Analysis of Hedging and Other Operations in Grain Futures

Information on the extent to which futures contracts are used for hedging purposes is not very complete.Farmers and small local buyers frequently hold grain for higher prices but, as a rnle, they do not use :futures contracts as hedges agait1,st losses from price declines.Country elevators, particularly in the l1urthwestern part of the United States, use futures contracts as hedge" to a considerable extent, but many of those in southwestern States sell 011 to-arrive basis and usually they do not use futures as hedges (4,5).3The larg{}r shippers, exporters, and terminal elevators usually hedge their market interests in cash grain by offsetting sales and purchases of futures contracts.4 Flour mills and food-products companies make some use of the futures market for hedg ing purposes (4).Grain growers normally market a large proportion of their crop soon after htrrvesting it, and flour mills generally are not in a position or are not disposed to buy their requirements for the year during this short period.Consequently, grain merchants usually buy large quantities during or soon after the harvesting season and hold it until it is needed by mills.This holc1ing of grain involves both risks of losses from priee declines and possibilities of gains from priee advances.Mills may sell flour or other prodnr ts in advance of the purchasc of grain for its manufacture; and these operations, when practiced, involve the risk of losses from probable advan~es in the price of grain between the date of selling the products and the time when the grain is bought by the mill, as well as the chance of profit from declines in prices.Grain merchants and millers usually specialize in merchandising grain and in manufacturing grain produr.ts,respectively, and generally thcy are not in a favorable posi tion to assume the risks of substantial losses from price changes.There fOl'C they make usc of the futures market, in offsctting the risks from price changes, by hedging.. The fear of loss and the possibility of gain from changes in prices motivate futures trading in grain.The amounts of the risKS of losses, as 'well as the possibilities of profits, from price changes are indicated by data showing that clming the period 1924-25 to 1940-41 changes in cash prices of grain in Chicago ovcr 8-week periods were as much as 45 cents per bushel for wheat, 60 cents per bushel for corn, and 34 cents per bushel for oats.It is apparent from these data that changes in prices over relatively sllort periods may be large enough to bring losses or gains many times greate:r:' than the average costs of merchan elising grain.Trading in grain futures consists either in assuming the risks of losses from price changes as speculators or in offsetting them as hedgers.'rhe term "speculation"" in common business usage is generally applied to the field of ventures, the outcome of which is relatively uncertain and, iW1lce, from which profits or 101;s('s are likely to he large.III futures tl'acling it is applied particularly to attempts to make profits by ,-oIun 3Italie TIumb('J"s in par('ntheses refer to Lit(,l'llturc Citrd, p. 66. 4 Thc expressions CI buying-or s('lling futuJ'l'~ 01' futures eontrllcts" are used in this report to nH,'un entering into eontract to buy "'1' to sell gntin for clrlh'ery during a spe('ifieumonth in IlCl'orclallcc with the rules and regulations of futures exchang-es.5 The term" speculation" as uscd in this bulletin includes the kind of truding designated as "!!pl'cuiatioll," "manipulatious," anu "tratling on prll'f' movement or 1Il0\'l'1l1CllC trading'," by Irwin (10).• • • 'l'BCHNICAL BULLE'l'IN 971, U. S. DEp'l'.OF AGRICUL'!'UlU: months were used.When comparing Chicago and Liverpool futures prices, Chicago quotations at 10 :30 a.m. were related to the closing ])tices of Liverpool futures.The data analyzed include cash prices for the three grains at.Chicago, Kansas City, :Minneapolis, and St. Louis.a Cash prices used for wheat include II basic cash pl'iecs" at Chicago, No.2 Hard •WirIte!~ of ot'dinary ])l'otcin content and No.2 Hurd 'Winter of l3-perccnt ])l'otcin content at Kansas City, No.1 Dark Northcrn Spring of ol'dinaJ'y protein content und No.1 Dal'k NOl'tlwl'Il Spring of 15-pereent proteIn content at :Miu 1 l eapolis, and No.2 Soft Winter at St. Louis.Cash prices used i01r corn include No. 3 Yellow at Chicago, :Kansas City, and Minneapolis, and No. 2 Yellow at St. Louis.Cash pt'iecs nsed for outs include No.3 at Chicago, Kansas City, Minneapolis, and St. Louis.Quotations of cash prices of gntln at Chicago, Kansas City, and }!inl1capolis arc bused on actual sales of the cash commodity, taking into account the l)l'C'\'ailing basis c1uril.lg the day, and they reflect as nearly as can be lelil'llecl the ac:tual commol'oial value of the commodity at the clOse of the futm'os market.At St. Louis thc quotations repI'esent ayct'ag-cs of repLescntatiye sales made during the day, but average changes in bases O\'el' S-week periods attributable to any failure of this method of alTiving at quotntions to l'efio('t accUl'lltely the commercial value of the grain at the dose of the futures market pl'obably are lI0t In.rg-e onough to be of much significance.'1'he data used al'e mostly quotations 011 FI'Way of caell w('ek.The qnotations on Jhidays arc thought to represent a fairly typical cross section of the prices from time to time in the markets studied.It is realized that closing pI'ices qUT fl'om day to day and that pI'ices dut'ing tho day may \,t~l'y considerably from those at the close.Purthermore, the closing pdcc on Priday docs not reflect aU variations in pric'es l'cgistcr.ed011 the gl'ain futurcs cx('lianges nor the pt'iccs at which cash gl'Uitl was sold in specified rnarkets.Cons('(luently, it is believed that the results obtained f1'om the use of these data rpprcsent a typical cross Set'UOH and mlly show ('onsidol'llbly more 01' kss hedge protection than was actually obtained by an individual in making specific transactions in these markets during the period covered.Obviously, those who wet'e adept in predicting changes in priecs of the cash commodity and in t. basis"i we"e able to obtain more hedge pl'otection and to make gr('ater gains or take smaller losses from trans ferl'ing hodges and from spreading operations than the average results of this stuc1~show.On thc Ot:ill'I' hand, thosc who were inept in predict ing price changes may havc obtained less hl'dgf~ prot('etioll and had gt'catet' losses or lllllde less gains than the an'rage results sho\\'l1h("'o.The number oE ObS('ITations uscd in thc analys(!s g-olH"'ally amountC'd to onc cadi wcd~ cxc'cpt for the" bank ho]jL1a~'" in 19:33 when the mal' kets were closed.Whell the madwts happened to be closed for holidays 6 (':ISlt pric('g lIl!l'tl for wh('atut ('hirago arc the "hilsic cash prkes" llS compi1rd by Working (1i).( Hl'e Wllftll Stlidil'S 01' thl' POQil H('sl'arl'il Ill8litllle, Yol.ll, N\l.J, Xov('ulllt'r 19:q 11/1{1 lllIIlS('(llI(,llt '•Ollllll('~.)Th(' ot./lI'r <':ls1l pril"('S Uiwd lire tll()~C quot('(l hy the Agde.ulllll'ni)[arkt'till!; Scn'it'e of the United.Slutes Department of Agri0ultufl" i'rhe tl'nn "basis" liS clllp1oy('tl in this hull('tin menl1s thl' tlitTl'rcnec or Rprl'rIll b(~tw~'t'J\ tit!' l":I;;h priNt of g'r:tin of II ~p('dtied quality iIi a gin•n market lind {he prke of (l specified futures ('ontract.• • • REDGIXG AND OTHER OPERATlOXS IN GRAIN FUTURES• on Pridays, price quotations for Thul'Sduys or Saturdays usually were used.Differences between cash prices on Fridays separllt.edby 4-, 8-, and 16-week periods were used to-show changes ill cash prices, Differ ences in the spread between cash prices and prices of futures contracts on Fridays separated by 4-, 8-, and 16-week periods werc used to show changes in the basis or spread between cash prices ane} prices of futures contracts, Differences in spread between two fnhtrGs contracts on Priduys, separated by S-week periods, weJ:e used in the analyses to show gains aild losses from switching hedges and ft'om spreading opera tions, Simple aye rages of these differences were calculated, and no attempt was made to use weights based on estimates of the volnme of 11ec1ges.As data on th1; duration of hedgos are laeking, these periods were arbitrarily selected, Most of the detailed analyses' of data on basis re1ate to prices Ot futures contracts for the 11eal'-active months,S hut analyses of data on basis in relation to 1)rioes of futures contracts fot' mOl'c distant months are shown as a basis for compari~on, •Results of analyses of data on cash pI'ices at Chicago and on pl'ices of C'hieago fntmes conh'acts for thc Ii-year l)criod 1!)24-25 to 1940-41 at'e presented to show c1HUlges in cash prices and in basis by years as It means of indicating trends in protection affol'ded by futures contracts as hedges, Data tOt' the 10 years 1931-32 to 1940-41 arc gi\'eu to show how the Pl'ott,etion afforded by futures as hedges yaries from mal'kct to market, from one fntures conb'act to another, with the quality of the grain, and from one part of the season to anothcr, III addition, data fot, this 10-year period are l/resented to show differences between prices 01' futures contl'acts for the same market but maturing in different months; differences betwe('n fntmes contracts for different markets but maturing in the same month; and differences between Chicago futures ('ont1'acts :for wheat, corn, and oats mutul'ing iu the same months, as a ml'uns or indicating probable gains or 10sses from switching hedges, Data on changes in tllese ditl'('r('llces are gi\'cn as a means of indicating probable gains and losseslrom spreading operations, RELATIOX OF CASH PRICES TO PRICES OF FUTl!RES CONTRACTSThe usdulness of futUres trnding in ma1'1;:eting grain depends mainly on the t'elation>;h ips between ('ash prices and prices of futures 0011 tra ('t>; (6, 8), TIll' extent to whieh losses from ehanges in cash priccs can h(' ot'6wt hy tlt~, use of fut