Section 2. Theoretical hedging operations and results. BASIS OF ILLUSTRATIONS EMPLOYED.-The following theoretical illustrations of the employment, and results of hedging by country elevators will sufficiently explain the practice. The Farmers Elevator Co. at Barrett, Minn., a subscriber to the Grain Bulletin price information service, is assumed to be the elevator engaging in the various trades, and the year 1913 has been selected as the time of the transactions, owing to the fact that the course of prices during that year was such that the various illustrations could be easily worked out. The prices employed are within the ranges of the actual cash and future prices prevailing in Minneapolis on the specific dates, and for the purposes of the example it is assumed that the Grain Bulletin card is followed exactly.3 The freight rate from Barrett to Minneapolis is 8.8 cents per hundredweight or 5.28 cents per bushel on wheat. On October 2, 1913, the Grain Bulletin price card received by the Farmers Elevator Co. made the minimum buying price of No. 1 northern wheat at Barrett 75 cents per bushel. The Minneapolis market price on which this price was based was about 85 cents per bushel. The difference between the price shown by the card and the terminal price, 10 cents, was the gross buying margin. As the freight rate is 5.28 cents per bushel and the Grain Bulletin price card usually eliminates the fractions, it may be assumed that the 10-cent margin was composed of 5 cents for freight and 5 cents to cover the costs of operation and the elevator's profit. Assuming that 33 cents per bushel covered the costs of operation and 14 cents per bushel is the balance of profit, the gross margin was divided as follows: LOSS ON CASH AND PROFIT ON FUTURES.-By 11 a. m. on October 2, 1913, let it be assumed that the Farmers' Elevator Co. has purchased from various farmers a total of 1,000 bushels of No. 1 northern wheat, paying for it the price shown on the card for grain of that grade, namely, 75 cents per bushel, making the total cost of this grain $750. In order to hedge this transaction the elevator operator would wire to his commission firm in Minneapolis about as follows: "Sell 1,000 December wheat against cash purchases." Upon receipt of the above telegram the commission firm executes the order in the future pit, either directly or through a pit trader. On October 2, 1913, the December wheat future opened at $0.843 and during the day's trading the high point was $0.851, the low $0.841, and the closing prices were $0.851 to $0.851. For the purposes of this illustration assume that the future sale of 1,000 bushels was made at $0.85 per bushel, or at a total cost of $850. After effecting the sale the commission firm sends a confirmation of this trade to the country elevator. For details regarding the Grain Bulletin card see the preceding chapter. 4 Weighted average price of No. 1 northern in Minneapolis on Oct. 1, 1913, was 84.83. The figures used are for illustrative purposes, and so approximations are made. 5 See preceding chapter. The December future is the nearest future delivery month to the month of the cash purchase. About a week later, on October 10, 1913, the elevator operator loads a car with 1,000 bushels of No. 1 northern wheat and consigns it to his commission firm at Minneapolis. At the same time the firm is instructed to buy in 1,000-bushels of the December wheat future upon sale of the carload of wheat, in order to close out the 1,000 bushels of December which was sold on October 2. On October 17 the car reaches Minneapolis. It is inspected and graded and a sample of the wheat is sent to the commission firm's table on the trading floor of the Chamber of Commerce. On that day No. 1 northern wheat sold for $0.81 to $0.833, this last price being for only one car which contained good dockage. The highest general price was $0.834. Let it be assumed that the commission firm's cash grain salesman receives an offer of $0.82 per bushel for the car and accepts it, and that the firm receives therefor $820. When the car of cash grain has been sold, the commission firm's pit trader buys in the pit 1,000 bushels of December wheat to close out or cancel the elevator's future account of 1,000 bushels sold on October 2. On the day in question-October 17, 1913-December wheat opened at $0.804, the high was $0.803-81, low $0.793-80, and the close $0.80 to $0.803. The pit trader executes the trade at $0.80 per bushel and purchases 1,000 bushels of December at a price of $800. An account sale of the cash transaction is then prepared by the commission house and also an account of purchase and sale of the future, and both are mailed to the elevator. The results of the cash transaction to the elevator are as follows, disregarding all charges for commissions, weighing, inspection, etc.: Sold 1,000 bushels No. 1 northern, at $0.82__ Gross profit--- $820.00 750.00' 70.00 52.80 Less freight, $0.0528 per bushel_. On the basis of prevailing cash market prices, therefore, at the time of the purchase and sale of this particular thousand bushels of wheat, and assuming a 10-cent buying margin, this elevator would have lost $17.80 had only the foregoing cash buying and selling transactions been effected." But at the same time that the elevator bought the wheat from the farmer it also, as stated, sold 1,000 bushels of the December future, and when it sold the actual grain at Minneapolis it bought back 1,000 bushels of the same future, thus canceling its previous sale. The results of this operation were as follows, disregarding commissions: Sold 1,000 bushels December at $0.85_ Net profit $850 800 50 The weighted average price of No. 1 northern on Oct. 17, 1913, was 82 cents. 9964°-2014 While, therefore, the elevator lost $17.80 on the cash operation, it made $50 on the future, and thus made a profit on the whole transaction of $32.20. Actually, of course, the profit was somewhat less, since commissions, fees, etc., would amount to at least a few dollars. SPECULATIVE POSSIBILITIES IN CONNECTION WITH HEDGING. While the above illustration is fairly typical, some elevator operators do not sell the future until the car of actual grain has been loaded and is ready to be hauled to the terminal market. The future is then closed out (purchased) upon sale of the actual grain. Again, there are elevator companies which do not close out the future at the time the cash is sold, thus incurring a speculative chance of loss or gain. For example, if in the above illustration the elevator operator had not notified the commission firm to close his future upon the sale of the cash grain, but had left it open in anticipation of a decline in the future price, he would, in essence, be speculating, since he would be taking the chance of an increase or a decrease in his profits. If the future prices had declined, his profit of $32.20 on the whole transaction would have been increased, as he had originally sold the future, and the declining prices would enable him to buy in and cancel this sale at a lower price than the 80 cents per bushel which he paid in the illustration given. Had the price of December wheat dropped to 75 cents per bushel, and had the operator bought in his future at that price, his net profit on the whole operation would have been $82.80 instead of $32.20. Sold 1,000 December wheat at $0.85 per bushel_ Net profit on future transaction___ Total profit $850.00 750.00 100.00 17.80 82.20 On the other hand, if we assume that the elevator operator had not closed out his future upon sale of his cash grain and the prices of futures had not declined, but had advanced to, say, $0.87 per bushel before he closed out his trade, the result would have been: From the above it follows that hedging in the most exact sense of the term and to secure the fullest possible protection requires that the execution of the cash and future transactions on opposite sides of the market should be as nearly simultaneous as possible and that the further apart they are in point of time the more the operation partakes of speculation and the less the reason for regarding it as hedging. LIMITATIONS OF PROFITS.-The foregoing illustrations show how as a result of a future operation a country grain merchant may reduce the possible loss involved in the buying and selling of cash grain when the cash market declines through the corresponding decline of the futures which the elevator sold as soon as it had bought 8 the grain. While hedging, therefore, in theory and practice tends to limit the losses of the cash operator in the event of a decline in cash prices, it should be clearly understood that it usually decreases the profits in the event of an increase in cash prices. For example, suppose the Barrett elevator in the foregoing illustration, after buying the thousand bushels of wheat on October 2 and selling the December future against it, had not shipped the grain, but had held it until December and then decided to carry it over until the spring of 1914 on the chance of a possible premium of the cash price over the future. Since the operator originally hedged in the December future, he must, in order to protect himself, switch his hedge to another future. This he does by buying in the December future for 1,000 bushels which he originally sold and selling 1,000 bushels of the May future. Assume that this transfer was made on December 20, on which day the December future sold at $0.834 to $0.84 and the May future at $0.87 to $0.873. Assume, further, that the country operator bought in his December future at $0.84 and sold 1,000 bushels of May at $0.87 and that on April 11, 1914, he loads out the wheat, which is shipped to Minneapolis and is sold there on April 24. On April 24 cash wheat ranged from $0.911 to $0.94 and the May future from $0.893 to $0.903. Assume further, for illustrative purposes, that the cash wheat in question was sold at $0.939 and that the future was bought in at $0.901. The results of the foregoing transactions would then have been as follows: Purchase of 1,000 bushels of cash wheat on Oct. 2, 1914. Profit on cash operations--- Sold 1,000 bushels of December wheat on Oct. 2 at $0.85. Profit on December future____ Sold 1,000 bushels of May wheat on Dec. 20, 1914. Loss on May future_. Less profit of $10 on December future___ Net loss on futures_. Total profit on cash operations__ Net profit‒‒‒ $750.00 930.00 180.00 850.00 840.00 10. 00 872.50 902.50 30.00 10.00 20.00 180.00 20.00 160.00 In other words, in the foregoing illustration, if the elevator operator had not hedged his grain, but had merely carried it over until spring and had sold at the prices indicated, he would have realized a profit of $180 in this particular instance. Not caring to assume the possible losses involved in carrying this grain, however, because he could not foretell the price at which he would be able to sell, he hedged in order to limit this possible loss, and by so doing in the particular instance reduced his profits from $180, which he would 8 Except the elevator speculates, as shown in the foregoing illustration, in which event, as stated, the operation is not hedging in the exact sense of the word. "Weighted average of No. 1 northern, cash, 93.37. have obtained in the absence of hedging, to $160. But by thus limiting his profit he had also limited the possibility that he would suffer loss. In other words, the hedging operator theoretically, as it were, consents to a limitation of his profits in return for a limitation of his losses. Being upon opposite sides of the market, in the cash and in the futures, loss as a buyer of cash wheat, if cash declines, will theoretically be compensated by his profit as a seller of futures on the corresponding decline of the future. Conversely, if the cash advances, the hedger's gain as a buyer of cash will be reduced by his loss as a seller of futures from the corresponding advance in the future market. Section 3. Some technical details of country-elevator hedging. On most of the exchanges trading in futures is in 1,000-bushel lots as a minimum. In consequence, orders for the purchase and sale of grain futures by country elevators for hedging purposes are usually instructions to buy or sell 1,000 bushels, or multiples thereof. Most generally, perhaps, the elevators in the Northwest wait until they have accumulated 1,000 bushels by purchases from the farmers or until the close of the day before sending in the hedging order. In some cases, however, they place hedging orders before they have accumulated as much as this minimum amount. Such action is most likely to be taken when the receipts at the country elevator are heavy and there is good reason for anticipating that the total receipts either during the day or by the close of the day will amount to the minimum quantity required by exchange regulations for a future transaction. For example, a few elevators in the Northwest and also in Illinois and Iowa reported the placing of a hedge when it seemed to be certain that sufficient grain to cover it would be received. As the most of the grain markets close very early in the afternoon, however, the bulk of the hedging orders of the country elevators are executed by their terminal market representatives on the morning following the day when instructions are given. Telegraphic or telephonic instructions given by the country elevators before noon, however, may be received sufficiently early to permit the execution of the hedge on the same day. When the country elevator operator consigns a car of grain to his commission house he also gives instructions to close out the hedge upon the sale of the grain, provided, of course, that he is using the future market strictly for hedging purposes. (Sec. 2.) (Sec. 2.) In some instances the order to close is attached to the bill of lading. In other cases the elevator operator telegraphs the order to close the hedge to the commission firm. As a rule the instructions specify the quantity of futures to be bought in, but if the elevator has sold several thousand bushels of futures the commission house may be told merely to buy in the future. Some elevators give standing orders to the commission houses to close out their hedges as fast as their grain arrives at the terminal markets. One operator reported that during the rush season he often did not close out a hedge upon the sale of a car of grain, but allowed this hedge to stand to cover the heavy receipts of grain. When receipts slackened he hedged the grain as it was received and the futures were closed as fast as the grain was sold. |