have increased since the two prices generally move in the same direction over time (not necessarily the same amount). The difference between the local cash price and the futures price is the basis.

What is the basis?

  • Basis is the difference between the local cash price and the nearby futures price.
  • Basis = Local Cash Price C$/cwt – (Nearby month CME live cattle futures price US$/cwt X exchange rate)
  • For example, assume the Ontario cattle price is C$106.66 per cwt, the nearby month CME live cattle futures price is US$120 per cwt and the exchange rate is $1.03

Basis = $106.66 – ($120 X 1.03) = $106.66 – $123.60 = -$16.94/cwt

What is margin?

Futures trading is conducted using a margin account. When a futures trader enters into a futures position they are required to post an initial margin amount as specified by the futures exchange.

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