Market participants who buy or sell physical grains and oilseeds are aware that the cash price in their local area, or what their supplier quotes for a given commodity, usually differs from the price that is quoted in the futures market.
This price difference is because the price in a local market is made up of the futures price adjusted for such variables as freight, handling, storage and quality, as well as supply and demand factors impacting that particular area. Even in the same market where delivery occurs, the cash price will typically differ from the futures price, predominately due to storage.
However, as the delivery month of a futures contract approaches, the cash price and the futures price come together, or converge, and it is this convergence that makes hedging effective.
This module will discuss the concept of convergence in the grain markets and its importance for effective hedging.
Hedging in the grain market is based on the principle that cash market prices and futures market prices are highly correlated and tend to move up and down together because they are affected by the same economic and market factors.
Convergence occurs because futures positions can be converted into cash at expiration.
Both correlation and convergence are keys to effective hedging. It is what makes it possible to reduce the risk of a loss in the cash market by taking an opposite position in the futures market; in other words, selling futures if you are short in the cash market, and buying futures if you are long in the cash market.
Taking the opposite position allows a loss in one market to be offset by a gain in the other market. Convergence assures that hedgers can expect a predictable relationship between cash and futures prices when they merchandize cash grain and simultaneously offset their futures hedges.
When you hear a hedger talking about managing basis, which is the relationship between cash and futures prices, they are speaking about the predictability of the cash/futures price relationship, and this is driven by convergence.
Continuous market forces ensure that the price relationships between cash grain and futures markets stay in line and that convergence takes place. If the cash and futures prices significantly diverge from one another, market forces will act to bring the two prices back in line. This is called arbitrage.
If the cash price is below the futures price, it will signal a profit opportunity to simultaneously buy grain in the cash market and sell it in the futures market to take advantage of that price discrepancy. Grain warehouses that have been approved to deliver on futures will quickly act to capitalize on that opportunity, which will then bring the two prices back in line.
Conversely, if cash prices are above the futures price, it signals a potential profit opportunity to simultaneously sell in the cash market and buy grain futures. Here an arbitrageur holds futures positions to delivery, loads out and uses the loaded-out grain to fulfill his cash market obligation. This action will bring the cash and futures prices back in line, drive convergence and quickly minimize any price disparities.
Thus, arbitrageurs help preserve the relationship between the cash and futures markets and ensure that convergence takes place by the time a contract expires.
Without this activity, futures markets may have little correlation to the cash market, making it difficult for hedgers to transfer their unwanted risk, which is the foundation upon which the futures markets were established.