Reduce Basis Risk with MGEX Index Futures

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Reduce Basis Risk with MGEX Index Futures
In late 2004, anyone who bought or                                                                 with an ineffective hedge when your
sold spring wheat learned all about                                                                local basis becomes volatile.
cash market divergence.
                                                                                                   Until recently, managing the basis has
During this period, cash prices soared                                                             meant resorting to illiquid paper
to historically high premiums when                                                                 markets, cash purchases or sales, and
compared to MGEX spring wheat                                                                      even Lady Luck. However, MGEX
futures. This divergence between                                                                   (Minneapolis Grain Exchange) now
cash market prices and futures prices                                                              offers five futures contracts that
is more often referred to as basis risk,                                                           promise to reduce the effects of cash
and this situation can throw a monkey                                                              market divergence.
wrench into even the best-made
                                                                                                   These financially settled contracts are
marketing plans.
                                                                                                   based on underlying indexes calculat-
Basis, the difference between the                                                                  ed by Data Transmission Network
local cash price and the corresponding                                                             (DTN) for hard red spring wheat
futures price, is attributed to local                                                              (HRSI), hard red winter wheat (HRWI),
supply and demand, freight rates and                                                               soft red winter wheat (SRWI), corn
other elements.                                                                                    (NCI) and soybeans (NSI). The indexes
                                                                                                   are a simple average of U.S. elevator
If you use deliverable futures, options
                                                                                                   bids, so they tend offer a truer
on these futures, minimum price con-
                                                                                                   representation of cash prices than
tracts, or other similar hedging tools to
                                                                                                   traditional deliverable contracts.
price your crop, you may find yourself

    CHART 1: North Central Iowa Corn Basis, 2004-2005
              0.00
              -5.00
             -10.00
             -15.00
                                                                                                                                      NCI Range = 10 cents
     Cents




             -20.00
             -25.00
             -30.00
             -35.00
                               CBOT Range = 24 cents
             -40.00
             -45.00
                      Jan 04
                                Feb 04
                                         Mar 04
                                                  Apr 04
                                                           May 04
                                                                    June 04
                                                                              July 04
                                                                                        Aug 04
                                                                                                 Sept 04
                                                                                                           Oct 04
                                                                                                                    Nov 04
                                                                                                                             Dec 04
                                                                                                                                      Jan 05
                                                                                                                                               Feb 05
                                                                                                                                                        Mar 05
                                                                                                                                                                 Apr 05
                                                                                                                                                                          May 05
                                                                                                                                                                                   June 05




             NCI
             CBOT
Tr a d i n g Tr e n d s


    For farmers, country elevators, feed        for the CBOT corn contract. The CBOT
    mills and others who supply or originate    corn basis fluctuated in a range of 24
    grain in the country, this means better     cents over the past 18 months, while
    price risk protection when they hedge.      the NCI stayed in a relatively narrow
                                                10-cent range.
    Two recent examples                         “This suggests that hedgers will have a
                                                more predictable basis and better
    One primary reason for cash market          hedging results using the NCI,”
    divergence is fluctuating local supply      Sanders says.
    and demand fundamentals. Futures
    markets tend to better reflect interna-
    tional pricing, while the price at your     2004 spring wheat
    elevator may be more influenced by          gyrations
    varying local factors.                      Another even more extreme example
    Dr. Dwight Sanders, assistant profes-       of basis risk occurred in the spring
    sor of agricultural economics at            wheat market during the latter half of
    Southern Illinois University, says the      2004. Quality issues with the crop
    corn market has experienced cash            caused a spike in the price of higher
    market divergence in recent years for       protein cash wheat, and as a result,
    another reason: increased use of corn       cash prices traded at historically high
    for ethanol.                                premiums to the deliverable futures
                                                market.
    Demand for corn from ethanol plants
    has begun to change corn market             Chart 2 shows just how strong the
    dynamics, because the Chicago Board         spring wheat cash market was during
    of Trade (CBOT) delivery points aren’t      this period (as measured by the hard
    as affected by this new demand as are       red spring wheat index) when
    country locations.                          compared with deliverable futures
                                                (nearby MGEX hard red spring wheat
    “Ethanol plants can impact the local        futures contract). This chart illustrates
    corn basis without impacting the Illinois   how the HRSI soared to a substantial
    River price that underlies the CBOT         premium to MGEX, while during the
    contract,” he explains. “As the ethanol     previous five years HRSI typically
    industry continues to expand, this effect   traded at a 10 to 30 cent per bushel
    may become more pronounced.”                discount to the deliverable futures.
    To illustrate the volatility in the corn    In this instance, as in the corn illustra-
    basis, Sanders refers to a chart of the     tion above, the HRSI basis volatility
    corn basis in North Central Iowa            was about one-half of that for the
    (Chart 1).                                  MGEX spring wheat contract, Sanders
    This chart shows that the range (or         points out. “In this case, neither hedge
    variability) for the National Corn Index    was perfect, but the HRSI still did a
    (NCI) corn basis in North Central Iowa      better job of tracking the country
    is less than one-half that of the basis     price.”



        MGEX index futures and their deliverable counterparts.
     Index                                      Deliverable counterpart
     HRWI (Hard Red Winter Wheat Index)         Kansas City Board of Trade wheat
     HRSI (Hard Red Spring Wheat Index)         Minneapolis Grain Exchange wheat
     SRWI (Soft Red Winter Wheat Index)         Chicago Board of Trade wheat
     NCI (National Corn Index)                  Chicago Board of Trade corn
     NSI (National Soybean Index)               Chicago Board of Trade soybeans
                                                                WWW.MGEX.COM


CHART 2: HRSI Minus Nearby MW Futures
                     40.00
                     30.00
                     20.00
  Cents per bushel




                     10.00
                      0.00
                     -10.00
                     -20.00
                     -30.00
                     -40.00
                     -50.00
                     -60.00
                               1/3/00
                               4/3/00
                               7/3/00
                              10/3/00
                               1/3/01
                               4/3/01
                               7/3/01
                              10/3/01
                               1/3/02
                               4/3/02
                               7/3/02
                              10/3/02
                               1/3/03
                               4/3/03
                               7/3/03
                              10/3/03
                               1/3/04
                               4/3/04
                               7/3/04
                              10/3/04
                               1/3/05
                               4/3/05
                               7/3/05
Utilizing index contracts                     For example, say a farmer wanted to
                                              forward contract a portion of his crop,
Repeatedly, research shows that MGEX          but at the time the local basis was
Index contracts tend to better reflect        weak. In this case, the farmer could
country prices because of the way they        forward contract to lock in a price for
are calculated and the way they are           his cash grain, and at the same time
settled.                                      buy HRSI futures and simultaneously
1. MGEX Index futures are based on a          sell MGEX hard red spring wheat
   simple average of country elevator         futures. This allows the farmer to
   prices, offering a truer representa-       create a synthetic basis contract and
   tion of prices at your elevator.           offset any extreme moves in the cash
                                              price.
2. MGEX Index futures settle to a
   financial value (the three-day              In this example, because the basis
   average of the cash price of the           was weak, the farmer would look to
   underlying commodity), which guar-         create a synthetic long basis position,
   antees convergence. As a result,           by buying MGEX HRSI futures and
   there are no delivery specifications,      selling MGEX deliverable hard red
   storage costs, grade differentials or      spring wheat futures.
   load-out costs. In fact, delivery is not   Conversely, to create a synthetic short
   a choice.                                  basis position, sell MGEX index
When MGEX Index futures and options           futures and buy deliverable futures.
are used to counteract cash market
divergence, the most straightforward
use is as a simple hedge. For example,        Additional information
to price ahead, a farmer would sell Index     For more information on using these
futures contracts or buy an Index put         innovative new contracts, check with
option. That same farmer also could sell      your broker or contact MGEX. We offer
cash grain at the local elevator, and then    information through the Web at
replace that grain on paper by buying         www.MGEX.com, or by regular mail to
Index futures or call options.                help you better understand how these
                                              products may work for your marketing
A second effective trade to offset cash
                                              program. For a free information packet
market divergence is to execute a
                                              call MGEX at 612-321-7101.
spread trade. This trade can be partic-
ularly effective for farmers who prefer
to utilize minimum price contracts or
forward contracts.
New Options Contracts Promise
to Save on Premium
A study completed by Dr. Dwight            Sanders further points out that
Sanders, assistant professor of            because these options expire monthly
agricultural economics at Southern         and since there is no delivery period
Illinois University, shows MGEX            (because the contracts are settled
index-based options can provide a          financially rather than through deliv-
premium savings of 1 to 4 cents (or        eries) growers can more closely
around 10%) over comparable                match an option expiration with cash
traditional options. This pricing          sales dates, obtaining a better hedge
advantage coupled with operational         and avoiding purchase of unneeded
advantages make MGEX options a             time value. They also don’t need to
preferred hedging vehicle in many          worry about deliveries.
instances, the study concludes.
                                           “For example, assume on May 15 a
There are a few reasons why MGEX           grower looks to hedge a cash corn
options premiums are lower, Sanders        transaction expected to occur on
says, but a primary fact is that tradi-    September 30,” he says. “If the
tional futures prices include a com-       grower used the traditional corn
ponent in their price to transport the     contract, the hedge would be placed
product from the country elevator to       in December options because the
the terminal market.                       September options contract expires
                                           in August. With NCI options, the
“Options premiums are based in
                                           September contract is used.”
large part on the price of the futures
contract,” he explains. “Traditional       This grower saves money by using the
futures contracts include a trans-         NCI September option because time
portation component (known as the          value is an important component of
basis), which inflates the price.”         an option’s price, and the further an
Because MGEX futures do not                option is from its expiration, the more
include this transportation compo-         it costs.
nent, the futures price is lower and
                                           A link to Sanders’ complete study is
the option premium is lower as well.
                                           available on-line at www.MGEX.com.




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