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Understanding hedging with an index-based contract

Tim Andriesen for Progressive Cattleman Published on 24 September 2018

Today’s cattlemen and women are well aware of the ever-increasing risks that could affect profitability. But when managing risk, there are still misperceptions around futures contracts.

For example, I’m often asked this question about contracts that are cash-settled to an index: “Doesn’t a futures contract require you to make or take delivery?”

One of the primary reasons futures markets work so well is because futures prices converge with prices in the physical markets upon contract expiration. The convergence of these two prices is driven by a delivery mechanism designed into the futures contract.

But not all commodities allow for a physical delivery mechanism – these are instead cash-settled based on an industry-accepted index of reported physical market prices. What matters is: There is a strong relationship between the physical market price and the underlying futures hedge.

The physical delivery system for live cattle has worked throughout the years because of the large concentrated demand centers for live cattle near the stockyards designated for delivery.

The feeder cattle market, however, is much more dispersed, making it more difficult to find concentrated demand centers – in other words, producers are too geographically diversified to support an efficient physically delivered futures contract that could discover a price used by the broader market. Because of this, we developed the CME Feeder Cattle Index.

Utilizing the CME index

The index is a weighted average consisting of prices reported from actual cash market sales of feeder cattle sold in the country and as reported by the USDA-AMS/State Market New Reporters and available online (www.ams.usda.gov/market-news/livestock-poultry-grain).

These prices from across the 12-state region include a total of eight eligible 50-pound weight brackets for the Index (Medium and Large No. 1 steers: 700 to 749 pounds, 750 to 799 pounds, 800 to 849 pounds, 850 to 899 pounds; and Medium and Large No. 1 and 2 steers: 700 to 749 pounds, 750 to 799 pounds, 800 to 849 pounds, 850 to 899 pounds).

Any cattle that have comments of fancy, thin, fleshy, gaunt or full, or ones indicating predominantly dairy, exotic or Brahma breeding, are disqualified from the calculation. Non-U.S.-origin cattle are also disqualified. From this data, the CME Feeder Cattle Index is calculated. By design, this includes a wide variety of cattle from across the nation to represent the “average” feeder.

It is not meant to reflect a specific location or weight of animal. This makes it a useful hedging tool for a wider range of cattlemen.

For many years, my experiences were with physically delivered contracts. As a grain buyer for a corn processor in central Illinois, I knew at a specific basis above the futures price, it was economical to take delivery of corn on the futures contract and ship it to the plant. Later, when working for a bank, we would provide a more attractive finance structure to customers who had commodities in warehouses where, in the case of financial hardship, we knew we could “sell” the commodity by delivering on our short futures hedges.

In both cases, physical delivery against the futures was extremely beneficial. The fact a futures contract could become a physical commodity purchase or sale gave market participants, such as myself at the time, a tremendous amount of flexibility. But is it necessary?

How the hedge works

Basic hedging theory tells us we want to hedge with a position having an equal but opposite price relationship to the commodity being hedged. If the price of feeder cattle goes down $1 per hundredweight in value, the hedge needs to increase $1 hundredweight in value to offset that loss.

The opposite should be true if the value of feeder cattle increases. This price correlation is what makes the hedge work. If we think of cash-settled futures contracts in this context, they are an equally effective tool for managing risk.

Another misunderstanding arises from the price differences between the CME Feeder Cattle index used by the futures contract and a particular producer’s cash price. The Feeder Cattle Index represents feeder cattle traded over a wide range of locations and is unlikely to represent any one producer’s price.

Consider an example in which feeder cattle in one part of the country are $148, and the index is $140. To quote one cattleman: “I won’t sell cattle at that price.” While this is a logical assumption, what matters is the hedging relationship.

When feeder cattle drop from $148 to $146, and the index changes from $140 to $138 – in both cases a change of $2 – there is an effective hedge. Although the prices are not the same, they are correlated.

Over time, the prices between the futures price and multiple cash prices move with similar behavior, even if they are not the same, allowing for market participants to use the index as a hedging tool on a national scale.

Many of us came up in this industry with a preference for physically delivered contracts, like Live Cattle futures, for effective price discovery. However, unless you plan to take or make delivery against your futures position, it’s important to understand hedging with an index-based contract like the CME Feeder Cattle contract can be just as effective.  end mark

Tim Andriesen
  • Tim Andriesen

  • Managing Director of Agricultural Products
  • CME Group

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