Watch for Hidden Volatility in Grain PricingPosted in: Business By Lawrence Klusa March 28 2016
Beware of Hidden Volatility! Hybrid Basis Contracts have Ramped up Farmers’ Foreign Exchange Exposure
Grain pricing has never been easy. In Canada, the foreign exchange component adds a whole new level of complexity because, historically, futures and basis needed to be converted to Canadian currency in order to calculate the price to the farmer.
In order to simplify the foreign exchange component many grain companies started to offer basis contracts using a hybrid pricing method. This essentially means the futures component is priced in US dollars at par, the basis in Canadian dollars, and payment in Canadian dollars. Any change in the exchange rate is now incorporated into the basis rather than the futures.
While this methodology is simple to understand, it creates increased volatility in the basis offered to farmers for their grain and potentially widely divergent price returns when pricing grain using hybrid basis contracts.
Let’s look at a pricing example for a farmer with a basis contract locked in using the hybrid pricing methodology, and a basis contract locked in using the Canadian dollar pricing methodology (all prices are dollars per tonne unless otherwise specified):
Time Period 1
US$1 = Cdn$1 (at par, which is where we were three years ago)
FOB values: US$300 = Cdn$300
Cost of shipping and elevation to export position: Cdn$60 (in the real world this basis is usually wider because of grain company margins)
US futures: US$275 = Cdn$275
Value in the country: Cdn$240 (Cdn$300 – Cdn$60)
Therefore, basis to futures would be: Cdn$-35 (Cdn$240 – US$275), the same for both the hybrid basis calculation method and the Canadian dollar basis calculation method
Time Period 2
Now assume the Canadian dollar falls to 75 cents per one US dollar:
US$1 = Cdn$1.3333
US$ FOB grain prices and US$ futures prices remain unchanged
FOB values: US$300 = Cdn$400 (in the real world wheat prices fell as the US dollar strengthened, but for illustration purposes we will keep the US dollar FOB wheat price and US futures price unchanged to provide a better understanding of the level of foreign exchange exposure the farmer faces with hybrid contracts)
Cost of shipping and elevation: Cdn$60
US futures: US$275 = Cdn$366.67
Value in the country: Cdn$400 – Cdn$60 = Cdn$340
Time Period 2, Part A – Hybrid Basis Change
In Time Period 2, when using the hybrid basis calculation method, the basis to futures would be:
Cdn$+65 (Cdn$340 – $275). The hybrid basis methodology keeps the futures component unchanged for calculation purposes.
When comparing Time Period 1 to Time Period 2, Part A, there is a net basis change of: Cdn$100 (Cdn$65 minus Cdn$-35).
The change in the basis is very large even though the price of the grain in US dollars is unchanged.
Time Period 2, Part B – Canadian Dollar Basis Change
In Time Period 2, when using the Canadian dollar basis calculation method, the basis to the futures would be: Cdn$-26.67 (Cdn$340 – Cdn$366.67). The Canadian dollar basis methodology changes the futures component to the Canadian dollar equivalent.
When comparing Time Period 1 to Time Period 2, Part B, there is a net basis change of: $8.33 per tonne (Cdn$-26.67 minus Cdn$-35).
When contacts are priced with the futures priced in Canadian dollars the change in the basis is small relative to the change in the basis is calculated using the hybrid methodology.
Now back to our original farmer with basis contracts to price against the futures after the change in the exchange rate.
Time Period 2, Part C – Calculation of Final Return using Hybrid Basis Methodology
The net value to the farmer that locked in a basis contract when the dollar was at par and now having to price after the change in the exchange rate using the hybrid methodology is: Cdn$240 ($275 – $35)
Cdn$6.53 per bushel.
Time Period 2, Part D – Calculation of the Final Return using the Canadian Dollar Basis Methodology
The net value to the producer that locked in a basis contract when the dollar was at par and now having to price after the change in the exchange rate using the Canadian dollar methodology is:
Cdn$331.66 ($366.67 – $35)
Cdn$9.03 per bushel.
The difference between the price in Part C, using the hybrid basis methodology and Part D, using the Canadian dollar basis methodology, is Cdn$ 91.66 or Cdn$ 2.50/bushel even though the US dollar value of the commodity did not change.
This value represents the loss to the farmer just from a change in the value of the Canadian dollar and the methodology used to calculate the basis.
A farmer takes on large foreign exchange exposure when locking in hybrid basis contracts. However, a farmer has considerably less foreign exchange exposure when locking in basis contracts priced using the Canadian dollar methodology.
Farmers will only want to lock in a basis using hybrid basis calculation methodology if they believe the foreign exchange rate will remain unchanged or the Canadian dollar will appreciate against the US dollar.
Pricing Canadian grains against US futures can be a complicated issue with the multiple pricing options and pricing methodologies available.
Farmers need to be on their mathematical toes to avoid having a bite taken out of their financial assets.
Lawrence Klusa is an Agri-Trend Market Coach. Call him at 204-489-1225 if you need assistance in understanding the pricing options and methodologies available.
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