AGEC 314 Exam 2

A futures price is a ________. The value depends on an ________ __________.

"derivative"; underlying asset

Sell @ 361'1 Buy @ 356'4

$3.6175 - $3.5650 = 0.0525 0.0525 x 5000 bu = $212.50 total PROFIT of $212.50

Commodity Futures Exchange

- A marketplace for persons interested in buying or selling commodities - based on today's information and the perception of where prices will be in the future.

Motivations to Contract

- Allocation of Value: EX) at the end sale, 30% of final value is given to the farmer that is the contractee because of production expenses - Allocation of Decision Rights: EX) if you have a production contract, the rights of buyer are in place so the are able to make decisions - Allocation of Risk: EX) if an animal dies is the buyer or a contractee responsible for it?

Hedgers

- An individual or firm that uses the futures market to manage or reduce price risk associated with their cash market position - ***CASH MARKET POSITION (deals with physical commodity)

The CME Group consists of which groups?

- CME (meat) - CBOT (corn, soybeans) - KCBOT (winter wheat) - NYMEX (coffee, cotton, oj, sugar, cocoa)

Why do we grade?

- Contributions to operational efficiency - Contributions to pricing efficiency

Challenges of Grading

- Do Grades reflect consumer preference - What about subjective judgements by graders - Are graders honest? - Do the grades measure quality as perceives by buyers? - What about quality deterioration after grading?

Organized Markets

- KEY: structured to give buyers and sellers public access to one another - also referred to as public markets - high level of price efficiency is expected!

Advantages of Pricing Systems

- Minimize transaction cost: least transaction cost is the electronic organized market - Spatial pricing efficiency: greatest potential for efficiency - Level and Stability of prices: government helping with price floors/ceilings - Integrity and Equity of the price making process: price manipulation in a thin market

Price Quote Keywords

- Open (price of first trade of the session) - High (highest price during the session) - Low (lowest price during the session) - Last (most recent price) - Close (closing range of prices, final minutes) - Settle/Prior (average of the closing prices) - Net Change (change from previous settle)

Disadvantages of Hedging

- Reduce exposure of price risk - Margin Calls - Basic risk is LESS than price risk

Buying Futures (LONG)

- The person who agrees to buy at the future date is said to have bought the futures contract or to be LONG futures - If you buy futures, you are agreeing to purchase something at a future date

Selling Futures (SHORT)

- The person who agrees to sell at the future date is said to have sold the futures contract or to be SHORT futures - By agreeing to sell something at a future date (you do not have to have the physically commodity now)

Marketing-Pricing Alternatives

- Timing of Price - Timing of Delivery - Timing of Sale - Contracting - Forward pricing in cash or futures markets - Pooling (cooperatives)

Price Ceiling

- a maximum price that can be legally charged for a good or service - not typically used in agriculture because it would disrupt the food markets (market shock, cobweb model, biological lag, administrative complexity)

Marketing-Procurement Contract (MP contract)

- an agreement between buyer and seller covering product, time/nature of delivery, price, and other aspects of exchange - there is a span of time between transaction happening - EX: if a packer decided 90-100 days in advance on the product their buying, price etc.

Advantages of Decentralized, Individual Negotiation (DIN)

- convenience and lower transaction cost - seller has more control

Production Contract

- involves buyer in physical production process - A farmer (or contractee) is not pricing the animals, they are getting paid for time labor and inputs in the process of production.

Disadvantages of Decentralized, Individual Negotiation (DIN)

- knowledge of alternate market options is low - lack of information and negotiating skills - information is SLOW***

Price Support (floor)

- legal price set above equilibrium - causes surplus - much more common in agriculture (help stabilize farm income)

Decentralized, Individual Negotiation (DIN)

- less formalized, public, structured but increasingly common pricing system in agriculture - referred to as 'haggling' or 'private treaty'

Vertical Coordination

- ownership of contiguous stages in the marketing channel - Vertically Integrated IF each level of production can produce a marketable product - EX: feed company that owns its own livestock, Sam's Club (they sell retail but they have their own processing firm)

Organized Markets (Electronic Version)

- saves TIME and MONEY related to travel and commodity transportation - there is a higher number of participants in the market so they become more efficient - eBay is a successful electronic market - In Ag, electronic trading has been revolutionary (commodity exchange)

Grading

- sorting of a commodity into quality classifications - used for commodities which will be turned into differentiated goods - MUST benefit trading - typically voluntary (except if export markets have to be federally inspected/graded)

Price Discovery Systems

- the process of buyers and sellers arriving at prices for a commodity when market conditions do not permit either group to set prices - occurs when all participants are price TAKERS or NEGOTIATORS - organized markets, decentralized individual negotiation

Quality

- the sum of attributes if a commodity that influence its acceptability and value to many buyers and the price they are willing to pay - (influence how much consumers are willing to pay!)

Main Structures of Decentralized, Individual Negotiation (DIN)

1. OFFER ACCEPTANCE STRUCTURE - multiple offers and retailer picks most desirable one - product branding makes this less efficient/useful - KEY: size of transaction, large packing companies (large corporations will not bother with a tiny retailer) 2. FORMULA PRICING - most commonly done with meat commodities - useful for participants that deal with each other a lot - sets a formula and sticks to it - LIMITATION: depends on a base price determined in an organized market or by active individual negotiation

Functions of Futures Markets

1. Risk Transfer 2. Price Discovery 3. Public Access to Information

Contributions to Pricing Efficiency

1. increased recognition of value differences 2. better allocation according to demand (consumers want higher quality products, so there will be a premium for high quality products for producers) 3. better market news 4. facilitating futures trading 5. broadening the market

Contributions to Operational Efficiency

1. saves time for traders 2. saves tume for consumers 3. saves time for lenders 4. permitting mixing of separately owned commodities in storage and pooled sales (EX. if 100 farmers deliver wheat, they will record amount each farmer brings they will take a sample of every truckload and then will be graded, based on quality it will be put into different bins)

Prices may be set by which three parties?

1. sellers 2. buyers 3. government

What year was CBOT founded?

1848

What year were futures contracts developed as an improvement on forward contracts?

1865

Thin Market

A market with few buyers and few sellers

What is a Futures Contract?

An agreement between buyers and sellers to make delivery (i.e., sell) or to take delivery of (i.e., buy) a given quantity and quality of a commodity at a specified price and on a specified future date.

Why are both the buyer and seller required to deposit margin money?

Both participants have the risk of losing money

Where does futures trading occur?

Chicago (main domestic futures exchanges)

If you are a long hedger...

FUTURES: buy futures -> long futures position CASH: buy -> short cash position

If you are a short hedger....

FUTURES: sell futures (short) CASH: sell cash (long)

What is the Bushel amounts?

Grains: 5000 bu Mini Grains: 1000 bu Livetsock: not standardzied (will be given in the problem)

Who are the market participants?

Hedger and Speculator

Hog and Pork Grades

Homogenous demand and alterable supplies

You have 150 head of cattle to market, you can use an organized public market (auction) or electronic market or using a decentralized individual negotiation structure. What are the disadvantages/advantages of your choice? ***POSSIBLE TEST QUESTION

I would choose an electronic market because its eBay for cattle, transaction costs are lower and it will reach more people

A profit on futures ______ a short hedgers realized price

Increases

Initial Margin

Initial deposit when the position opened

Market Liquidity

Measure of the markets efficiency

Considerable diversity is inevitable in commodities marketed from agriculture because of ____________.

Mother Nature (EX. drought v. flooding)

Is the margin a down payment for a purchase?

NO

NB

New Buyer

NS

New seller

In Futures Contract, everything is standardized, except __________.

PRICE

Margins are also called ________.

Performance Bonds

Fruit and Vegetable Grades

Presumed to be Homogenous

Milk and Dairy Product Grades

Quality of milk is alterable (different from other foods because they talk about wholesomeness of milk vs the quality)

Advantages of Hedging

Reduce exposure of price risk

Why do producers not hedge?

Risk of harvest failure

How do we communicate quality & type?

Standardization (commodity grades)

Open Interest

Total number of contracts open (not offset). Each open contract has a buyer and seller. Cumulative - starts today where it ended yesterday.

Public Access to Information

Used for decision making

What is Hedging?

Using futures to manage (reduce) price risk - lock in price now - protecting yourself - NOT an effort to have a profit in the futures

Homogeneous Demand

When buyers agree on the ordinal relationships of the various qualities (grades) of a commodity. For example, buyers may agree that grade X is better than grade Y

Heterogenous Demand

When two or more groups of buyers disagree on the ranking of various qualities (grades) of a commodity

Margin Call

a request for additional money to meet the maintenance margin

Transaction Cost

all the costs incurred by a buyer/seller as they make complete deals (ex. transportation, time it took to find buyer/seller)

Speculators

an individual or firm that assumes price risk by buying or selling livestock futures in an attempt to profit from a potential change in price or price relationship

transaction cost

any other costs the buyer or seller incurs in the transaction

What is a long hedge?

buying the futures

Changing Basis

can either improve or reduce the price protection of the hedge

Prices are typically discovered for _______

commodities

Motivations for Vertical Integration

control prices and quality

What agricultural commodity has the largest volume?

corn

A loss on futures ________ a short hedgers realized price

decreases

A profit on futures _______ a long hedgers realized price

decreases

What groups are considered HEDGERS?

essentially anyone who is HANDS ON with the commodity - farmers/livestock producers - merchandisers, elevators - food processors, feed manufacturers - exporters and importers

Price Setting Systems

firm price making, group negotiation, government price setting

Risk Transfer

from hedges to speculators

If short cash...

hedge by going on long futures

If long cash ....

hedge by going short futures

In a short hedge, if prices rise, there is a _______________ but a _____ on futures.

higher cash price; loss

A strengthening hedging basis...

hurts a long hedger (bc stronger basis means your paying more out of pocket) helps a short hedger

A weakening hedging basis...

hurts a short hedger (bc it means you get less money in your pocket per bushel) helps a long hedger

A loss on futures ______ a long hedgers realized price

increases

when do livestock contracts expire?

last business day of the month

LL

long liquidation (selling futures position to liquidate long futures)

In a short hedge, if prices fall, there is a ____________ but a _______ on futures.

lower cash price; profit

Speculators provide a major benefit to hedgers and the marketplace by _____ ________.

market liquidity

Pricing System

market mechanism or process by which market participants discover, negotiate, or fix prices

Maintenance Margin

minimum amount to be maintained

Volume

number of contracts traded in a specified period ***STARTS AT 0 EVERYDAY***

Price Discovery

persons interact to use assimilated information to determine a market clearing price based on different perceptions of where supply and demand factors will be in the future

What is a short hedge?

selling the futures

SC

short covering (buying futures to cover that short)

What is the main difference between the stock market and the futures market?

stocks are assets whereas futures contracts are derivatives

Transaction cost are important in determining __________.

system's popularity

How do you hedge?

taking a position in the futures market that is opposite to the position in cash

What are margins set by?

the exchange

Contract Expiration

the last business day prior to the 15th

What is transaction price?

the money the buyer gives to the seller