Swaps, Spreads and Safety Nets

• Swap participants must each have an active futures account with a clearing firm in which your swap trades will appear
• All swap buyers and sellers must also register initially with CME/NYMEX Clearport®. (www.nymex.com/cp_start.aspx)
• All ag hedgers who wish to buy or sell exchange-cleared swaps to manage business risks must have a federally required minimum net worth of $1 million

Grain veterans from the mid-1980s will remember when the government disposed of surplus CCC inventories by transferring them to farmers in the form of Payment in Kind certificates in lieu of paying cash for farm program benefits. Farmers could redeem the certs for physical grain at a warehouse (and sell the grain) or sell the certificate in a secondary market -- "Over the Counter."

Traders quickly caught on to arbitrage opportunities and a thriving secondary market arose with certs trading freely at varying premiums to face value. The cert buyer and seller had no lasting relationship and were often far apart geographically. Shipping the certs to the buyer's bank controlled counterparty risk.

Basis Swaps

Trading the new basis swaps reminds me of trading in PIK certificates. The functions of swaps and certs are different, of course, but the process is similar: Unrelated parties execute a financial transaction. They don't have to know each other, and why each is doing the transaction is irrelevant to the other party.

Basis swaps offer a way for buyers or sellers of cash grain to hedge basis risk for a negotiated time slot, without being committed to a cash grain contract. The basis swap benchmark must be one of the six Corn Belt regional cash Indices CME has approved: 1) Southern Minnesota, 2) Eastern Nebraska, 3) Eastern South Dakota, 4) Northeast Iowa, 5) Northwest Iowa, or 6) Southern Iowa. The daily settlement of each index is compiled by DTN using elevator, terminal and processor cash bids within each region.

The basis-swap buyer and seller both retain some basis risk — any amount their local cash basis doesn't track with the regional basis index designated in the swap at settlement time.

Final (basis) settlement will be calculated as the average of the Regional Index basis over the final five trading days of the swap.

Finding counterparties for swaps won't be as hard as it sounds. Brokers will search out willing buyers and sellers. Market-makers will watch for dislocations, just as arbitragers watched for CCC price dislocations in the old PIK days.

Basis swap example

A feed mill that wants to own cheap corn basis might find it hard to buy corn from farmers. They could "hedge" the basis by buying a basis swap and buy physical corn when the swap matures. If basis rises, the inventory basis will cost more but the basis hedge — the swap — will pay the mill the amount the underlying basis index rises.

Or assume basis in your general area is strong for summer and you would like to sell inventory. Assume that your main market is an ethanol plant that isn't ready to buy yet or you're concerned whether that buyer is financially sound. You could sell a basis swap to protect against basis potentially weakening.

You don't have to be located in the Upper Western Corn Belt to use basis swaps. What is important is whether basis changes in the Index region reflect basis moves in your area. If your correlation is sufficiently high, then a basis swap may remove enough of your risk to make it an effective, if not perfect, hedging tool.

Calendar swaps

A feedlot that wants to lock in the (futures) price of corn for the next six months could buy a corn calendar swap to protect against rising corn prices. The feedlot still has to eventually buy real corn from suppliers. The feedlot's final local cash prices depend on their respective local basis/cash price plus the gain or loss from the swap.

All cleared calendar swaps will settle on the last business day prior to the designated swap maturity month.

• June 2009 corn swaps expire on May 29, 2009 using the settlement price of July 09 corn futures;
• July 2009 swaps expire on June 30, also using the settlement price of July 09 futures

The final swap settlement price at expiration is calculated as the average of the cumulative futures settlement prices during the expiration month (May 09 for June 09 swaps) divided by the number of trading days. Settling at a monthly average price is attractive for many end users; futures limit them to a single-day's settlement price per 5,000 bushels.