(DTN) While farmers are optimistic for 2011, they wonder how long current profits will last.

The further out contracts are, the higher the LIBOR rate, reflecting market expectations that interest rates will rise. Although this makes it harder to hedge, these rates are still modest compared with possible increases that some fear. (DTN chart by Darin Newsom)One concern is expected increases in interest rates in the face of super-sized operating loans. This is because of rising input costs and because some farmers need to fund three years of crops: last year's crop still in storage, this year's in the field and for pre-purchase of some of next year's inputs.

Hedging short-term interest rates was a high-interest topic at the DTN/The Progressive Farmer Ag Summit recently where the concept was explained by CME Group Associate Director for Financial Research James Boudreault and farmers who trade eurodollars to lock in interest rates. Boudreault listed five features to consider.

1. Eurodollar futures have nothing to do with the Euro currency. Rather, they are directly tied to the three-month LIBOR (London Inter-Bank Offered Rate), the interest rate banks charge each other for loans. They technically are a U.S. dollar time deposit held in an overseas bank, typically in Europe and the United Kingdom -- hence the name eurodollars. They trade 10 years out, with strong trading volume up to six years ahead.

Contracts are for $1 million and last three months (quarterly), so some traders consider each contract to be covering $250,000 (a quarter of a million dollars) of borrowing needs because most people think in annual terms. If you want to borrow $1 million for a year, you need four sequential contracts to cover your annual borrowing needs. If you want to cover your borrowing needs of a half million dollars, you need two sequential eurodollar contracts. If you want to protect rates on a $250,000 credit line, you only need one eurodollar contract in that year.

To protect your risk against LIBOR interest rates rising, you would sell a contract. The price of eurodollar futures is 100 minus the three-month LIBOR. A eurodollar contract priced at 99 is the equivalent of LIBOR at 1 percent (100 -- 99). Every basis move is worth $25 per contract.

If you consider interest rates will not go negative, the maximum upside risk for a short position is 100. On December 14, March 2013 eurodollars traded at 97.75, so if LIBOR went to 0 percent, your total upside risk on that trade would be $5,625 per contract: 100 (0 percent interest) -- 97.75 (current eurodollar price for March 2013 contract) x 100 (basis point = 0.01 percent) x $25 (per basis point).

Colon, Mich., farmer Barry Mumby sold September 2013 eurodollars in 2009 at 95.20, implying an interest rate of 4.8 percent. But a year later, when eurodollars moved higher (interest rates lower) against Mumby's position, he got nervous and decided to cut his losses and study the market a little more. He got out with a loss of $4,200 and sat out the market when it continued to rally. Mumby reinstated his hedge on October 28 at 98.275 (implying an interest rate of 1.725 percent). On December 15, his hedge had gained $2,712.50. "The eurodollar charts have turned very bearish in the last three weeks, indicating higher interest rates are expected," said Mumby.

2. Eurodollar futures are the most liquid interest rate futures in the world, said CME's Boudreault. Open interest in corn futures is about 1.5 million contracts; open interest for eurodollar futures is more than 7 million. Daily trading volume for corn is about 282,000 contracts; eurodollars, more than 2 million.

3. Although some loans, including most agribusiness loans and large farm loans, are indexed to LIBOR, others are tied to the U.S. prime rate. eurodollars are not a direct hedge against moves in the prime rate, which is calculated by using the top of the range of the U.S. Federal Funds target rate (what the Fed charges member banks) plus 3 percentage points. For example, if the Fed Funds target is 0 to 25 basis points, prime rate is 0.25 percent plus 3 percent, making the prime rate 3.25 percent. Generally, the U.S. prime rate and LIBOR track together. But in times of financial upheaval, the two may diverge.

Pat Duncanson, who raises corn, soybeans, canning beans and hogs with his family in Mapleton, Minn., added: "It's not a perfect hedge but we're trying to manage our operating risk by hedging the trends with eurodollars. We hope to catch the big moves if interest rates jump drastically higher over the next couple of years."

4. The trading cost is relatively low. Mumby's initial margin was $1,000 per contract with a maintenance margin of $800 and his round-trip commission is $25 to $35, he said.

5. Drawbacks include: If interest rates stay low, risk protection is not needed. Trading in a nearby contract won't protect your risk if the rates in the deferred years rise. Rural bankers may not be willing, or knowledgeable enough, to fund a margin account for this purpose.

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