Producers’ decisions as to when and how to market their cattle can greatly impact the net profits. Cattlemen have many marketing alternatives available. In the cash (spot) market producers may sell their cattle through live auctions, video auctions, direct or through terminal markets. Cattlemen also have the ability to use forward contract or hedging with futures and options. Although the commodity futures and options markets serve as an important risk management instrument, only a small number of cattlemen directly use them. In order to better compare the traditional cash sale to forward contracting or hedging with futures, cattlemen need to recognize the relationship between cash and futures prices.
In any commodity market, cash and futures prices are typically thought to be positively correlated. As shown by Postin (2005) in the following graph, the traditional relationship between cash and futures prices of live and feeder cattle has remained intact despite incidents in recent years including Bovine Spongiform Encephalopathy (BSE) commonly known as mad cow disease, hoof and mouth disease, 9/11 terrorist attacks and on-going threats of terrorism.
Figure 1 shows the relationship between actual 5-state live cattle cash prices and the average weekly live cattle futures prices. It is evident the two prices move together over the 260 evaluated weeks, indicating these two prices are highly correlated. Futures prices were more often higher than cash prices, with a few slight exceptions where futures prices were sharply lower than cash prices. These occurrences were during the weeks 18, 111, 115, 198 and 201. There were no obvious differences in cash and futures during the months immediately surrounding the United States’ terrorist attacks, Canadian mad cow incidence, as well as United States mad cow incidence as was expected in the hypothesis.
Cash Basis in the Marketplace
The relationship between cash and futures is known as basis. Basis is defined as the difference between cash and futures prices. Basis is a positive number when cash price is higher than the futures price. A negative basis implies that futures price is higher than cash price. Since cash price pertains to a specific location, time and quality of the livestock, basis “localizes” the futures prices. Many factors influence basis including the supply and demand situation at the local, national and international level, quality of livestock, and transportation costs. As these situations would change over time, the basis would also change. A successful marketer of livestock not only tracks the trend in basis, but also tries to understand the causes behind the deviation from the normal basis pattern. Farmers and ranchers can use basis information in a) judging the profitably and b) evaluating forward contract bids.
If a rancher has the knowledge of expected basis based on the historical pattern, he/she can determine whether an available forward cash contract is a “good deal." Since basis incorporates the location and quality differences of the livestock delivered, by properly estimating the basis, Missouri producers can use the futures market to forward price their cattle. Producers may fail to take advantage of potential profit opportunities if the basis is underestimated. Producers may have to bear losses when basis is overestimated while evaluating the forward contracts. For example, a producer is offered a forward cash contract to deliver a truckload lot of live cattle at $84/cwt. in April. If the April live cattle futures contract on this day was $89/cwt., the contract's implied basis is -$5.00/cwt. If the producer thinks that historical basis difference has been -$1.00/cwt, the producer may be better off by rejecting the offer and choosing to hedge himself. That is he could sell live cattle futures contracts at $89/cwt. If his basis estimate is correct, the basis difference in April ought to be $1. This will happen if the futures price for live cattle decreases to $84/cwt and cash price decreases to $83/cwt. He can: 1. Buy back the futures contract and make $5/cwt. 2. Sell the livestock in the spot market for $83/cwt. 3. Receive a net proceed of $88 ($83 + $5) instead of $84 as offered in the forward contract.
If he chooses to hedge himself, then he will take the risk that the basis turns out to be worse than normal. However, he would not lose money compared to the contract unless the basis was worse than -$5.00/cwt. Suppose the futures price increases to $95/cwt and the cash price increases to $88/cwt. In this situation, the actual basis in -$7, worse than the basis difference offered by the forward contract. The producer will buy back the futures contract and make a loss of $6/cwt. He will sell the livestock at the spot market for $88/cwt. The net proceeds will be $82/cwt ($88 – $6). The producer would have been better off by accepting the forward contract.
Dr. Rimal and Dr. Perkins co-chaired Rachael Postin's Masters of Science degree thesis. This is the result of her thesis as accepted by the College of Natural and Applied Sciences at Missouri State University.
