Defining Cash and Futures Markets

When you are developing a grain marketing plan, it is important to ensure that you have all of the information you need to make the best decision possible. Information from the cash and futures markets will provide you with the numbers from which to base your grain marketing decision making. This article will provide you with the background knowledge about the cash and futures markets.

Cash Market

The cash sale, spot sale, or daily to arrive contract is the most common sales method used by farmers.

Every grain marketing transaction results in the sale of the physical commodity in the cash market.

The cash sale may be a stand-alone transaction, or it may be the completion of a hedge or other price risk management strategy.

Futures Market

A futures contract is a legally binding commitment to make or take delivery of specific quantity and quality of some commodity on a predetermined date and time. All terms of the contract are standardized except for the futures price, which is discovered by the supply (or offers in the futures market) and the demand (the bids in the futures market). The price discovery process occurs through an exchange’s electronic trading system.

Quality: U.S. No. 2 Yellow Corn
Quantity: 5,000 bushels
Delivery location: Chicago – or further south
Delivery date: By 2nd day after contract closes

All contracts are settled through liquidation by an offsetting transaction (a purchase after an initial sale or a sale after an initial purchase) or by delivery of the actual commodity.

Delivery occurs in less than 2 percent of all agricultural contract trades.

History of Futures Market

The CME Group combined the histories of two groundbreaking marketplaces for trading futures and options in 2007, the Chicago Mercantile Exchange and the Chicago Board of Trade. The CME Group is an exchange that you can look at to see the future price of a particular grain commodity.

The main economic functions of a futures exchange are price risk management and price discovery. An exchange accomplishes these functions by providing a facility and trading platforms that bring buyers and sellers together. An exchange also establishes and enforces rules to ensure that trading takes place in an open and competitive environment.

Traders participating in the exchange are guessing, based on historical data, what the market will really look like in the future. When buyers and sellers make a trade, they have found someone who is thinking the opposite of them – because they both think they just made money!

The farmer’s perspective

The futures market gives you valuable planning data, and allows you to have access to price risk management tools. As a farmer, you would be termed a hedger if you need protection against declining prices for crops or livestock or against rising prices of purchased inputs such as feed. Other hedgers may include grain merchandisers and grain elevators.

Hedging is defined as the management of price risks inherent in the purchase or sale of commodities. Hedging transfers price risk to the futures market. Another way to look at hedging is that you are taking action now in the future markets that you will take later in the cash market. Even for farmers who never actually trade in the futures market, understanding what price could be achieved is critical in making good cash market decisions. Most cash price opportunities are tied to the futures market.

If you are not a hedger, then you are a speculator.

Speculator may be a “bad” word to farmers, but without speculators the futures market probably would not offer some of the opportunities that may be available. Speculators don’t necessarily care about the actual price of a commodity, but do care which way the price moves. They are attracted to the opportunity to realize a profit if they prove to be correct in anticipating the direction and timing of price changes.

It is important to remember that the cash market may be the best sale that can be made at a given point in time. Deciding when to use the cash market as your primary pricing method for grain, instead of other price risk management tools, depends on many factors. A futures contract is one tool farmers can use to manage price risk. A futures contract is a standardized contract to exchange a set amount of grain at a chosen future date for a given price (futures price).

Hedging

Hedging is taking an equal and opposite position in the futures market than the position you may have in the cash market. Hedging works as an effective price risk management tool because futures contract prices and cash crop prices tend to move together. Hedging is using futures contracts as a temporary substitute for a later cash market transaction.

As the figure displays, having a hedge in place is sort of like balancing items on a scale. You have the cash price on one side of the scale and the futures price on the other end. As one side of the scale goes up, the other side goes down. But the middle of the scale remains steady. A hedge provides steadier returns than strictly relying on cash markets.

Summary

Understanding the relationship between local cash prices and prices in the futures market is key to making any grain marketing decision.

Knowledge of historical basis patterns will be useful to you when estimating the expected selling price or purchase price at the conclusion of futures or options hedge, forecasting the cash prices in the local market, to evaluate the quality of the local grain price bids offered by the grain elevators, and to make storage decisions.

Even producers who never use the futures market directly benefit from understanding the relationship between their local market and the futures market.