Hedging Against Rising Feeder Cattle Prices using Feeder Cattle Futures

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Hedging Against Rising Feeder Cattle Prices using Feeder Cattle Futures

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

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

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

Feeder Cattle Futures Long Hedge Example

A feedlot operator will need to procure 5.00 million pounds of feeder cattle in 3 months’ time. The prevailing spot price for feeder cattle is USD 0.9520/lb while the price of feeder cattle futures for delivery in 3 months’ time is USD 0.9500/lb. To hedge against a rise in feeder cattle price, the feedlot operator decided to lock in a future purchase price of USD 0.9500/lb by taking a long position in an appropriate number of CME Feeder Cattle futures contracts. With each CME Feeder Cattle futures contract covering 50000 pounds of feeder cattle, the feedlot operator 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 feedlot operator will be able to purchase the 5.00 million pounds of feeder cattle at USD 0.9500/lb for a total amount of USD 4,750,000. Let’s see how this is achieved by looking at scenarios in which the price of feeder cattle makes a significant move either upwards or downwards by delivery date.

Scenario #1: Feeder Cattle Spot Price Rose by 10% to USD 1.0472/lb on Delivery Date

With the increase in feeder cattle price to USD 1.0472/lb, the feedlot operator will now have to pay USD 5,236,000 for the 5.00 million pounds of feeder cattle. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the feeder cattle futures price will have converged with the feeder cattle spot price and will be equal to USD 1.0472/lb. As the long futures position was entered at a lower price of USD 0.9500/lb, it will have gained USD 1.0472 – USD 0.9500 = USD 0.0972 per pound. With 100 contracts covering a total of 5.00 million pounds of feeder cattle, the total gain from the long futures position is USD 486,000.

In the end, the higher purchase price is offset by the gain in the feeder cattle futures market, resulting in a net payment amount of USD 5,236,000 – USD 486,000 = USD 4,750,000. This amount is equivalent to the amount payable when buying the 5.00 million pounds of feeder cattle at USD 0.9500/lb.

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Scenario #2: Feeder Cattle Spot Price Fell by 10% to USD 0.8568/lb on Delivery Date

With the spot price having fallen to USD 0.8568/lb, the feedlot operator will only need to pay USD 4,284,000 for the feeder cattle. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the feeder cattle futures price will have converged with the feeder cattle spot price and will be equal to USD 0.8568/lb. As the long futures position was entered at USD 0.9500/lb, it will have lost USD 0.9500 – USD 0.8568 = USD 0.0932 per pound. With 100 contracts covering a total of 5.00 million pounds, the total loss from the long futures position is USD 466,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the feeder cattle futures market and the net amount payable will be USD 4,284,000 + USD 466,000 = USD 4,750,000. Once again, this amount is equivalent to buying 5.00 million pounds of feeder cattle at USD 0.9500/lb.

Risk/Reward Tradeoff

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

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

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Hedging Against Falling Feeder Cattle Prices using Feeder Cattle Futures

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

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

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

Feeder Cattle Futures Short Hedge Example

A feeder cattle producer has just entered into a contract to sell 5.00 million pounds of feeder cattle, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of feeder cattle on the day of delivery. At the time of signing the agreement, spot price for feeder cattle is USD 0.9520/lb while the price of feeder cattle futures for delivery in 3 months’ time is USD 0.9500/lb.

To lock in the selling price at USD 0.9500/lb, the feeder cattle producer can enter a short position in an appropriate number of CME Feeder Cattle futures contracts. With each CME Feeder Cattle futures contract covering 50,000 pounds of feeder cattle, the feeder cattle producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the feeder cattle producer will be able to sell the 5.00 million pounds of feeder cattle at USD 0.9500/lb for a total amount of USD 4,750,000. Let’s see how this is achieved by looking at scenarios in which the price of feeder cattle makes a significant move either upwards or downwards by delivery date.

Scenario #1: Feeder Cattle Spot Price Fell by 10% to USD 0.8568/lb on Delivery Date

As per the sales contract, the feeder cattle producer will have to sell the feeder cattle at only USD 0.8568/lb, resulting in a net sales proceeds of USD 4,284,000.

By delivery date, the feeder cattle futures price will have converged with the feeder cattle spot price and will be equal to USD 0.8568/lb. As the short futures position was entered at USD 0.9500/lb, it will have gained USD 0.9500 – USD 0.8568 = USD 0.0932 per pound. With 100 contracts covering a total of 5000000 pounds, the total gain from the short futures position is USD 466,000

Together, the gain in the feeder cattle futures market and the amount realised from the sales contract will total USD 466,000 + USD 4,284,000 = USD 4,750,000. This amount is equivalent to selling 5.00 million pounds of feeder cattle at USD 0.9500/lb.

Scenario #2: Feeder Cattle Spot Price Rose by 10% to USD 1.0472/lb on Delivery Date

With the increase in feeder cattle price to USD 1.0472/lb, the feeder cattle producer will be able to sell the 5.00 million pounds of feeder cattle for a higher net sales proceeds of USD 5,236,000.

However, as the short futures position was entered at a lower price of USD 0.9500/lb, it will have lost USD 1.0472 – USD 0.9500 = USD 0.0972 per pound. With 100 contracts covering a total of 5.00 million pounds of feeder cattle, the total loss from the short futures position is USD 486,000.

In the end, the higher sales proceeds is offset by the loss in the feeder cattle futures market, resulting in a net proceeds of USD 5,236,000 – USD 486,000 = USD 4,750,000. Again, this is the same amount that would be received by selling 5.00 million pounds of feeder cattle at USD 0.9500/lb.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the feeder 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 feeder cattle prices while still be able to benefit from a rise in feeder cattle price is to buy feeder cattle put options.

Learn More About Feeder Cattle Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

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Investing in Growth Stocks using LEAPS® options

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Effect of Dividends on Option Pricing

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

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging with the CME Feeder Cattle Index

What is the CME Feeder Cattle Index?

The CME Feeder Cattle Index (Index) is intended to serve as a benchmark for the price of cattle being placed on feed at the feedlot. Or as defined by the USDA in the monthly “Cattle on Feed” report:

“Placements are steers and heifers put into a feedlot, fed a ration which will produce a carcass that will grade select or better, and are intended for the slaughter market.”

The Feeder Cattle Index broadly represents the price of cattle purchased by feedlots that will likely grade select or higher, be placed on feed for an extended period, and finally marketed

to a packer for slaughter. The Index underlies the CME Feeder Cattle futures contract. The data used by CME to calculate the Index facilitates convergence — the tendency of the cash and futures prices to come together as the futures contract nears expiration — to the weighted average price of feeder cattle sold across 12 major feeder cattle-producing states.

The data used to calculate the Index is collected and reported by the USDA’s Agriculture Marketing Service and is publicly available. The states included in the Index are Colorado,

Iowa, Kansas, Missouri, Montana, Nebraska, New Mexico, North Dakota, Oklahoma, South Dakota, Texas and Wyoming. By defining the area and type of cattle used for calculating the Index, CME provides a reliable and publicly available benchmark for market participants to reference when making risk management decisions. USDA-AMS summaries and sales reports are available on the USDA webpage: ams.usda.gov/market-news/livestock-poultry-grain#Cattle

CME Feeder Cattle Index – 12 State Region 1

How is the CME Feeder Cattle Index Constructed?

The Index is based upon transactions from the USDA-AMS Feeder Cattle Reports, and the cattle included in the Index must meet the following criteria:

Weight and Frame Score Categories

  • 700 to 899-pound Medium and Large Frame #1 feeder steers
  • 700 to 899-pound Medium and Large Frame #1-2 feeder steers

All feeder cattle auction, direct trade, video sale and Internet sale transactions within the 12-state region for which the number of head, weighted average price and weighted average weight are reported are used in the Index calculation.

All direct trade reports are considered Friday transactions. Reports that are designated as “preliminary” are not included. Cattle identified in the report as being fancy, thin, fleshy, gaunt or full; having predominantly dairy, exotic or Brahma breeding; are currently excluded 2 . Transactions for cattle that are reported as having an origin outside of the United States are also excluded. Direct trade, video sale and Internet sales transactions must be quoted on an FOB basis, a 3% standing shrink or equivalent and with pickup within 14 days.

The Index is a seven-day weighted average and is defined as the total dollars sold during the seven-day period divided by the total pounds of feeder steers sold during the same seven- day period. Every pound of feeder steer sold during the seven- day period has the same impact on the final price.

Current and historical Index data can be found on the CME Group website here: cmegroup.com/market-data/reports/ cash-settled-commodity-index-prices.html

Why Not Physical Delivery?

Benchmark agricultural futures contracts that have maintained the physical delivery system through the years have done so because of the underlying market’s structure. Physical delivery is effective when a market has large, concentrated supply and/or demand centers. The feeder cattle market has evolved geographically over the years so that concentrated supply/demand hubs no longer represent this market. The old CME Feeder Cattle futures contract was physically delivered and had two delivery points: Oklahoma City, OK and Amarillo, TX. These locations stationed deliveries in areas with concentrations of large-scale feedlots and in relative markets that were similarly priced. This delivery system was limited by the fact that producers of feeder cattle are relatively small and geographically dispersed, leading to deliverable supply and freight issues.

The old contract required a feeder cattle owner in Iowa to haul his feeders to Oklahoma City to deliver against the contract. Because of the high cost to haul cattle that far, the basis would need to be strongly negative for it to be economical. If more delivery points were added, long/buy-side market participants would risk buying cattle that would be delivered to a location that is neither close to their operation nor has other feedlots nearby, further increasing the cost of freight.

In short, the feeder cattle market became too decentralized to support an efficient deliverable futures contract settlement process. Leading up to the transition to cash settlement, Feeder Cattle futures trading volume declined by nearly 70% from its peak (at the time) in 1979 of roughly 1 million contracts to only about 316,000 contracts by 1984. These factors led the Exchange to pursue a cash-settled contract that began with the September 1986 contract. The cash-settled Feeder Cattle futures contract provides effective risk management opportunities for market participants regardless of where they are located.

Hedge Effectiveness

Hedge effectiveness in the futures market is a function of the correlation between futures prices and cash prices. In other words, if cash market prices go up, futures price are expected to go up as well. This means cash prices are not expected to be the same as futures prices but the basis (the difference between cash and futures prices) at any given location in the country should be stable.

Hedge effectiveness is represented statistically by regressing cash prices on futures prices 3 . Hedge effectiveness measures the percent reduction in the variability of daily price changes between an unhedged versus hedged position. For example, a hedge effectiveness of 99 percent means that, on average, a hedged position faces 99 percent less daily price variability compared to an unhedged position.

Daily feeder cattle cash prices from Texas, Kansas and Nebraska were collected and regressed on daily Feeder Cattle futures prices, with the resulting hedge effectiveness percentages.

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