By Matt Dalgleish | Source: MLA, NLRS, ACA, Riemann
Earlier this week we published an article advising that cattle forward contracts were now available and a similar over the counter (OTC) contract is also available for lamb, cash settled against the Meat and Livestock Australia’s (MLA) National Trade Lamb Indicator (NTLI).
Click here to read the piece on cattle forward contracts.
OTC forward contracts are a standardised product which means that the specifications of the contract, such as the maturity date, contract volume and volume increments are fixed. Although this can limit the flexibility of the contract to tailor it to a specific set of lamb or sheep the standardisation process means that contracts are easily tradeable between parties with different hedging requirements and price risk exposures. Click here to find out more about the OTC forward contract for lamb and sheep.
Consider a NSW producer that has 1,000 head of trade lamb scheduled for sale in late November 2016 and wants to lock in a price now through using an OTC forward contract, when the NTLI is at 578¢ and NSW trade lambs are trading at 581¢. Assuming the producer can forward sell his lamb at an NTLI price of 515¢ on ten OTC lamb contracts for settlement on 25th November 2016 he has hedged 20,000 kg/cwt of his lamb destined for sale.
If at the saleyard in late November, he is able to achieve a price of 493¢ on his trade lambs and the NTLI is trading at 495¢ he will end up with a final sale price on his lambs of 513¢ as he will gain an extra 20¢ from the settlement proceeds of his OTC forward contracts. Figure 1 shows the price movements of the NTLI and NSW trade lambs. As it is a fairly close price relationship this means that the OTC forward contract should be a reasonably good hedging tool for the producer to use as part of his price risk management strategy.
Indeed, the seasonal percentage spread pattern between the NTLI and NSW trade lambs, as shown in figure 2, demonstrates how close the two prices track each other during the season. The ten-year average percentage spread shows that prices between the two series usually fluctuate between a 5% discount to a 5% premium. Although, as the green shaded 70% range shows there are times when the price of NSW trade lambs can deviate more widely from the NTLI so this consideration need to be taken into account when assessing the use of an OTC forward contract. The 70% range shows that since 2000 the spread between the NTLI and NSW trade lambs have fluctuated between a 14% discount and 20% premium for 70% of the time.
During those times when the spread between the NTLI and NSW trade lambs moves toward the upper or lower part of the 70% range, or indeed beyond the 70% range, the OTC forward hedge may be more, or less, effective as a hedging tool.
Consider the saleyard example used earlier, but instead of the NTLI trading at 495¢ it was at 510¢. Assuming the producer sold his lambs at 515¢ (a 1% premium to the NTLI) then he would achieve a final price of 520¢ once the 5¢ OTC settlement proceeds were accounted for. However, if he was only able to sell his lambs at the saleyard for 485¢ (a 5% discount to the NTLI) he would achieve a final price of 490¢. Clearly, the prevailing spread between the NTLI and the relevant category of lambs being sold at the time of the settlement of the OTC forward contract can have an impact on the success of the hedge.
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