Risk Management 101: Part 3

Sep 26, 2023 | Uncategorized

Over the past few posts, we’ve been learning about Risk Management (RM) from our ESP Devin Patton.

Now it’s time to see a real world example of what he’s been teaching us…

Refresh. A futures contract is for a specific quality and quantity of a specific commodity. 5,000 bu. of number 2 Yellow corn is what a corn futures contract represents. A short hedger example:
 
A 50,000 bu corn farmer in the western corn belt decides to hedge 15,000 bushels of his normal production early in the season. He shorts (or sells) 3 futures contracts on December delivery at $5.25/bu and deposits $5,000 into his hedge account for initial margin capital.

As harvest approaches, the regional Ethanol plant suddenly bumps their Basis bid from it’s typical –20 to +10 for harvest delivery. He calls and sells the 15,000 bushels he hedged at +10 basis for fall delivery and then lifts his hedge by buying his 3 contracts back at $4.80/bu.

By using futures contracts to hedge against a price drop for some of his production, he was able to capitalize on the 30 cent/bu basis bid increase, without risking the flat price. If he had not hedged at $5.25, he would have lost 45 cents/bu before gaining the 30 cents on the increase in basis, a net negative of 15 cents/bu. Had he simply sold instead of hedged his net cash sale would have been $5.05 ($5.25 futures and –20 cent basis.)

Instead, he was able to get $5.35 ($5.25 futures and +10 cent basis) as a result of hedging futures market and waiting for an opportunity to sell a stronger basis.

While this example does demonstrate a good net result of the hedged 15,000 bushels of corn, the remaining 35,000 bushels of his expected production went unhedged and lost 45 cents of futures market value.

This is a better net result than being 100% unhedged, but it is the risk tradeoff of being partially hedged and hopeful for higher prices.

In a perfect world, we would be 100% hedged when we know the market is going down, and 100% unhedged when we know the market will go higher.

The reality is that we don’t know anything with complete certainty, and can only make risk tradeoffs using the tools we have available.  

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