Honey the Hamster

Suppose a farmer is worried about falling prices when his animals are ready to be put on the market. It uses the futures market to hedge or minimize its price risk. He can calculate the spot price he needs for his livestock and then sell live cattle futures on the futures exchange to guarantee that price. This will ensure its profitability, despite a drop in the market price for its herd. As described above, futures can be an effective tool for managing price volatility if their exchanges are functioning properly, as they allow producers to hedge against the price risks of their products. However, it should be stressed that this instrument does not reduce price volatility as such. [29] Marketing contracts are more prevalent throughout U.S. agriculture: more than 156,000 farms used them in 2016. Marketing contracts are used by field and specialty crop farms, as well as cattle and milk producers, but corn and soybean farms still accounted for 60% of all farms using marketing contracts in 2016. (See image below.) First and foremost, futures are a risk management tool.

Futures contracts give farmers the opportunity to “secure” a certain harvest price for (part) of their agricultural production, thus eliminating the possibility that their selling price will fall in the future. [17] This method is commonly referred to as “hedging.” As a result, farmers no longer have to deal with fluctuations in the prices of these raw materials, as the risk of price changes is transferred from farmers to speculators who are willing to accept this risk in the hope of profiting from it. [18] [19] Other plant products also have well-functioning European markets for derived products. ICE Futures Europe has a liquid exchange for refined white sugar and all varieties of cocoa and provides reliable price references for these products. These markets are liquid because both products can be stored for a relatively long period of time, allowing for smooth trading and higher trading volumes. [50] Nevertheless, some crops in their European futures markets also suffer from very low liquidity due to limited trading volumes, such as. B barley and potatoes. [51] Second, futures can also be useful as a pricing tool. Because futures markets reflect the price expectations of buyers and sellers, they allow farmers to estimate future spot prices for their farm products.

In the context of unstable agricultural markets, it is particularly useful for farmers to be able to estimate the selling price at the beginning of the production process. [20] In addition, this complex regulatory framework for commodity derivatives will not be fully implemented until January 2018, as important details still need to be addressed by ESMA`s technical standards, delegated and implementing acts and guidelines. The effectiveness of the current legal framework is therefore largely determined by implementation decisions at European and national level. [73] Due to the incomplete nature of financial reforms, there is no guarantee that European agricultural futures are already sufficiently protected against excessive speculation and market abuse. [74] Futures (or simply “futures”) are standardized and binding agreements in which a buyer and seller agree to exchange a certain quantity of a (agricultural) product at an agreed price at a certain future time. The 2016 survey found that 12% of corn and soybean producers used futures, options or marketing contracts, so most farmers of these crops do not rely on these tools to manage risk. Farms that use these tools cover some, but not all, of the production, with a single tool. On average, farms that use futures contracts cover 41% of their corn production and 47% of their soybean production. When farms use marketing contracts, they sell similar shares under those contracts – 42 percent of corn and 53 percent of soybeans. When using option contracts, farmers cover just over 30% of their production.

Farms typically use a portfolio of risk management tools and don`t rely on just one tool. In general, the number of futures contracts traded on European stock exchanges and the use of futures contracts by farmers have steadily increased in recent years. Nevertheless, the number of commercial activities remains significantly lower than in the United States, even for commodities, which are largely produced and consumed in the European Union. European farmers also use fewer commodity futures: it is estimated that between 3% and 10% of them have used this risk management tool, compared to 33% in the United States. [45] In the past, there was also a limited number of forward trades where contracts for animal products, particularly pork, were negotiated. One of the first examples was the Hanover Commodity Futures Exchange, which was founded in 1998 and had a considerable trading volume in the early 2000s, but was closed in 2008 due to insolvency. Similarly, contracts for live piglets and piglets were concluded in Amsterdam in 1980 and 1991, but they disappeared in 2003. [43] A major problem for these exchanges was the lack of market players: only producers were positioned, while the interest of buyers (slaughterhouses, processors, manufacturers, etc.) was limited. [44] Farmers rarely cover all their production with futures or options contracts; Instead, they use a portfolio of risk management tools, including marketing contracts and investments in on-farm storage. Futures and options contracts usually do not lead to the actual delivery of the goods, as most participants make final financial settlements with each other at the end of the contracts.

These contracts therefore only serve to limit the price risks associated with the sale of goods. In a marketing contract, on the other hand, a farmer undertakes to deliver a certain quantity of goods to a specific buyer within a certain period of time. While futures and options contracts are highly standardized and focus on a common set of a precisely specified product delivered to a single location for pricing purposes, marketing agreements can be quite idiosyncratic and tailored to the needs of individual buyers and sellers. Marketing contracts may specify a fixed price at the time of the agreement, thus setting a price for the seller, or they may set a base price (often linked to a forward price) with premiums and discounts applied to the attributes of the delivered products. For example, under marketing contracts, hog buyers may pay premiums for pigs that meet certain lean targets, while cattle buyers may deduct for cattle that are too large or too small. A futures contract is an agreement (applied by the rules of the organized commodity exchange on which it is traded) to deliver or accept the delivery or acceptance of a certain amount of a commodity during a given month at a price determined by trading on the exchange. For example, a farmer (or other market participant) could enter into a futures contract at the end of July 2020 that specifies the delivery of corn in December (in futures terminology, the farmer would have a “short position” that offers to deliver corn in December at the end of July). Corn futures for December delivery were trading at $3.36 a bushel at the time, while September delivery contracts were trading at $3.28 and those to be delivered in March 2021 were trading at $3.45. By entering into a futures contract, the farmer was able to obtain a certain price for a cropless harvest and conclude supply contracts in different months. Farmers can also buy and sell futures to hedge against the risks of future price fluctuations and thus manage price risks.

The proper functioning of futures markets therefore requires a sufficient number of players, both hedgers who want to protect themselves from price changes and speculators who want to bet on these price changes, as this should ensure that futures prices reflect the “real” prices of (agricultural) commodities. .