MARKETING
PIH-19
pork industry handbook
PURDUE UNIVERSITY • COOPERATIVE EXTENSION SERVICE • WEST LAFAYETTE, INDIANA
Using Futures Markets for Hedging
Authors
John C. McKissick, University of Georgia
Emmit L. Rawls, University of Tennessee
John E. Ikerd, University of Georgia
Reviewers
Dwight Aakre, North Dakota State University
David DuPont, Chicago, Illinois
Michael A. Hudson, University of Illinois
Bob Key, Princeton, Indiana
Why Do Pork Producers Hedge?
A pork producer who is not familiar with futures markets and hedging may have many questions regarding how to use this pricing tool. But the most basic question is: why be interested in learning about futures markets? In other words, why do producers hedge?
To answer this question, it is first necessary to define futures markets and hedging. A live hog futures market is a market in which prices are established for live hogs that will not be deliverable until some time in the future. Any producer who uses the futures market to forward-price his hogs is hedging.

There are two basic reasons why a producer might want to forward-price hogs. First, the producer may feel that current quotes of futures market prices are higher than cash prices will be when his hogs are ready for delivery. Second, a producer may be unable, or unwilling, to accept the risks of prices lower than the current futures price, even if he thinks cash prices may be higher at delivery time.

The producer with the sole objective of getting the highest price will not price unless the forward-price offered exceeds his cash market price expectations. Thus, he must be in a position to accept the risk that his expected price is wrong. It should also be pointed out that a producer with this objective must accurately anticipate future prices to achieve his objective. He fails if he forward-prices at a price lower than he could have gotten later. He fails if he does not forward-price and later must sell his hogs at a price lower than he could have obtained by forwardpricing.

The producer with the objective of reducing price risk has a much greater chance of achieving his objective through forward-pricing. Such producers include those who choose not to produce unless they can forward-price
at a profit and those who may be required to hedge at profitable prices to obtain credit to finance their hog production. In either case, the producers will have no hogs to sell unless they have been forward-priced.

Other producers may make decisions to produce independent of their forward-pricing decisions and yet have an objective of reduced price risk. They forward-price anytime they are unwilling or unable to accept the risk of having to accept a lower price for their hogs than the price offered through forward-prices. For example, they may choose to forward-price to insure a certain return to management or profit. In any case, at some price level the risk of loss associated with a lower price outweighs the value of a potentially larger but uncertain profit that might occur without forward-pricing. Hedgers with this objective have a high probability of satisfaction from using the futures market. Of course, producers would prefer to get the maximum price and the minimum price risk simultaneously. But this rarely is possible. Producers may consider both objectives to be important, but in any given situation they will probably have to decide which is more important if they are to make a sound pricing decision.

Forward-pricing is not the only alternative to managing price risk. Floor-pricing or minimum-pricing through the options market provides a minimum price while allowing the producer to take advantage of any higher prices. Forward-pricing on the other hand will provide more price protection against lower prices than will floor-pricing, but also precludes gains from higher prices. The mechanics of floor-pricing are explained in fact sheet PIH-109 Commodity Options as Price Insurance for Pork Producers.

Many producers can forward-price through either the futures market or through forward cash contracts. In many areas packing plants and buying stations offer forward cash contracts which are a direct result of the futures
Cooperative Extension work in Agriculture and Home Economics, State of Indiana, Purdue University and Department of Agriculture Cooperating. H. A. Wadsworth, Director. West Lafayette, IN. Issued in furtherance of the acts of May 8 and June 30, 1914. The Purdue Umversity Cooperative Extension Service is an affirmative action/equal opportunity institution.