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Title: Reducing business risk through hedging Valencia oranges in the futures market
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Title: Reducing business risk through hedging Valencia oranges in the futures market
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Creator: Van Blokland, P. J.
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Table of Contents
    Copyright
        Copyright
    Assumptions
        Page 1 (MULTIPLE)
        Page 2
        Page 3
    Remarks
        Page 4
    Bibliography
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UNIVERSITY OF

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Cooperative E\tension Service
Institute of Food and Agricultural Sciences



Reducing Business Risk Through Hedging Valencia

Oranges in the Futures Market1

P.J. van Blokland2


The following paper presents a simple hedging
procedure for grove owners in Florida. It covers the basics
of hedging and emphasizes the importance of budgeting
and knowing basis before the hedge is placed. It also
shows how the hedge ended up in terms of cash returns to
management. What it does not do is to suggest that this
sort of hedge is a reasonable strategy to adopt. So the main
purpose of the paper is to present the logical thinking
steps necessary for a successful hedge.

Assumptions

1) Growing Valencia oranges for processing in an
irrigated, mature grove.

2) Yield 400 boxes per acre.

3) 6.5 pounds solid (p.s.) per box.

4) Have always marketed fruit by forward contracting to
a fruit processor, who processes the fruit into Frozen
Concentrate Orange Juice (FCOJ).


The Nine Logical Steps of Hedging

Step One Start the Hedging Process

On January 11, 1996, the January 1997 FCOJ
contract settled at 123.90. Believing in planning well
ahead we ask ourselves, "Can we spend money to produce
oranges this season and make a profit from this price?"

Step Two Calculating the Investment Costs
of Growing Valencias

We lay out our calculations as follows:

Item Cost per acre ($)
total production costs 800
management costs 50
tax and regulatory costs 90
interest on production costs 40
interest on capital costs 400
TOTAL grower costs 1,380
Harvest Cost 750
TOTAL Cost 2,130


1. This document is Circular 1195, one of a series of the Food and Resource Economics Department, Florida Cooperative Extension Service, Institute of Food and
Agricultural Sciences, University of Florida. Publication date: July 1998. Please visit the FAIRS Web site at http://hanunock.ifas.ufl.edu.
2. P.J. van Blokland, Professor, Food and Resource Economics Department, Cooperative Extension Service, Institute of Food and Agricultural Sciences, University
of Florida, Gainesville, 32611.


The Institute of Food and Agricultural Sciences is an equal opportunity/affirmative action employer authorized to provide research, educational
information and other services only to individuals and institutions that function without regard to race, color, sex, age, handicap, or national origin.
For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative
Extension Service I Institute of Food and Agricultural Sciences / University of Florida / Christine Taylor Waddill, Dean


Circular 1195







Reducing Business Risk Through Hedging Valencia Oranges in the Futures Market


* This $2130 per acre is 2130/ 400, or $5.32 per box;
* or 5.32 / 6.5, or $0.82 per p.s.

So we now are looking at three sets of costs that we
must cover before we invest. Again, these are:
cost per acre of $2130.
cost per box of $5.32.
cost per p.s. of- $0.82.

Step Three Calculating a Break Even Price
(BEP)

The concept here is that we want more than a cost of
production coverage. If we can cover our costs of
production, we don't lose money. But we don't make any
either. We need to make a profit. We will call this profit a
"return to management," or RTM. For example, if our
costs are $100 and we make $115, then our profits or
"return to management" is $15, or 15%.

Our calculation of RTM is obviously affected by what
the market will bear. At times of low market prices, our
RTM must be set lower than at times of higher prices. So
how do we calculate what RTM we want? There are
several ways to do it. You can pick whichever you feel
comfortable with. We'll use a percentage of total costs and
then see whether the market price can support it. Let's try
10% as our required RTM and see if the market will bear


1) 10% of per acre cost
so BEP per acre =

2) 10% of box cost =
so BEP per box =

3) 10% ofp.s. =
so BEP per p.s. =


$213.
$2,343.

$0.53.
$5.85.

$0.08.
$0.90.


These are the BEPs we are looking for in the market.
Let's for simplicity just use the p.s. BEP from now on and
bring the others in only when we need them. So we now
need to see if the market is offering us $0.90.

Step Four What Is the Market Offering?

This step requires a knowledge of basis. Basis is
simply the difference between two prices. Here though, we
will use basis only as the difference between the cash and
futures price:


Cash price minus futures price
OR 90 123.90 = 33.90.


basis;


This is a negative basis and it means that the cash
price is less than the futures price. In futures market
language, this is referred to as "basis under." Why is basis
under? Suppose that your job was to pick up oranges,
process them into juice, match the juice to the
requirements of the futures contract and then deliver it to
one of the delivery points. Suppose also, that you agree to
pay 90 cents for the fruit. How much would you charge
for the rest of the tasks? Presumably your costs of pick
up, hauling, remixing, packing, grading, loading and
hauling again, plus a little RTM. And all this collectively
is your BEP, or the basis.

The basis is the cost, including management, of
getting stuff in the form that the market wants, from where
it is to where it should be. Basis must be time, place and
form specific in order to be useful. So basis, as we are
using it, is not simply cash minus futures, but the cash
commodity price at a particular time, place and form
MINUS the futures market price at a particular time, place
and form. So our above equation now looks like this:

Cash price at locality in Florida in December 1996
MINUS futures price at the Cotton Exchange (CTN) in
New York City in January 1997 = basis;
OR 90 123.90 = 33.90.

Or our locality in Florida basis in December for
oranges against the January futures for FCOJ is typically
33.90 under. Change any one of these six variables and
you will change the basis. Basis is that specific.

Basis lowers the risk of investing by linking the cash
and futures markets in the equation. This is because cash
and futures markets move together. They will rarely move
equally together but usually pretty closely. Unfortunately,
when there is a freeze, we tend to see cash and futures
diverge for a bit. But over a longer period, if prices move
up or down, they tend to do so in matching fashion in both
markets.

Where do we get basis information from? Sometimes
we get this information from the industry, or a brokerage
firm or a bank or the extension service. But often this
basis information is averaged, old or misleading. The best
method is to gather and keep our own basis information.

How do we actually use basis? We learn from one or
more or our above sources that basis is typically 30 under
for our specific time, place and form. Remember we are in


July 1998


Page 2







Reducing Business Risk Through Hedging Valencia Oranges in the Futures Market


January 1996 deciding whether to spend money on
growing oranges this season, and then matching our price
against the January 1997 futures price. Let's go back to
our general basis equation:

Cash price in locality in Dec Jan futures CTN = basis;
OR cash price 123.90 = 30 under.

Therefore, we expect a cash price for our oranges of
93.90 per p.s. Note that this is an expected cash price. It is
what we expect to receive for our fruit per ps if basis stays
at (30). This presentation tells us two things. The first is
that we have to know the basis before we hedge. The
second is that because we can see the futures prices in the
media, and we know our basis, our calculations are to find
the expected cash price at our local market.

Realize that basis will rarely stay at (30) for our
hedging transaction. This is because the basis components
change. Recall that basis here is composed of processing
costs, the costs of haulage, insurance, handling, etc. As
these and their component fuel prices and wages change so
does the basis. But the basis will not change as much as
prices in either market do, because basis is the price
difference between the two markets, so its variation is less.
Suppose, for example, that futures prices rose from 109
cents to 135 over a six-month period. This is a 24% price
rise. And assume cash fruit per ps was 79 cents and it rose
(cash and futures prices move together) to 108 cents, or
37%. Both these price moves are considerable. But basis,
which was (30) and changed to (27), has only changed by
9%.

Because the basis changes during the life of nearly all
hedges, we probably will not get our expected cash price
of 93.90 cents. But if it's a good hedge, it probably doesn't
matter. Why is it a good hedge? Because we are practically
certain to get a positive RTM which should be our main
objective anyway. However, our work so far shows us that
the market is offering us 93.90 for our fruit per p.s.

Step Five Make the Hedging Decision

The question is "should we hedge or not?" We
calculated in step 2 that our BEP for our grove is 90 cents.
Our step 4 calculations show that the futures market is
offering us 93.90 if we hedge. This is 3.9 cents more than
our BEP so we should hedge. With costs of production of
82 cents, we can hope for a RTM of 11.9 cents (93.90 -
82).

How much should we hedge? This question can only
be answered by grove records showing how much our


yield varies from year to year. The smaller the variation the
greater the proportion of our anticipated yield that we can
hedge. Assume, for example, we have a fairly steady
annual yield pattern. Consequently, we'll hedge 85% of
our anticipated yield. The calculation looks like this:

500 acres x 400 boxes x 6.5 p.s. x 0.85 hedging %
divided by
15,000 p.s. per contract
= 74 contracts.


Step Six Placing the Hedge

We now have to phone the broker to go short 74
January 1997 contracts. The set up looks something like
Table 1.
Table 1. Step six placing the hedge

Markets ($ per P.S.)
Date Item
Cash Futures Basis

Jan 11 '96 short 74 123.90
Jan '97

cash Dec 93.90 (30)
'96



Step Seven Watch the Market

We are going to assume that nothing untoward
happens during the time that we are in the futures market.
On the whole, this is a fair statement, but we need to recall
that this is the point in the paper to reiterate that it does
not cover strategy recommendations. The strategy
presented here is simple, used widely and often works. But
it is presented to illustrate the main points of hedging only.
It is usually described as a naive hedge in that we have
hedged all our contracts in one month and do not do
anything between the time we place the hedge and offset it.
In today's market, we can probably still put all our
contracts in one month, but we would be rather lucky to
have prices move our way over the nearly one year's
duration of this hedge. This remark refers to margin calls
which will be covered in another paper.


July 1998


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Reducing Business Risk Through Hedging Valencia Oranges in the Futures Market


Remember that cash and futures prices do move
together. So that what is bad news in one market is usually
countered by good news in the other. And, because we are
using both cash and futures markets, we will win in one
and lose in the other. We cannot win in both, nor can we
lose in both.

Step Eight Lifting the Hedge

After our November/December harvest, we sell our
fruit locally as we have always done, and receive 89 cents
per ps for it. Now we are faced with a problem. We have a
legal obligation to deliver 74 contracts of FCOJ to a
specified delivery point, but we have just sold all our fruit.
How do we get out of this legal obligation? We do it by
"offsetting" our futures commitment. This is done by
purchasing or going long 74 contracts of January 1997
FCOJ. This transaction offsets or cancels our obligation to
deliver.

Note that we expected our local cash price to be 93.90
cents. But our actual local cash price was 89, or less than
we expected. The cash price has fallen. Consequently, we
would expect the futures price for January FCOJ to fall as
well. Assume it has fallen to 116. Our total transaction
now looks like what is shown in Table 2.


Table 2. Step eight lifting the hedge.

Markets ($ per p.s.)
Date Item
Cash Futures Basis

1-11-96 short 74 123.90
Jan '97

cash Dec 93.90 (30)
'96

12-20-96 cash Dec 89
'96

long 74 116 (27)
Jan '97

Totals (4.90) +7.90 3

What do all these numbers mean in terms of our RTM?


Step Nine How Did we Do?

1) We received 89 cents in the cash market and 7.90
cents from our broker, to end up with an overall price
of 96.90 for our oranges per p.s.

2) Our costs of production were 82 cents.

3) Therefore, our RTM was 96.90 82 or 14.90 cents
per p.s.

How do these numbers convert to our final returns?

1) We received 74 contracts x 15,000 p.s per contract x
14.90 cents, or $165,390 RTM for our whole futures
market transaction.

2) Our total return was 74 x 15,000 x 96.90 or
$1,075,590 from the futures trade.

3) And (500 acres x 400 boxes x 6.5 p.s. x .15 percent
non hedged x 89), or $173,550 from the cash market
for our non hedged portion.

4) Ending up with a total return of $1,249,140.

If we had not hedged, we would have made 500 x 400
x 6.5 x 89 = $1,157,000. Therefore, we made an extra
$92,140 from our total hedging transaction.


Remarks

1) We made our extra money because basis moved in
our favour. Look at the transaction again. We
expected basis to be 30 under. It ended up 27 under,
which is good news for us in the futures part of our
transaction. This movement of basis is called
"narrowing". When we are originally short and basis
narrows, we make our extra money on basis
movement.

2) The commission to do this total transaction is cheap.
It is usually not worth worrying about commission
costs as a hedger. This trade would probably cost
around $ 20 to $30 per contract per round turn and it
is not paid to the broker until we offset our trade.

3) Futures are traded on margin. Margin is the money we
give the broker to ensure that we can follow through
on our trades. It is margin which provides the large
leverage in futures markets. If futures prices move in
our favour then our margin account increases. But


July 1998


Page 4







Reducing Business Risk Through Hedging Valencia Oranges in the Futures Market


leverage is a two edged sword. If futures prices move
against us, our margin decreases and we may have to give
the broker more margin money (i.e. a margin call).
Because fruit prices do not always move consistently with
FCOJ prices, margin calls are a distinct possibility.

4) We should have peace of mind from knowing that we
were going to make a positive RTM or profit from our
investment.

5) We have just completed a "naive" hedge. It is the
simplest hedge possible in that we put all our
transaction into one month and never changed our
position over the whole time period. Yet we still made
money. As we get more sophisticated, we should be
able to make more money.

6) The rewards from this example are kept rather low.
This is on purpose. The primary purpose of futures is
to lower our business risk. The secondary objective is
to make some extra money as basis moves our way.
The above transaction showed that basis narrowed
and allowed us to make an extra 3 cents, which
boosted our RTM.

7) Finally, perhaps the main advantage of futures is that
it keeps us aware of prices. Hedgers can profit from
price movements. And they should try.


Bibliography

van Blokland, P.J., "Hedging for Beginners", FRE 47,
FRED, IFAS, FCES, UF, 1985.

Ibid., "A Simple Method for Hedging Citrus", FRE 55,
FRED, IFAS, FCES, UF, 1985.

Muraro, Ronald P., and Thomas W. Oswalt, "Budgeting
Costs and Returns for Central Florida Citrus
Production, 1994-95", Economic Information Report
El 95-2, FRED, IFAS, FAES, FCES, UF, August
1995.


July 1998


Page 5




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