Question

A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live-cattle futures contract traded by the CME Group is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer’s viewpoint, what are the pros and cons of hedging?

Answer 1

The farmer would wish to hedge against a fall in the price of cattle. Therefore, the farmer would sell (short) 3 contracts for delivery in 3 months. As each contract is for 40,000 pounds of cattle, taking a short position in 3 contracts (120,000 pounds) would fully hedge the farmer's expected sale in 3 months. By selling the futures contracts today, the selling price of the farmer's cattle is locked-in, and thus the farmer's risk is hedged.

The pros of hedging are :

• The selling price is locked in. Even if cattle prices fall in 3 months, the farmer will realize a higher selling price.
• The farmer knows the selling price beforehand. This allows for better planning due to higher certainty.

The cons of hedging are :

• If the price of cattle in 3 months is higher than the price at which the futures contract is sold, the upside benefit is lost. The selling price is locked in at the futures selling price, and a higher price cannot be realized
• Taking a futures contract position requires depositing a margin amount. This can involve a substantial cash outflow for the farmer;