Farm Risk Management using Futures Contracts
Each planting season, farmers are exposed to the uncertainty that their crops will yield poor results. Additionally, the seasonality of their product lends itself to price volatility as a result of unpredictable factors such as weather, pests, and supply and demand. In an industry where small price fluctuations can have a big impact on profitability, risk management is extremely important!
Farm risk management decisions are often based on past experience and making guesses. While traditional farming practices have been passed down through generations, risk management strategies often lack the same expertise. This article aims to provide a basic understanding of future contracts, and their use in risk management.
What are Futures Contracts?
A futures contract is a standardized, legally binding agreement, where two parties agree to buy and sell an asset at a future date. Futures contracts specify the commodity, quantity, grade, delivery point, delivery period and delivery terms.
Consider the following example. Assume Joe is a local wheat farmer growing 5,000 bushels of wheat that he intends to sell six months from now in December. Joe is concerned that the price of wheat is going to decline and result in a loss of money. Now, assume that Sarah owns a local bread factory and needs to purchase wheat six months from now when her current stock is depleted. Sarah is concerned that the price of wheat may increase, and does not want to charge her customers more for her bread. If Joe agrees to sell his wheat to Sarah in six months for an agreed upon price this is considered a forward contract.
For simplicity, a futures contract is a standardized form of a forward contract, purchased through a commodity exchange.
What is a Commodity Exchange?
A commodity exchange is a place where commodities are bought and sold. The exchange displays the price and market information for each commodity contract that it offers. Market participants can choose to buy or sell commodities in two different ways - either in the cash market or via a futures contract. The cash market is where physical commodities are bought and sold at a price TODAY. This price is known as the “cash price” or the “spot price.” In comparison, future contracts involve potential receipt or delivery of the commodity at some future date. It is important to note that future contracts do not necessarily involve the transfer of ownership of the commodity. One can buy or sell futures contracts whether or not they grow or possess the physical commodity. Market participants who are interested in the physical settlement of the commodity we call “hedgers,” participants who are more interested in cash settlement and exploit small price fluctuations are called “speculators.”
The primary North American exchanges with agricultural commodity contracts include the following:
The Chicago Mercantile Group exchanges:
Chicago Mercantile Exchange (CME)
Chicago Board of Trade (CBOT)
Kansas City Board of Trade (KCBOT)
How to Read a Futures Contract?
To better understand Future contracts let's go back up to our previous example with Joe and Sarah. Let’s assume that Joe and Sarah never reached an agreement. Joe decides to sell his wheat on a commodity exchange instead. Joe heads to the Chicago Board of Trade (CBOT) website and sees the following quote:
Let’s take a look at what this means:
ZWZ21: This is known as the contract code. A contract code is expressed in the following format XXY00.
XX specifies the type of commodity being traded, in this example ZW is the ticker for Chicago Soft Red Winter Wheat.
Y specifies the delivery month for the contract. ZW contracts have 5 different delivery months - March (H), May (K), July (N), September (U) and December (Z).
00 specifies the delivery year.
In this example ZWZ21 means a Chicago Soft Red Winter Wheat contract with delivery December 2021.
748-6: This is the latest price quote.
Wheat contracts are quoted in USD cents/bushel, and have a contract size of 5,000 bushels. Typically exchanges in the United States will quote their contract size using imperial units.
Exchanges in Canada such as the Intercontinental Exchange (ICE) will quote their contract in metric units. The standard size of Canadian contracts is 20 tonnes, and is quoted in CAD cents/tonne.
To find the total contract price we have to multiply the latest price quote by the contract size.
In this example the December Wheat contract is trading at $7.486 / bushel. Or $37,430 / contract ($7.486 x 5000).
+4-0 (+0.54%): This specifies the change in contract price since the end of the previous trading day.
The units of change are the same as the units of the price quote.
In this example the contract price has increased by 4 cents/bushel.
Some additional terms you should be familiar with include the following.
Volume: This is the number of trades that have been made during the day, for the specified contract.
Open Interest: This is the number of contracts that currently exist for the given commodity, irrespective of the purchase / sale date.
Contract Quality: Most contracts specify a certain grade for the commodity. If the commodity being sold is of a different grade, the contract will be subject to a premium or discount.
Minimum Price Change “tick”: This is the minimum increase or decrease in bid that must be made on a contract.
Entering a futures contract
Looping back to our example, let's assume that Joe is happy with the futures price and decides to sell his wheat. Joe can not directly buy or sell a futures contract through the commodity exchange, and must use a registered broker to place the order on his behalf.
Because Joe wants to sell his wheat in six months he will SELL a futures contract. Any market participant who sells a contract is known as the “short” side of the trade. Similarly, any market participant who buys a contract is known as the “long” side of the trade.
Once Joe’s broker places the sell order, Joe will own a ZWZ21 contract with the obligation to deliver 5,000 bushels of wheat on the delivery date. In exchange he will receive a guaranteed $7.486 cents/bushel.
Closing out a futures contract
In order to close out Joe’s position, he has two possibilities.
The first is to deliver the 5,000 bushels of wheat on the delivery date to a buy futures position holder.
The second is that Joe decides to offset the contract by taking an opposite position in the same futures contract. In this scenario Joe will no longer have an obligation to deliver his wheat to a buy futures position holder.
Let's take the following example. Joe sees that the ZWZ21 contract has decreased to 705-6 by the end of September. Joe decides to take a long position in this contract, offsetting his short position. Joe will make a profit on the difference between his short position and his long position ( $7.486 c/bu - $7.056 c/bu) for a total profit of $2,150 ($0.43 x 5,000). In order to deliver his wheat Joe will either purchase another futures contract, or sell it at the spot price.
Conclusion
Future contracts are an effective risk management strategy which should be included in a farmers repertoire. Price trends show that commodity prices are often lowest at harvest when supply increases resulting in a lower profit for farmers. By buying futures contracts farmers eliminate the risk of taking a lower profit at harvest, and guarantee a purchaser. While there are additional risks and complexities associated with futures contracts, this article aims to provide a basic understanding of their use in risk management.
