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Hedging Hogs by the Farm Manager

by 5m Editor
18 September 2006, at 12:00am

By the Alberta Government - Hog prices can vary significantly from year to year and even from day to day. With this volatility in the hog market, forward pricing opportunities arise that are worthy of locking in. This article deals with the more specific topic of using the futures market, known as hedging, to lock in a hog price in advance of delivery.

A hedge being done is to lock in the price (preferably a profitable one) regardless of whether the market goes up or down from that point. More information on other ways forward contracting of hogs is available in the module Hog Market Contracting.

The Futures Contract

A futures contract is a legal and binding agreement to deliver or accept delivery of a specific commodity on or before a specific date in the future. The only North American futures market for hogs trades on the Chicago Mercantile Exchange (CME). CME Lean Hog futures quotes are available at
http://www.cme.com/trading/dta/del/product_list.html?ProductType=com .

CME Lean Hog Contract Specifications
Trading Unit: 40,000 lb. carcass basis hogs
Description: Packer base weight, 51-52% lean and .80-.99 inches of backfat at the last rib or equivalent.
Daily Price Limit: $3.00/cwt US
Contract Months: Feb, Apr, Jun, Jul, Aug, Oct, Dec
Last Day of Trading: the 10th business day of the futures month
Delivery Days: Cash settled to CME LEAN HOG INDEX (weighted average of three area packers). The holder of a futures market sell position may deliver to a participating slaughter plant at this index. An open futures position, either a sell or buy position, is cash settled against the CME LEAN HOG INDEX as of the day of expiry of a month of the lean hog futures contract.

Calculating the Price

The lean hog futures contract is hogs is based on carcass weight and is priced in US dollars per pound. To convert to a Canadian hog price, some adjustments must be made.

First, there are differences in what remains with the carcass of a US hog compared to the carcass of a Canadian hog. The average dressing percentage of a US hog is 74 per cent, (i.e. the average carcass weighs 74 per cent of the live animal weight), while the average dressing percentage in Canada is 80 per cent. An adjustment is therefore made to account for the differences in the average dressing percentage between the US and Canada. To convert from a US dressed price to a Canadian dressed price, first multiply the US price by .925. This factor is derived from the respective dressing percentages of .74 divided by .80.

Second, a currency conversion must also be done. Because there can be differences between the spot currency exchange and a forward currency exchange, the exchange rate to use depends on the month of hog futures used. For example, if you are using the December lean hog futures, use the December Canadian dollar futures for the exchange conversion. If the lean hog and currency futures months do not match, use the next exchange rate futures month after the lean hog futures month being converted.

Finally, US hogs are priced in pounds and Canadian hogs are priced in kilograms so a weight conversion must also be completed. Multiply by 2.205 to convert from pounds to kilograms.

Below is an example of converting a US hog futures price to a Canadian hog price, given the following factors:

  • December US lean hog futures at 62 cents/pound
  • December Canadian dollar futures at 85 cents US
  • 2.205 pounds = one kilogram
Applying the formula:

Getting the Hedge in Place

To hedge by directly using the futures market, an account with a commodity futures brokerage firm is required. A hog producer would enter into (or opening) a sell futures position by using the lean hog futures contract nearest (immediately after) the date that the hogs are expected to be ready for sale. In a true hedge, once the hogs are actually priced on the cash market (usually at the time of delivery), the futures hedge is exited by buying the same number of futures contracts for the same futures month as originally in the sell position.

If, on a sell hedge, the futures market is lower at the time of exiting (or lifting) the hedge than when the hedge was entered, the futures trade result will be positive. If the basis (described in more detail below) between the US and Canadian hog market at the time of exiting the hedge was at the level estimated when the hedge position was entered, then the profit on exiting the futures trade would offset the lower cash hog selling price. See Using Hedging to Protect Farm Product Prices for more details on the hedging process.

Changes in the currency exchange rate affects the Canadian hog price. Therefore, producers may consider also locking the Canadian dollar against the US. The risk is that the value of the Canadian dollar rises against the US dollar, so protection would be taken to offset that possibility. This can be done in several ways:

  • by contracting the exchange rate through a bank,
  • by hedging using a “buy” position on the Canadian dollar futures market, or
  • by using the exchange options market by buying a Canadian dollar “call”.

Hedging factors to consider

Hedging, using the futures market, does not eliminate all price risk, since there is still basis risk. Basis is the difference between the cash price and a futures price. On a futures hedge, the final price received by the producer will be lower if the basis is weaker (or wider) or, in other words, the difference between the cash and the futures price increases, when the hogs are sold than when the basis was estimated when the futures hedge was opened. Also, using a futures hedge does not address market access issues, since it does not involve the packer. Figure 1, below, shows the seasonality and range of basis for the Alberta hog price.

Figure 1, Alberta Lean Hog Basis Levels

Producers using hedges must be aware of the possibility for a margin call if the futures price moves “against” a hedge position. A margin call is a requirement to send funds to the broker to cover possible losses in hedge trades. In the case of a short (sell) hog futures hedge, if the futures price rises above the price when the sell was filled, a margin call could result. However, it is also important to remember that, when hog futures prices are rising, the Canadian cash hog market is also likely to be rising. So in a hedge, a margin call from a hedge is not lost money. A hedge is done is to lock in the price (preferably a profitable one) regardless of whether the market goes up or down from that point.

A Hog Futures Hedge

Example 1, below, shows a hog futures hedge. The first and most important step in any marketing plan is to know one’s costs of production. With that information, a breakeven price can be calculated. Any price above that breakeven point implies a profit on that hog sale.

In Example 1, for sake of a simple demonstration, the basis and the Canadian/US exchange rate was unchanged from the time the hedge was entered into in June until the cash hogs were sold and the futures hedge was exited in December.

Also, the cost of the futures trade or brokerage commission was omitted in this example. For a 40,000 pound (18,140 kg) futures contract, approximate total commission would be $80, or about one-half cent a kilogram. A cost could also be assigned to the margin money that was tied up while the hedge was in place. If the cost of borrowing was six per cent and $2000 Cdn margin was needed to secure the hedge position for the six-month period, the interest on that margin would have cost $60, or about one-third of a cent per kilogram. Some brokerage firms do offer interest on margin money while it is used to secure a trade position.


In Example 1, the combined price result of the cash sale and futures hedge, $1.09/kg, was exactly the price that was targeted when the hedge was initiated. The same combined result would be obtained if the hog futures price had gone up from June to December, as long as the basis at the time of the actual hog sale was equal to that estimated, and the exchange rate was also unchanged. In such a case, the loss on the futures trade would be offset by the higher than targeted cash price received for the hogs.

Hedging in-coming feed supplies

Similarly, a hog producer may be able to lock in some of the costs of production, particularly feed costs. Feed costs can also be forward priced either by using forward cash price contracts or hedging with the futures market. For example, to lock in the major variable in the price of feed barley, a hog producer could buy – go long - barley futures as a hedge. Again, as with a hog futures hedge, using the futures market to forward price barley does not lock in the basis component of price. Other useful information is that of market outlook, keeping in mind that no market predictions are consistently accurate.

In Example 2, below, a buy position is entered into at $136/tonne for the March Western Barley futures in, say, early September. Subject to a change in basis from the $25/tonne estimate, the cash price for barley in late February or early March will be locked in at $111/tonne regardless of whether the March futures price for barley goes up or down. If, at the end of February, the physical barley is purchased at a price of $125/tonne, the buy hedge position is no longer needed and is removed by selling the March barley futures position via the broker. If the March barley futures price is at $150/tonne when the hedge is removed (the March futures is sold or offset) the futures trade will have resulted in a futures profit of $14/tonne, again not considering broker commission. When the $14/tonne futures profit is subtracted from the $125/tonne purchase price of the physical barley, the net cost of the barley is $111/tonne. This is exactly the price that was estimated to be locked in via the futures hedge.


On the other hand, Example 3, below, shows what happens if the price of barley had gone down from the time that the hedge was entered into and when the physical barley was purchased. In this case, end result is the same. Say the physical barley cost $100/tonne and the March futures buy position (entered into at $136/tonne) was closed out at $125/tonne. In that case, the futures trade would result in a $11/tonne loss (excluding commission). Adding that $11/tonne loss to the $100/tonne cost of the physical barley again results in a barley cost of $111/tonne. Note that in these barley-pricing examples, the basis was $25/tonne at the time of purchasing the physical barley and closing the futures hedge.


In both of these examples, a weaker basis than originally estimated, in other words a basis of greater than $25/tonne, would result in a lower net cost of the barley. A stronger basis at the time of physical barley purchase, say, $20/tonne, would result in a higher net cost of the barley. Hedging doesn’t protect against a stronger than expected basis. See Basis – How Cash Grain Prices are Established for more details on basis and grain markets.

Summary

This module has provided an overview of hedging hogs via the futures market. Using the futures market to hedge the hog price can be a very useful alternative to cash contracting under certain circumstances. If, for example, a producer believed that the basis level offered under available cash contracts was weaker than the cash market would offer when the hogs go to market, yet wanted to protect against price downside risk on the futures component of the price, then the futures hedge would be appropriate to consider. The “sell” lean hog futures position would lock in the futures price while leaving the basis open.

Some factors that need to be considered before entering into a hedge are exchange rate risk, basis risk and the possibility of margin calls.

Producers considering the futures hedge strategy are advised to complete a few hedges on paper before actually entering into one. A hedge using the futures or options market should only be entered with the assistance of a respected broker and support of the lender if margin financing is required. Various strategies also exist for use of options on futures to provide price risk protection.

August 2006