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Spread Savvy - Grain Service Corporation

Merchandisers’ CornerBy Diana Klemme, Vice President, GrainService Corp., Atlanta, GAHarvest futures spreads are a key part of mostelevators’ merchandising programs. Elevatorstypically buy and hedge a large volume ofgrain before and at harvest, and look to spreads to paytheir costs of carrying the ownership. The challenge isto decide when or at what value to set a carrying chargespread or to move short hedges to a deferred futuresmonth. There’s no single answer, and the decision process ispartly art, partly science.First, calculate the maximum potential carry for a spread, thevalue known as full carry (FC). Second, decide what percentageof FC you’re willing to accept if opportunities arise. Is it 65%,

Notice how far from Full Carry the 2001 crop spread is. Using 2000 crop spreads as a guidefor this year may prove costly.75%, or will you gamble, hopingfor an even wider carry?One factor in that calculationhas changed for Chicago Board ofTrade (CBOT) corn and soybeans.The CBOT recently approved anincrease in the daily premiumcharge for delivery shipping certificates.(The premium charge on ashipping certificate is comparableto a daily storage charge on warehousereceipts.) That rate risesfrom $.0010 per day on the IllinoisRiver and at St. Louis ($.0012 inChicago and Burns Harbor) to$.0015 per day for all locations. Thenew rate starts effective Nov. 1,2001 for all new or outstandingCBOT shipping certificates. Thisincreases Full Carry on CBOT cornand soybean futures spreads.All else equal, Full Carry =(All daily costs of ownership +daily expected interest rate return)X number of days of the spreadThe December/March cornspread is a three-month spread. Aseller can deliver against Decemberfutures on December 1, and along may be forced to take deliveryon March 1, a time span of about90 days. A November/Januarysoybean spread is a two-monthspread. When Day 1 of the frontmonth is reached, FC declinesdaily as the number of days to thedeferred month declines (e.g., Dec.10 to March 1 = 80 days).The interest rate to use in estimatingfull carry for a spreadshould reflect a realistic maximumreturn for using the delivery marketas a short-term investment vehicle.In English, “At what interest ratewould available investment capitalflow away from other homes andstart taking delivery of futures?”Assume an investment advisersaw the December/March cornspread at 22¢. The adviser couldbuy futures, take delivery (even onDec. 1), pay the 90-days’ PremiumCharge (storage equivalent) of13.06¢ and redeliver on March 1.That would leave 8.9¢ return onthe money for 90 days, or 35.6¢ fora year. That would be an investmentreturn of 14.2%, far above themarket for investments of comparablerisk (e.g., 5% to 6% for threemonthCDs, or 4.5% for T-Bills).As a result, it’s highly unlikely a90-day corn spread could reach22¢, given these parameters.Investment money would flow in,buying December futures and sellingMarch as a spread. This in turnkeeps the spread from reachingsuch wide levels. The three-monthLIBOR (London Interbank OfferRate) + 1/2 to 1% is a commonlyused benchmark rate for generalFC calculations. In our example,LIBOR was 5.2%, and we used6.2% for the rate at which thefutures delivery market shouldattract capital.Keep in mind the impact of bothslightly higher interest rates andthe higher premium charge:Carrying charges could be largerthis year. The new daily CBOT premiumcharge raises (theoretical)December 2001/July 2002 corn Full Carry is about 40¢ this year vs. 30¢ last year.WWW.FEEDANDGRAIN.COM • APRIL/MAY 2001 • FEED & GRAIN • 73

FC 4 1/2¢ per bushel on theDecember/March corn spread versuslast year. It raises FC on theDecember 01/July 02 corn spreadby 10 1/2¢ per bushel.The reason for the CBOT changewas ostensibly to enhance convergence,the coming together of cashand futures during the futuresmonth at the delivery locations. If aspread is near full carry, and nearbycash weakness and sellingexceed demand or space, there’sanother way to stop the cashmovement. That is for the nearbybasis to collapse to a point whereenough people see enough returnto shortstop the movement. (e.g.,corn is stored on the ground, farmersfill little-used farm bins etc.)With the higher premium (storage)charge, futures spreads canprovide more of the carryingcharge instead of making the basisdo all the work.Theoretical example:Old rate Higher rateDec/July FC 27¢ 35¢ (ex)Oct basis -15 Dec - 7 Dec= -42 July -42 JulyNote that the October basis, vs.December futures, is higher underthe new rate: -7 Dec in this example.Yet the overall merchandisingsituation is really no different. Inboth situations the elevator wasbuying corn in October at -42 July.Part of the carry just shifted frombasis movement to thefutures carry.Another interesting thing is thatthe higher “storage” rate doesincrease Full Carry, but it doesn’tguarantee the spot basis can’t collapseanyway. If selling is heavyenough, the basis has to do whateverthe spread can’t do. Deliverydoes not set a floor on the cashbasis. (It certainly hasn’t in KansasCity Board of Trade wheat inrecent years.)Merchandising riskFor the country merchandiser,this new CBOT premium chargemeans that all else equal, when thebasis is very weak, you shouldexpect greater spread volatility oncorn and soybeans, and somewhatless basis volatility.Last year it was an easy decisionto roll short corn hedges fromDecember to March at 12 to 12 1/2¢carry; that represented 92% of fullcarry. Waiting offered almost nochance of further gain (in thespread). This year, at 12¢,December/March could widenanother 5¢.Charts 1 and 2 show theDecember/July spread for 2000and 2001 crop corn. Notice how farfrom FC the 2001 crop spread is.Merchandisers should alreadybe watching new-crop corn andsoybean spreads. Using 2000 cropspreads as a guide for this yearmay prove costly, however. Don’tbe quick to lock in spreads at levelsbecause they were great last year.December 01/July 02 corn FC isabout 40¢ this year vs. 30¢ lastyear. Watch the spread as a percentageof FC instead. Whenthere’s little left to gain in thespread (near FC), roll short hedgesforward or preset the carry.Be cautious also about assuminglast year’s basis values, relativeto nearby futures, will be avalid barometer for 2001 cropcorn and soybeans. All else equal,the potential for wider futurescarries means spot basis valuescould be somewhat stronger relativeto the nearby futures month.(e.g., October basis relative toNovember soybean futures, orDecember corn futures.)Note: Spreads prior to Nov. 1will also reflect this rate changeon any portion from Nov.1 forward.For example, September01/December 01 equals onemonth under the new rate.For more information contactDiana Klemme at (800) 845-7103 ore-mail: diana@grainservice.com.The CBOT increase in daily premium charge for delivery shipping certificates increases Full Carry on CBOT corn and soybean futures spreads.74 • FEED & GRAIN • APRIL/MAY 2001 • WWW.FEEDANDGRAIN.COM

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