314 exam 2

Margin- money deposited by both the buyer and the seller - Accounts adjusted ("marked-to-market") daily -Based on closing (settlement) price -Reflects gains/losses on open positions

*MARGIN IS ALSO CALLED A PERFORMANCE BOND*

BASIS =

CASH - FUTURES

Method 2:

Cash Price+ result on futures (if hedger is long then you subtract instead of add)

Differences in futures vs forward contracts

Differences: Most futures contracts do not result in delivery—Standardization —Ability to offset/cancel

The stock market and the futures market are ___ the same.

NOT

Price Quotes

Open - price of the 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 (Prior) Settle - average of the closing range Net Change - change from the previous settle E.g.: +6'4 = up 6 ½ from the previous settle

Futures Market Functions-

Risk transfer- Price Discovery- Public assess to information-

ELECTRONIC ORGANIZED MARKETS

Saves time and costs related to travel and commodity transportation. example- eBay. — has been nearly revolutionary

Months grain traded-

Wheat and Corn: March (H), May (K), Jul (N), Sep (U), Dec (Z) Soybeans: Jan (F), March (H), May (K), Jul (N), Aug (Q), Sep (U), Nov (X)

Pricing Systems

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

Hedger -

a person or firm that uses the futures market to manage or reduce the price risk associated with their cash market position. (a livestock seller usually buys or sells the physical product or by-product in the cash market) **(hedgers will choose the futures contract that matches the physical market commodity)

Motivations to contract-

allocation of value allocation of decision rights all of risk

Futures contract

an agreement between a buyer and a seller that requires the seller to deliver and the buyer to accept the delivery of a "specific amount" of a "specific commodity" at a "specific location" at some "specific future date" at a negotiated price.

Motivations for vertical integration

control prices and quality (example- HEB)

Fruit/vegetables-

demand for most is homogeneous

Futures price is a ____ the value depends on an underlying asset.

derivative

Contract Expiration

the last business day prior to the 15th

**Chicago remains the location of the main domestic futures exchange**

-- chapter 10

advantages and disadvantages of price discovery systems

-Advantages: convenience, lower transaction costs, seller has more control. -Disadvantages: not much knowledge of alternate market options, lack of information and negotiating skills

Hedging Hazards

-Changing basis -Failure to distinguish between hedging and speculating -Hedging too early in rising markets or too late in declining markets -Inadequate liquidity to finance margin calls -Production shortfalls

Challenges of Grading

-Do grades reflect consumer preferences? -Are graders honest? -How much diversity within a grade should be allowed? -Do the grades measure quality as perceived by buyers?

Margin Accounts:

-Is the margin a down payment for a purchase? No! -Why are both buyer and seller required to deposit? Both participants have the risk of losing $$$

MARKETING-PRICING ALTERNATIVES

-Timing of pricing. -Timing of delivery -Forward pricing in cash or futures markets -Timing of sale. -Contracting -Pooling

Contractual Exchange Arrangements-

-marketing procurement contract -vertical coordination -production contract

formula pricing-

-useful for participants that deal with each other a lot. -sets a formula and sticks to it until it needs to be renegotiated

types of price discovery systems

1- Organized markets 2-Organized markets- Electronic Version 3- Decentralized, individual negotiation

advantages in futures vs forward contracts

1- Performance is guaranteed in futures contract -with a futures contract, the exchange acts as a "middle-man" in every contract. - every buyer and seller deposits "margin" money with the exchange - this procedure is termed "clearing" 2. Standardized (transferable) terms- - all contracts are identical. - same quantity -same quality -same time -same location (only thing negotiated is price)

types of price setting systems

1- Price Ceiling. 2- Price Support

- a farmer ____ has a production contract when they take responsibility for caring for broilers or feeding pigs owned by another party called a _______

1- contractee 2-contractor

Contributions to pricing efficiency

1- increased recognition or value differences 2-better allocation according to demand 3- better market news. 4-facilitating futures trading 5- broadening the market

Contributions to operational efficiency

1- saves time for traders 2- saves time for consumers. 3- saves time for lenders. 4- permitting the mixing of separately owned commodities in storage and pooled sales

Liquidity -

A measure of the efficiency of the market. Efficiency results in better bids and offers for all market participants, including the hedger. The key to initiate and offset futures positions.

Forward Contract-

An agreement between a buyer and seller to exchange something at some future date Performance is NOT guaranteed.

strengthening vs weakening

Basis becomes more positive or less negative - strengthening Basis becomes more negative or less positive - weakening

Milk and dairy-

Grades for whole milk consumption are different from most other food grades. Quality of milk is alterable

Short vs long positions

In the cash market- sell= long. buy=short In the futures market- sell= short. buy=long

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 individual price takers or price negotiators -Prices are usually discovered for commodities -Continually rediscover prices

Factors that determine basis

Transportation costs Local supply and demand conditions Quality variation from underlying futures contract specifications Availability of substitutes

Marketing procurement contract

an agreement between and seller and a buyer covering the product, time, and nature of delivery, price, and other aspects of an exchange in which some of the terms do not take place at the time of the immediate transaction.

Speculator -

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. Usually does not hold or plan to acquire the cash product. Provide a major benefit to hedgers and the marketplace- MARKET LIQUIDITY

**Understand graphs of price ceiling and price support**

can be found in chapter 7 notes

Price-Setting system-

can be made or set by buyers, seller, or government

Homogeneous demand

demand for quality. When buyers agree on the ordinal relationships of the various qualities of a commodity.

limitation of formula pricing

depends on a base price determined in an organized market or by active individual negotiation.

Grain-

developed during the 1920s, generally homogeneous, may decline by one or more grade during shipment overseas due to broken kernels and dust. (Issues- mold and dust explosions)

all of risk:

establishes who bears the costs should something go wrong.

offer-acceptance structure

example:retailer asks that all bids are placed on Monday and then accepts the most desirable. (Product branding makes this less useful)

Risk transfer

from hedgers to speculators

Grading of Selected Commodities-

homogeneous demand and alterable supplies

Hog/pork

homogeneous demand and alterable supplies Usually the yield grades are used for transactions between producers, packers, and market news reports. **Grades of beef and pork carcasses do not change once assigned.**

Beef cattle-

homogeneous demand and alterable supplies. Dual characters Yeild and Quality grades. Yield grades- the classification of beef carcasses according to how lean they are, numbered 1-5. Select, choice, prime, **Grades of beef and pork carcasses do not change once assigned.**

-allocation of value:

how to share of the value of the commodity or product being produced is allocated

ORGANIZED MARKETS

important historically and now, structured to give all potential buyers and sellers easier access (publicly) to each other as they discover prices, referred to as public markets since the operation is mainly public, high level of price efficiency is expected.

Method 1:

initial futures + actual basis

Production contract-

involves the buyer in the physical process

Volume-

is the number of contracts traded in a specified period (usually a day). -Starts at zero every day -Especially important for technical analysis - the charting of trends in current and historical price and trading patterns to predict future price direction

Open Interest-

is the total number of contracts open (not offset). -not the same as volume! - also important for technical analysis

Price limits -

largest permitted change from the previous close— Example: Soybeans - limit is +/- $1.15/bu Sep Soybean contract settled at $14.00/bu on August 25th The market would be "limit down" at $12.85; at $15.15, the market would be "limit up"

DECENTRALIZED, INDIVIDUAL NEGOTIATION-

less formal, less public, less structured, but an increasingly common pricing system in agriculture. -Referred to as "Haggling" or "Private Treaty"

-If short cash hedge by going

long futures (long = buy) E.g.: If you need to buy corn, buy futures. Short vs long hedge

advantages of price setting systems

minimizes transactions costs, spatial pricing efficiency, level and stability of prices, integrity and equity of the price-making process.

History of futures trading

n the 19th century, Chicago was growing as a grain terminal. Eventually, a problem arose. At harvest, there was an oversupply of grain, and grain was dumped.— 1848, the CBOT was founded, this started "forward contracts" — 1865 futures contracts were developed.

Farmers, livestock producers

need protection against declining prices for crops or livestock, or against rising prices of purchased inputs

Food Processors, feed manufacturers-

need protection against increasing raw material costs or against decreasing inventory values.

Merchandisers, elevators-

need protection against lower prices between the time they purchase or contract to purchase grain from farmers and the time it's sold.

Vertical coordination-

ownership of contiguous stages in the marketing channel

Price Discovery

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

BUYING FUTURES

person agrees to buy at a future date. (LONG FUTURES)

SELLING FUTURES

person agrees to sell at a future date (SHORT FUTURES)

allocation of decision rights:

provisions of the contract that require the grower to follow a certain protocol

If long cash hedge by going

short futures (short = sell) E.g.: If you are growing wheat, sell

Grading -

the sorting of a commodity into quality classifications - each class has distinctive acceptability to a significant group of buyers Grading is typically voluntary and must benefit trading!!

Quality -

the sum of the attributes of a commodity that influence its acceptability and value to many buyers and the price they are willing to pay.

THE BIG ISSUE (pricing systems)

transaction costs!! ( all costs made by a buyer or seller as they make and complete deals ). *important in determining the system's popularity*

Public assess to information

used for decision making

Hedging-

using futures to manage (reduce) price risk Hedge by taking a position in the futures market that is opposite to the position in cash. -Which contract? Most producers don't fully hedge! -Which month? Futures that is nearly at the time you plan to buy/sell -Why does it often work? they move close enough in the same direction to allow for effective use of futures as a price insurance tool.

Heterogeneous demand-

when 2 or more groups of buyers give different rankings to various qualities.