(Extract from Using Risk Management in Grain Trade: Implications for Developing Countries1)1 Using Risk Management in Grain Trade: Implications For Developing Countries, Prepared by UNCTAD for Intergovernmental Group on Grains meeting organised by FAO June 1995.
Introduction and Background
.....During the last few years, there has been a growing trend towards liberalisation of commodity markets, both domestically and globally. The impetus for such changes stemmed from structural adjustment programmes and government commitments to more open trade polices in the context of the Uruguay Round of Multilateral Trade Negotiations. Many governments of developed and developing countries have abolished structures and institutional arrangements that regulated commodity marketing and market prices in the past. Especially in the developing countries, often drastic measures have been taken to give a larger role to the private sector.
However, reducing government intervention in commodity markets has also left important vacuums. One of these relates to the role formerly played by the state in setting producer and consumer prices for food commodities, enhancing the image and reliability of export regimes and providing counterparty guarantees to oversees importers. The second relates to a considerable shift of exposure to the risk of world market price instability from the state to farmers, private traders and processors. By and large, the degree of their exposure to price risks and their capacity to manage such risks have not been taken into account fully in the new liberalised environment.
For an important share of internationally traded agricultural commodities, risks can in principle be laid off on the market, by using risk management instruments. Two broad types of market-based commodity price risk management instruments are standardised or tailor-made contracts. The former (commodity futures and options) stipulate the price to be paid for a specified volume of the commodity, its precise quality and delivery period. The latter are over-the-counter contracts (forward contracts, swaps and commodity bonds and loans) offered by commodity trading houses and financial institutions and are tailor-made to the needs of the client.....
Standardised Contracts
Well functioning futures and options exchanges provide the most efficient and equitable price discovery mechanism available and facilitate physical trade. Their creation is an alternative for countries which are moving away from internal price and marketing controls. Domestic futures markets can also serve as "collection points" for local risk management needs, accessible to those unable to use foreign markets, while larger market participants can transfer the risks abroad. The futures markets in developed countries are strictly supervised by governments, and the performance of contract obligations is guaranteed by highly-capitalised, clearing houses. These markets can be accessed directly through brokerage firms, the larger of which have offices in some developing countries, and indirectly through trading houses.
Futures Contracts
A futures contract is an agreements to purchase or sell a commodity an o specified future date at a pre-set price. Futures are used to hedge against price risks by locking-in a future price, while avoiding the credit risk involved in forward contracts. There is and initial cash transfer for margin payments and daily cash transfers may be required. An initial position can easily and quickly be closed or reversed. Physical delivery of the commodity is not necessarily implied. The maturity is mostly up to 18 months and sometimes 36 months.
The commodities contracts offered by the Chicago Board of Trade (CBOT) and other futures exchanges are standardised: they specify a standard quality, quantity, time and location of delivery. Taking delivery on these standard contracts is rarely useful for developing country importers. Rather, while continuing to buy grain from regular suppliers, the use of the futures market allows importers to price the contracts more or less independently because import prices will not be at the same level as the Chicago prices. The difference is called the "basis", or the difference between the import price of a country and the reference price on the futures market (which normally reflects transport costs, competitive pressure and eventually also currency values). However, the "basis risk" importers run when hedging is generally much smaller than the absolute price risk without hedging. Hedging on the basis is also a highly valuable tool for importers eager to lower their purchasing prices; they can be used, for example, to reduce the impact of temporary localised bottlenecks in transport, port discharging facilities, etc.
The following example illustrates the use of futures contracts to reduce the price risk as well as the basis:
A grain importing agency knows that, in three months time, it will have to import 27,200 tonnes of wheat (200 standard contracts of 5,000 bushels or 136 tonnes). The price quoted in Chicago for delivery in three months is US$ 116/tonne. The importer finds this an attractive price (a price which, even taking into account the normal price differential between Chicago and the country's ports, allows it to stay within its budget), and approaches a number of traders for offers of forward contracts, with delivery in three months time. The lowest delivered price offered is US$ 135/tonne. However, the importing agency considers the basis of US$ 19/tonne (US$ 135 - US$ 116) too large. Nevertheless, since it does not want to risk that prices increase before it can sign a more attractive contract, it decides to hedge the major portion of the price risk by buying 200 contracts on the CBOT. One month later prices have increased to US$ 130/per tonne, but for delivery to the country, traders now quote a basis of only US$ 15/tonne over the Chicago contract, that is,US$ 145/tonne. The importer decides to close out its futures position (by selling 200 futures contracts), and to enter into a forward contract for delivery in two months. The effective price is somewhat over US$ 131/tonne, that is the contract price of US$ 145/tonne minus the US$ 14/tonne profit on the futures transactions (US$ 130 - US$ 116), plus commission costs which are to be paid to an intermediating futures market broker.
While this type of hedge transaction allows an importer to lock in an attractive price and to negotiate a better "basis", it has two major disadvantages. First, there is the risk that prices will decline, making the importer vulnerable to criticism for having locked in a price which, in hindsight, is no longer attractive. In the example above, if Chicago prices had declined to US$ 100/tonne (and the basis to US$ 15/tonne), the importer would still have effectively paid around US$ 13 I/per tonne, because of a USS 16/tonne loss on the futures market. Second, the importer has to pay a deposit as "security" for his position, and if prices move adversely, the trader faces additional "margin calls". The margins involved can be considerable; in the example above, if the Chicago wheat price declined by US$ 5/tonne, the importer would have to pay an additional US$ 136,000, within 24 hours.
Options
The use of options can provide a partial solution to the above problems. An option is the right, but not the obligation, to purchase or sell a commodity on or before a specified date at a pre-set price. Options are used to limit the size of losses from unfavourable movements in commodity prices in the future but also allow the opportunity to take advantage of favourable price movements. Put options (option to sell) provide protection against price declines, call options (option to buy) provide protection against price increases. There is an initial cash transfer, the premium, or the cost of the option, from the buyer to the seller of an option. Sellers (but not buyers) of exchange-traded options are exposed to margin requirements. Options are largely executed on a futures contract for the commodity rather than the physical commodity itself. The maturity of exchange-traded options contracts is mostly up to one year.
Options can best be compared with insurance: they protect against unfavourable price movements, and, if no adverse developments take place, one is free to profit from whatever the market offers. As insurance, the premium is lost if the option expires unused. The easy availability of options provides one of the most radical innovations in grain trading in the last decade, even though, in practice, making effective use of options may not be easy.
The following example of the use of options to limit an importer's exposure to price increases:
An occasional wheat importer may not wish to pay more than a world market price of US$ 160/tonne. In February 1994, CBOT prices were US$ 150/tonne and an option for the right to buy at US$ 155/tonne during the period of 6 months had a premium of US$ 3/tonne. By buying 200 contracts at a total cost of US$ 81,000 (27,200 tonnes times US$ 3), the importing agency effectively protected its import price at US$ 158/tonne, plus the basis. Six months later, however, market prices had declined to US$ 140/tonne, and the options expired worthless with a loss of US$ 81,000. The importer would have been compensated by lower grain prices if it had wished to import, but as it still had no imminent import needs, the importing agency decided to re-establish an options position for 200 contracts which gives the right to buy at US$ 145/tonne, again at a premium of US$ 3/tonne. In October, there is a need for imports, and the importer buys 30,000 tonnes on the market, at the world market price plus the country's normal margin of CIF delivery. The world market price in October is US$ 168/tonne, but the options that the importer holds have a value of around US$ 23/tonne, giving a net profit on the options of US$ 17/tonne (US$ 23 minus US$ 6/tonne for the two premium charges). For that part of its import needs for which the importing agency had established a price protection, it pays a net price of only US$ 151/tonne (saving around US$ 462,000, or 10 percent of the import bill). It is worthwhile to note that if futures contracts had been used, the effective import price would have been US$ 150/tonne (the CBOT market price for February), but this strategy would have put a larger pressure on cash flows; requiring a deposit of US$ 200,000 as initial guarantee, and by June, an additional US$ 150,000 for margin calls....
