Hedging of Livestock
Hedging is one of the marketing tools livestock producers can use to forward price their livestock. Hedging protects against adverse price changes.
Two types of hedgers
There are basically two types of hedgers, one to protect against a price decline (short hedge) and the other to protect against a price rise (long hedge).
This publication will be devoted mainly to discussing short hedges.
• Short hedge
Short hedgers are producers who have livestock that they plan to market in the future but want to protect themselves against potential price declines. Producers become short hedgers if they sell a futures contract (futures contracts that are applicable to the type of livestock they plan to market).
• Long hedge
Long hedgers are just the opposite of short hedgers. Long hedgers need a product at some future date, do not want to purchase the cash product now, but want to protect themselves against a price rise. Producers become long hedgers if they buy a futures contract (futures contract applicable to the type of feed or feeder livestock they plan to purchase).
An example of a long hedger would be a cattle feeder planning to put feeder cattle in the feedlot in three months but wanting to establish a price and protect against a price rise during the next three months. This hedger would buy feeder cattle futures to protect against a cash price rise.
Another example of a long hedge by a livestock producer would be buying corn futures to establish a price for corn and protect against a price rise.
Placing a short hedge
A producer who is feeding livestock, plans to market them later, and would like to establish a price now rather than take a chance prices will decline may want to consider hedging.
Selecting the appropriate futures contract
The first step is to select the appropriate futures contract, one that will mature at the time the livestock will be marketed. Unfortunately, contracts are not available for every month of the year. For example, a producer might plan to market hogs or cattle in January. Neither hogs nor cattle have contracts that mature in January. In cases such as this, the producer should use the contract that matures one month after the livestock are marketed. Therefore, a producer wanting to hedge hogs or cattle in January should use the February futures price. The reason for selecting a contract that matures after the livestock are marketed is so the futures contract can be offset at the time the livestock are marketed.
Localizing using basis
The most common method of localizing the futures price is to adjust the futures price for the expected basis as shown in Example 1. The basis represents the expected difference between the local cash price and the futures price at marketing time (see Basis files in Information Files Understand Livestock Basis, Lean Hog Basis and Live Cattle Basis.)
Analyzing hedge potential
Once the localized futures price has been obtained, the hedger can estimate the potential returns from the hedge. Three additional factors need to be subtracted from the localized futures price to obtain a net return from the hedge. Computing the estimated return is shown in Example 2.
• Brokerage fee
If the producer decides to hedge, the fee charged by the broker to handle futures trading will have to be paid. This fee ranges from $50 to $100 per contract (varies by brokerage firm and number of contracts traded, which puts the cost of trading at 15 to 20 cents per cwt.).
• Interest on margin
A deposit is required for every contract traded. The size of the initial margin deposit will vary by type of livestock futures contract and the price level. Normally the initial margin deposit will range from 5 to 10 percent of the value of the contract. Also, if the futures market price moves in a direction that is adverse to the futures position, the hedger will have to deposit additional funds.
Since the margin deposit has to be paid as the market requires (as the loss accrues) an interest charge should be assessed as a part of the cost of hedging as shown in Example 3. The size of the interest charge will depend on the direction of futures price and how long the contract is held. The best one can do is to make a rough estimate of the interest charge.
• Cost of production
A third factor in analyzing whether or not to hedge is to compare the adjusted futures price with the cost of production and price objectives to determine the estimated net return from the hedge. The level of desired profit and price risk one is willing to assume by not hedging varies by individual producer. So each producer must determine whether the estimated return from hedging is satisfactory.
Lifting the short hedge
Lifting a short hedge involves buying back (offsetting) your futures position and simultaneously selling your livestock on the cash market. A hedging example is shown in Example 4. From the time the hedge is placed until it is lifted, the hedger can ignore both cash and futures markets because the gain (loss) in one market will offset the loss (gain) in the other market. For example, if the price declines after the hedge is placed, the decline in the cash market is offset by the gain in the futures market. If the price rises, the rise in the cash market is offset by the loss in the futures market. Implications of using basis to lift a hedge are discussed in Information File Understanding Livestock Basis.
How to lift the hedge
Live cattle futures short hedges can be lifted two ways:
1. Buying a futures contract (same contract month that was sold earlier) and simultaneously selling the cattle in the normal way on the cash market
2. Delivering the cattle on the contract as the contract specifies.
When lifting a short livestock hedge, the producer should remove the futures position just prior to selling the livestock on the cash market. The sequence of events would be as follows:
1. Obtain cash price bid for livestock.
2. Obtain futures price for appropriate month.
3. Examine basis and compare with historical basis data.
If the decision is to lift the hedge,
4. Buy futures contract for appropriate month.
5. Sell livestock on cash market.
The greater the time between the cash sale and offsetting the hedge, the greater the basis risk.
Hold into contract month
Contrary to advice given to grain hedgers who are advised never to hold into the delivery period, livestock producers can hold hedge positions into the delivery period. The livestock basis is more stable during the delivery period; hence, it is more predictable than during non-delivery periods. With cash settlement contracts (lean hogs and feeder cattle) it is not necessary to lift the hedge. The hedge will be closed out at the settlement price.
A cattle hedger holding into the delivery period should monitor open interest, or the number of contracts still open. If the open interest drops much below 1,000 contracts, the hedge should be lifted regardless of the basis.
Hedging in non-contract months
Futures contracts are not available for every month of the year. Therefore, the livestock producer may have livestock going to market in months when there is no futures contract. Hedging in non-contract months is more risky than in contract months. The basis in the non-contract months is less stable than in the contract months.
Hedging and quality
Producers selling livestock that are not of the grade specified in the futures contract face additional basis risk. Discounts for select grade cattle and carcass premiums and discounts should be factored into the basis.