In the second of our Academies looking at how farmers can get maximise returns from grain, the HGCA’s Mike Mendelsohn explores the least understood of risk management tools – derivatives.

In the previous academy, we looked at the broad range of approaches that can be taken to manage price risk in an increasingly volatile market. This week, we focus on futures and options – commonly called “derivatives” - and their use as risk management tools.

These exchange-traded derivatives are the most flexible and the least understood ways to manage grain price volatility, and a good grasp of these tools can be extremely helpful in planning pricing and marketing strategies.

The Basis

For futures contracts to be useful, movements in futures prices must reflect those in the physical market. This is achieved by allowing sellers to physically deliver and for buyers to receive the underlying commodity. Although in practice this seldom happens, the possibility of delivery ties the futures and physical markets together.

It is therefore essential that all participants in the futures market understand the link between physical prices and futures prices, a relationship known as “the basis”.

The basis answers the question as to how you can derive an ex-farm grain value from the futures market price. Your basis represents the relationship between your local price and the futures price. It is calculated as follows: Basis = physical price minus futures price (in a specific month).

This will account for costs incurred due to storage, handling and freight as well as any premium for grain quality. It is important to note that because of local issues such as storage or transport, the basis value can rise or fall independent of whether futures prices are rising or falling.

You can determine the basis for your region by keeping track of futures prices compared to similarly timed ex-farm quotes. In this way, a pattern of basis changes through the season will emerge.

Futures

A futures contract is an agreement to exchange a specific quantity and quality of a commodity like wheat at a specified time and at a price determined on an open exchange like Euronext.liffe.

Futures work in much the same way as forward sales of physical grain, the main differences being that contract specifications are standardised (and are the same to all parties), and that transactions take place through a regulated exchange.

These standardised specifications make clear in advance to buyers and sellers what the quantity, origin, quality, location, and timing of delivery are. This leaves price as the only element to be determined between buyers and sellers in the market.

The beauty of the futures market is the assurance that no party can default on the other. This is because all futures and options contracts are traded through a regulated exchange and are backed by a clearing house that steps into the middle of all transactions.

This clearing house effectively becomes the seller to every buyer and the buyer to every seller.

But an exchange does not set the price at which the futures contract trades. That is determined in much the same way as in the physical market for that commodity – buyers and sellers will exchange the product at a value which both sides feel is a fair reflection of the market at that time.

A futures contract does not involve delivery of a physical product until a specified date, just before the contract expires. In fact, most futures contracts never reach delivery.

Instead, the holder of a futures contract will usually offset his existing position by taking out an opposing position on the exchange, which will cancel out the existing commitment.

Options

An options contract is an agreement giving the buyer of the option the right, but not the obligation, to buy or sell a specified futures contract (usually called the “underlying”) at a pre-determined price.

Options allow you to choose whether or not to go through with the contract, while futures leave you with the obligation to sell or buy at the specified date in the future. Put simply, options provide the ability to lock in a minimum price, while still gaining benefit from possible favourable price movements.

Options work like insurance policies. For instance, the buyer of the option has to pay a premium to the seller.

The seller receives a premium and in return gives the buyer the ability to make a claim. The buyer of an option is insured against a certain risk - the price of the underlying commodity falling below, or rising above a certain price.

 There are two types of options that can be bought:

• “Put” options give the buyer the right, but not the obligation, to sell the underlying futures contract on or before expiry at a prearranged price.
• “Call” options give the buyer the right, but not the obligation, to buy the underlying futures contract on or before expiry at a prearranged price.
• Typically, one would buy a “Call” option having sold the physical crop in order to gain some benefit from a rise in the market after the sale. And a “Put” option might be bought where the grain hadn’t been sold, in order to protect against a fall in the market, while remaining open to benefit from any rise.

It’s often easier to remember it like this:

• Put Options can protect the value of unsold grain - If the market falls, the Put option makes money, compensating for any physical loss
• Call Options can capture price rises after a grain sale - If the market rises, the Call makes money, compensating for any physical loss

The seller of an option, in return for the premium, is obliged to either buy or sell the relevant futures contract at the specified price if the buyer chooses to exercise their option.

Only specialists should be involved in the selling of options, as a number of elements influence the value of the premium. In addition, the selling of options carries significant risk, and a seller’s potential losses are limitless.