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Monday, June 27, 2016

Turn grain swaps around.

By Andrew Whitelaw  |  Source: ACA

Key points

  • A number of banks offer growers the ability to buy a swap instead of selling.
  • Using a buy swap-sell physical strategy is most attractive for a grower when basis levels are high and futures are low.
  • The buying of a swap should be used as a hedge, and not as a speculative tool.
  • There are advantages to using derivatives post-harvest, due to immediate cash flow recouped from the physical sale and ending storage fees.

 

There will be many of our readers who use swaps as an instrument in their grain marketing toolbox. The swap is a simple tool to use, and in general are used pre-harvest but are there opportunities to turn the swap on its head and use post-harvest?

The traditional method of utilizing a swap, would be to sell a swap prior to harvest in order to lock in a futures price, and then unwind the swap by buying back the swap from the bank at or near harvest. The main point of using swaps as a marketing tool is to create a hedge to protect against downside in physical prices, not as a speculative tool. At its most basic, if physical market rallies you will lose on the swap and gain on the physical and vice versa (fig 1) 

A detailed explanation of swaps and a video on how to use them is available on the below link:

Grain Swaps - farmers' friend or hazard to be avoided?

The above explanation explains briefly the traditional use of swaps, with the grower as the seller in advance of harvest. In our previous analysis article ‘3 elements you must consider when pricing grain’, we have explained the importance of thinking of your grain price as three distinct components. It is important to always keep in mind basis and futures. 

During a year with low harvest prices, many growers will elect to hold onto grain with the hope of prices increasing in the post-harvest period. The holding of grain has a cost attached (interest lost, storage costs), and alternatives where you can cash your grain and still have exposure to the market are an attractive proposition.

It is possible with a number of banks to turn it around and instead of selling a wheat swap, buy a wheat swap. Let’s say for instance the current basis levels were high, and futures were low. It would be possible to sell your physical grain and lock in the basis, at the same time as buying a wheat swap. 

The buying of the swap would give an exposure to the futures market. Therefore, if the futures market rallied you would participate in any upside. In an ideal world you would then close out your swap position when you had reached your target price, and with the addition of the basis already captured, would be your overall price.

It has to be noted that there is also the potential for downside risk, and for many it may be more beneficial to use a cash and call strategy which has a known ‘worst case scenario’.

The use of derivatives as an alternative to holding onto grain either on farm or in the system storage has a number of advantages:

  • You are able to gain cash flow from the physical sale of your grain.
  • You no longer have to pay storage costs
  • If the basis levels are attractive they are locked in, leaving no exposure to local issues.

What does this mean?

It is important to understand a number of different ways of marketing your grain, as the tools available will work better in different marketing environments.

The opportunity for growers to buy a swap is best utilised when futures values are low, and basis levels are high.

 

Mecardo information is provided to assist in your marketing decisions. It contains a range of data and views on the current market. It is not intended to constitute advice for a specific purpose. Before taking any action in relation to information contained within this report, you should seek advice from a qualified professional. The information is obtained from a variety of sources and neither Mecardo nor Ag Concepts Advisory will be held liable for any loss or damage whatsoever that may arise from the use of information or for any error or mis-statement contained in this report. 

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