Ag Decision Maker
extension.iastate.edu/agdm
File A2-60
Crop Price Hedging Basics
Revised March 2022
The business of a crop producer is to raise and market
grain at a profitable price. As with any business, some
years provide favorable profits and some years do
not. Profit uncertainty for crop producers arises from
both variance in the cost of production per bushel
(especially from yield variability) and uncertainty of
crop prices.
Many techniques are used by producers to reduce risk
from production loss. These may include adequate
size of machinery, rotating crops, diversification of
enterprises, planting several different hybrids, crop
insurance, and many others.
Crop producers also have marketing techniques
which can reduce the financial risk from changing
prices. Rising prices generally are financially
beneficial to producers and falling prices are generally
harmful. However, it is never known with certainty
whether prices will rise or fall. Futures hedging can
help establish price either before or after harvest. By
establishing a price, the producer protects against
price declines, but also generally eliminates any
potential gain if prices rise. Thus, through hedging
with futures, producers can greatly reduce the
financial impact of changing prices.
How Prices are Established
Prices of corn and soybeans are established in two
separate but related markets. The futures market
trades contracts for future delivery. These future
contracts are traded at a commodity exchange and
are for a specific time (contract delivery month),
place (primarily Chicago, Illinois), grade (#2 yellow
shelled corn), and quantity (1,000 or 5,000 bushel
contract sizes). The cash market is where the physical
grain is handled by firms such as country elevators,
processors, and terminals.
The term basis refers to the price difference between
the local cash price and the futures price. The basis is
different at alternative marketing locations. Thus, for
effective marketing, it is important to be aware of the
local basis at country elevators, as well as at nearby
processors or terminals.
Local cash prices thus reflect two components: the
futures price and the local basis. Figure 1 helps
illustrate this point. As an example, a local cash bid of
$5.50 per bushel for corn may be derived from a
futures price of $5.70 and a local basis of $-.20. It is
helpful to think of local cash prices in terms of the
futures component and the basis component when
examining marketing alternatives.
The Hedging Concept
Producer hedging involves selling corn futures
contracts as a temporary substitute for selling corn
in the local cash market. Hedging is a temporary
substitute, since the corn will eventually be sold in
the cash market.
Hedging is defined as taking equal but opposite
positions in the cash and futures market. For
example, assume a producer who has harvested
10,000 bushels of corn and placed it in storage in a
grain bin. By selling 10,000 bushels of corn futures
the producer is in a hedged position. In this example,
the producer is long (owns) 10,000 bushels of cash
corn and short (sold) 10,000 bushels of futures corn.
Since the producer has sold futures, price has been
established on the major component of the local cash
price. This can be seen in Figure 1, which illustrates
that the futures component is the most substantial
portion of the local cash price.
Figure 1. Components of local cash corn prices
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Ag Decision Maker File A2-60, Crop Price Hedging Basics
Selling futures in a hedge leaves the local basis
unpriced. Thus, the final value of the corn is still
subject to fluctuations in local basis. However, basis
risk (variation) is much less than futures price risk
(variation). By selling futures, the producer has
eliminated the financial loss which would occur on
the cash grain from a futures price decline.
The hedge position is removed or lifted when the
producer is ready to sell the corn in the cash market.
It is lifted in a simultaneous two-step process. The
producer sells 10,000 bushels of corn to the local
grain elevator and immediately buys back
the futures position. The purchase of futures offsets
the original short (sold) position in futures, and
selling the cash grain converts the position to the
cash market.
Producer Hedging Illustrations
Hedging involves taking opposite but equal positions
in the cash and futures markets. If you own 10,000
bushels of corn as discussed above, you are long
cash corn. If you sell 10,000 bushels of corn on the
futures market you are short corn futures.
If the price increases as shown in Figure 2, the value
of the cash corn also increases. However, the futures
contract incurs a loss because you sold (short) corn
futures and now have to buy corn futures at the
higher price to close out the futures position. If both
the cash and futures prices increase by the same
amount, the increase in the value of the corn will
exactly offset the loss in the futures market. The net
price received from the hedge is exactly the same
as the cash price when the hedge was initiated (not
including trading cost, interest on margin money, or
storage costs).
Figure 2. Producer hedging in a rising market
Figure 3. Producer hedging in a declining market
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Ag Decision Maker File A2-60, Crop Price Hedging Basics
If the price decreases as shown in Figure 3, the value
of the cash corn also decreases. However, the futures
contract results in a gain because you sold (short)
corn futures and now can buy corn futures back at
a lower price to close out the futures position. If
both the cash and futures price decrease by the same
amount, the decrease in the value of the corn will
exactly offset the gain in the futures market. The net
price received from the hedge is exactly the same
as the cash price when the hedge was initiated (not
including trading cost, interest on margin money,
and storage costs.)
The difference between the cash price and
the futures price is the basis. The basis in the
illustrations in Figure 2 and 3 is the same when
the hedge is lifted as when it was initially placed.
However, if the basis is smaller when the hedge is
lifted as shown in Figure 4, the gain in the cash
market will be greater than the loss in the futures
market and the net price received from the hedge
will be slightly larger. The outcome is the same if
prices decline (Figure 5). The loss in value of the
cash grain will be less than the gain in the futures
market resulting in a higher net price.
Basis usually narrows from harvest into the winter,
spring and summer; resulting in a higher price.
However, a higher price is needed due to the cost
of storing grain past harvest. Whether the basis
narrows and by how much is not known until the
hedge is lifted. Although hedgers can lock in the
futures price when they hedge, they are vulnerable
to basis changes.
Hedging can also be used to establish a price for
a crop before harvest. Assume the hedge is placed
before harvest but lifted at harvest. The net price
(not including trading cost or interest on margin
money) is the futures price at the time the hedge
is placed, less the expected harvest basis. If prices are
higher at harvest, the higher cash price is offset by
the futures loss. If prices are lower, the futures gain
is added to the lower cash price.
Figure 4. Producer hedging in a rising market Figure 5. Producer hedging in a declining market
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Ag Decision Maker File A2-60, Crop Price Hedging Basics
Processor Hedging Illustrations
If you are a grain processor or livestock producer
needing grain for processing or feed, hedging can
be used to protect against rising grain prices. Once
again hedging involves taking opposite but equal
positions in the cash and futures markets. But in this
case, you don’t have grain that you plan to sell but
rather plan to buy grain at a future time period to
fill your processing or feed needs. Instead of selling
futures at the time of placing the hedge, you buy
futures. So you own grain (futures) in the futures
market but are short grain in the cash market (will
need grain but don’t own any).
If grain prices rise as shown in Figure 6, you make
money in the futures market because you purchased
futures and can now sell them at a higher price.
However, the grain for processing or feed needs
now cost more. So the gain in the futures market
offsets the increase in the grain purchase price.
If grain prices drop as shown in Figure 7, the
futures you purchased at the beginning of the
period must now be sold at a lower price. How-
ever, the grain for your processing or feed needs
now cost less. So the loss in the futures market
offsets the decrease in the grain purchase price.
If the difference between the cash and futures
prices remains the same over the hedging period,
the loss in one market will exactly offset the gain
in the other market (not considering transaction
and interest costs).
Figure 6. Processor hedging in a rising market Figure 7. Processor hedging in a declining market
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Ag Decision Maker File A2-60, Crop Price Hedging Basics
Mechanics of Placing a Hedge
Once hedging principles are understood, a key
decision in the hedging process is selecting the
right method to carry out the trades. This could
be a brokerage firm, elevator, processor, or online
trading platform that offers a hedging program.
A producer should expect the firm to execute
orders accurately and quickly and often serve as
a source of market information. Most firms have
daily market reports as well as periodic in-depth
research reports on the market outlook which
may be useful in formulating a marketing strategy.
Also, a broker or merchandiser that is familiar with
local cash market opportunities has some distinct
advantages.
It is extremely important that the firm understands
how hedging and price risk management fit into
the marketing program of the producer. The
producer and the broker or merchandiser must
realize that hedging is a tool to reduce price
risk. However, producers sometimes use futures
markets to speculate on price changes and thus
are exposed to increase price risk. Generally,
speculation and hedging should be done in two
separate accounts. Inexperienced hedgers should
seek a broker or merchandiser willing to help them
increase their understanding of market mechanics.
After selecting a broker or merchandiser,
formulating a marketing plan, and opening a hedge
account, the producer is ready to place trading
orders. The broker or merchandiser can supply
information on the types of orders to place. Once
the broker or merchandiser receives the order, it
will be placed with the commodity exchange. The
order will be placed electronically, and it will be
executed, provided it is within the current market
range. A confirmation of the executed order is then
relayed back to the local broker or merchandiser.
To maintain a position in the futures market,
producers must deposit margin money with the
trading firm. Initial margin requirements provide
financial security to insure performance on the
futures commitment. If the producer sells (buys) a
contract in the futures market and the futures price
subsequently rises (declines), this represents a
loss of equity in the futures position. These higher
(lower) prices may require additional funds to
maintain the hedge position. If the futures price
moves down (up); the producer who sold (bought)
futures will have futures profits credited to their
account. The producer can call for this excess
margin to be paid to them. In the futures market,
the margin position is updated each day.
Margin calls should not be viewed as a loss but
rather as part of the cost of insuring against a
major price decline (increase). In a producer
hedged position, losses on futures contracts are
offset by the increasing value of the physical grain
inventory. In a processor (livestock producer)
hedged position, losses on futures contracts are
offset by lower priced cash grain purchases.
Although margin calls should not be viewed as
a loss, they complicate a producer’s cash flow.
If prices rise, the futures loss must be paid
(additional margin) as the loss accrues. However,
the additional value of the grain is not realized
until the grain is sold when the hedge is lifted. For
grain processors and livestock producers, falling
grain prices can result in margin calls before the
benefits of lower priced cash grain purchases are
realized. So, a cash flow problem may occur.
Once the position is closed out, the producer is no
longer required to maintain a margin account (for
that transaction). Thus the producer (processor)
can receive their margin deposits, plus (minus)
futures profits (losses), less brokerage fees.
Revised by Kelvin Leibold, farm management
field specialist,
Original author Don Hofstrand, retired extension
value added agriculture specialist
www.extension.iastate.edu/agdm
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