Tax treatment of trade in cattle futures: possible implications to market efficiency and price stability

Prolonged imbalances between feeder cattle costs and the pricing opportunities being offered cause highly variable placements of cattle into feedlots and variability in fed cattle prices. Such variability imposes costs on everyone in the system, from producer to consumer.

Cattle feeders are in a position to exert the influence of very current and highly specific information on costs of feeding into trading levels for live cattle and feeder cattle futures. The tax treatment of speculative trades in the cattle futures markets has the potential to block participation of cattle feeders. To the extent that cattle feeders are effectively blocked from trading in futures in any capacity other than trades that meet the IRS "equal and opposite" criterion of a hedge, the correction of market imbalances may be impended. The economic viability of investments in cattle feeding can be influenced in a significant way by those market imbalances.

This research examines the interaction of traders in the risk transfer and price discovery process in the live cattle markets. Econometric models over disaggregated data sets were developed to explain expected margin behavior in response to the changes in the positions held by identifiable and specific trader groups. In addition, trader behavior reactions to the levels of the feeding margins offered by the distant live cattle futures were examined.

A weekly data series was constructed using the daily records of reporting trader positions in the live cattle futures at the Chicago Mercantile Exchange. Feeding margins offered by the futures were calculated using cash prices for feeder cattle and feed fixed at the time of placements of feeder cattle on feed. The analysis was for the 1983-1987 period.

The analysis indicates that increases in large, long (short) trading activity were associated with increases (decreases) in the expected margin offered by the futures. More importantly, the behavior of large speculators were found to exert a constraining influence on margin changes and to start the market correction at extreme levels of negative margins. This implies that cattle feeders, trading as large traders, could contribute to correcting the market imbalances if they were allowed to fully participate in the price discovery process.