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Why Millers Prefer to Hedge at the Kcbot and Grain Elevator Operators at the Cbot

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Why Millers Prefer to Hedge at the Kcbot and Grain Elevator Operators at the Cbot Why millers prefer to hedge at the KCBoT and grain elevator operators at the CBoT Sören Prehn1, Jan-Henning Feil2 1 Leibniz Institute of Agricultural Development in Transition Economies (IAMO), Halle, [email protected] 2 Georg August University Goettingen, Goettingen, [email protected] Contribution presented at the XV EAAE Congress, “Towards Sustainable Agri-food Systems: Balancing Between Markets and Society” August 29th – September 1st, 2017 Parma, Italy Copyright 2017 by Sören Prehn and Jan-Henning Feil. All rights reserved. Readers may make verbatim copies of this document for non-commercial purposes by any means, provided that this copyright notice appears on all such copies. Why millers prefer to hedge at the KCBoT and grain elevator operators at the CBoT Abstract In this paper, we analyze why grain elevator operators tend to hedge hard red winter wheat at the CBoT and not at the KCBoT. They do so because they trade not only the basis but also the premium risk. Like the basis, also premiums of hard red winter wheat have a tendency to increase after harvest. Only a short hedge in the lower priced CBoT wheat contract makes it possible to participate in a post-harvest premium increase. For this reason, grain elevator operators favor a loose hedge at the CBoT. Our results underscore the importance of premium risk for hedging decisions. Keywords: Wheat, hedging, millers, grain elevator operators, Kansas City Board of Trade, Chicago Board of Trade 1 Introduction In his seminal paper “Whose Markets? Evidence on Some Aspects of Futures Trading” (Journal of Marketing, Vol. 19, No. 1, pp. 1—11) Working hints to a tendency at US wheat markets that is still intact today: Millers of hard red winter wheat prefer to hedge at the Kansas City Board of Trade (KCBoT) while many grain elevator operators prefer the Chicago Board of Trade (CBoT). This is an interesting observation since one would have expected that also grain elevator operators favor for hard red winter wheat hedging a close hedge at the KCBoT. Yet, the opposite is the case.1 According to Working (1954), this tendency is based on the fact that the Chicago soft red winter wheat contract is deliverable by different wheat classes.2 The latter creates a sort of bias in favor of short hedgers (i.e., grain elevator operators) and against long hedgers (i.e., millers). This is why, grain elevator operators as traditional short hedgers prefer a loose hedge at the CBoT to a close hedge at the KCBoT. Because neither Working nor someone else has ever elaborated further on this issue, we will do so in this paper. We will clarify what Working (probably) had in mind when he stated that “multiplicity of deliverable classes of a commodity, as for Chicago wheat, creates a sort of bias in favor of hedgers of stocks (short hedgers) and against hedgers of forward orders (long hedgers),” (p.7). We will show that the Chicago soft red winter wheat contract usually tracks the lowest priced wheat in the United States (Garbade & Silber, 1983) and that premiums of high protein wheat (i.e., hard red winter and spring wheat) have a tendency to increase from spring to fall are the real reasons why grain elevator operators tend to hedge hard red winter wheat at the CBoT. Only a short hedge at the CBoT makes it possible to participate in a premium increase from spring to fall. For grain elevator operators, the latter is appealing because it promises additional profits. In the end, what the operators of grain elevators are doing is that they trade not only the basis but also the premium risk. On the other hand, millers of hard red winter wheat deliberately refrain from trading the premium risk. For them, there is no way to participate in a premium increase. On the contrary, a long hedge at 1 If not otherwise stated, here, and in the following, the notation miller will always refer to a hard red winter wheat miller and grain elevator operator to a grain elevator operator trading hard red winter wheat. 2 For details see the CBoT rulebook, chapter 14, rule 14104 (CBoT, 2016). the CBoT can even cause an additional loss. Therefore, millers favor a close hedge at the KCBoT that eliminates (or at least minimizes) any premium risk (Moore, 1950). We contribute to the existing literature on futures trading3. Our findings reveal whenever different classes and grades for a commodity, as for U.S. wheat, exist and there is uncertainty about the future availability of higher grades, short hedgers have an incentive to trade the basis and the premium risk, whereas long hedgers try to hedge the premium risk. For this reason, short hedgers favor futures with a large exposure to premium risk and long hedgers favor a low exposure. The latter explains the tendency of millers to hedge at the KCBoT and of grain elevator operators at the CBoT. In addition, our findings relativize the importance of liquidity of futures markets for hedging decisions. It was not the liquidity that brought the grain elevator operators to hedge at the CBoT but it was the possibility to trade the premium risk. The liquidity of the CBoT only developed as a consequence of the increased market engagement of grain elevator operators and it is now an additional advantage of the CBoT. Yet, liquidity has never been the main reason for the increased market engagement of grain handlers (e.g., the Australian Wheat Board) at the CBoT as has been suggested many times (e.g., Bond et al., 1985; Sheales & Tomek, 1987). To our knowledge, this is the first paper highlighting the importance of premium risk for grain merchandising. So far, premium risk has been neglected. This, however, is not justified. Premium risk is actively traded by grain elevator operators and it influences the choice of an appropriate futures market for hedging. Beside the basis and spreads, premium risk is the third important determinant of grain merchandising. The remainder of the paper is organized as follows. First, we revisit Working’s paper and elaborate on his findings. Based on this, we provide a reinterpretation for Working’s observation that millers tend to hedge at the KCBoT and grain elevator operators at the CBoT. The final section concludes. 2 A revisit of Working’s paper At the time, Working was writing his paper, it was already a well-known fact that millers tend to hedge hard red winter wheat at the KCBoT and grain elevator operators at the CBoT. The events at the U.S. wheat market after the election of Herbert Hoover as U.S. president had clearly revealed this fact. Herbert Hoover had been elected as President of the United States in 1928. Contrary to his predecessor Calvin Coolidge, Hoover was a strong advocate of federal farm interventions. Already in his acceptance speech, Hoover had expressed his willingness to increase the income of farmers. To achieve this aim, Hoover created the Federal Farm Board in July 1929. The Farm Board immediately set to work and decided that the best way to boost the income of farmers would be to corner the world market and drive up prices. Therefor, in a first step the Farm Board pressured the federal credit banks to liberalize their loans to agricultural cooperatives. The cooperatives, in return, should make more generous loans to farmers, so that farmers could hold their wheat off the market. In a next step, the Farm Board set up a state-owned enterprise—the Grain Stabilization Corporation—to accumulate own wheat stocks (Bovard, 2006). The first wheat was bought in February 1930. At first, it seemed that the strategy of the Farm Board could work out: The massive buyout of wheat by the Grain Stabilization Corporation in 1930 boosted the U.S. wheat price to 18 cents per bushel above the world market price, which again led to the collapse of U.S. wheat exports. The Farm Board was confident that a world shortage of wheat was imminent and finally the world market price would go up. Yet, the opposite happened. The market already priced in the large carryover of the Grain Stabilization Corporation being convinced that the Farm Board would eventually dump its surpluses 3 For a literature review see Garcia & Leuthold (2004). on the market. In the end, the Farm Board policy even further depressed the world market price. The prices only recovered after the Farm Board had resold all its wheat stocks in 1933 (Bovard, 2006).4 Working was interested in another aspect of the Farm Board policy: The impact of the policy on wheat futures markets. As expected, the intervention in the storage market had adverse effects in particular for operators of grain elevators whose stocks sharply decreased. The former were not anymore able to compete with the Grain Stabilization Corporation whose sole purpose was to bid up prices. Because of that the grain elevator operators had lost most of their warehousing business to the Grain Stabilization Corporation. On the other hand, millers were only marginally affected by the Farm Board policy. They usually only keep smaller wheat stocks, just enough to keep their mills running for a couple of months (Working, 1953a). << Figure 1 here >> Against expectations, the Farm Board policy had a much stronger impact on the CBoT than on the KCBoT (cp. figure 1). At the CBoT, the number of open interests declined much more than the KCBoT number. During 1929/30 and 1930/31, the number of open interests at the CBoT halved despite a strong increase in carryovers in the United States and worldwide (Working, 1953a).
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