Most volatility and the risk in cattle production is now in the value of the Canadian dollar.
In the last article, we took a look at live cattle futures (LC) and the fundamentals of that contract. Live cattle futures are just one of the commodities that can be protected through a hedge.
A hedge is somewhat like insurance. It reduces the risk against volatility in a market and insures against what you might call a negative event. This does not mean that an event will not happen – the hedge simply reduces the impact. In a true hedge, using futures or options, one investment is used against the other.
As an example, if you believe that live cattle futures (LC) will go down you may enter into a futures contract stating that you will sell your LC at a set price at some point in the future. The price of those cattle may be protected under the contract but a true hedge employs an offsetting position. You may also want to secure the production costs and the value of the currency. For example, if corn is expected to go up during the same period, you will enter into a futures contract that allows you to buy corn at a future set price. If corn goes up then you have protected the sell price and the production cost of the cattle. If corn goes down, you still have to pay the difference and the premium. If you want to bail out while corn is going down, you will short the market and pay the premium and difference. Hopefully the offsetting position reduced the risk in the cattle to zero.
The market will change every few seconds, based on the psychology of the investor and the information they have. Much of the fluctuation or volatility in markets is reactive. It may not be enough to hedge both your cattle and your corn; you may also use currency or other commodities, interest rates, stocks or precious metals to reduce your potential risk. To keep it simple, we will look at the situation of a person wanting to offset risk in Canada. It is a timely discussion, as the most volatility and the risk in cattle production is now in the value of the Canadian dollar.
Take a LC contract at US$96 for a future month, with the currency of the day at C$0.83. Converted to Canadian dollars, the value of the contract before costs and deductions is $115.66 cwt. While holding the contract the Canadian dollar will fluctuate. If you did not protect yourself though a currency position from this volatility, then it can really work against you. If at the time of settlement, the value of the Canadian dollar to the U. S. dollar is $0.89, then the realized value of the cattle in Canadian dollars is $107.86 cwt. for a loss of $7.80 cwt.
The ideal hedge reduces your risk to nothing. It is the same in a simple forward contract. To hedge, you need not use the futures market and the related instruments, you can do this between fence lines, but the principles remain the same. The hedge is used to reduce risk. So, if you have sold feeder cattle at some point in the future through a delivery contract, then you will want to pay very close attention to the details of the contract. And if there is a lot of volatility expected in the currency between the time you enter the contract and the time of sale, then you should consider hedging by taking an offsetting position on the money as well.
You can implement a very successful hedge with your cash cattle, feed grain and input costs at home. Every time you take a position to reduce risk in one or more assets, that is a hedge. Every hedge has a risk and a cost. Because you are employing an offsetting position, you need to look at hedging from a systems approach, to fully appreciate how one position affects the other. Remember, your goal is to reduce your level of exposure to risk.
There is no greater way to reduce risk than to stay informed. Your perfect hedge is based on unbiased information that looks at all the fundamentals of a market. Drop us a line at [email protected] and we will start your year off with a free month of our newsletter.
Brenda Schoepp is a market analyst and the owner and author of BEEFLINK, a national beef cattle market newsletter. A professional speaker and industry market and research consultant, she ranches near Rimbey, Alberta. Contact her at [email protected]