Table of content
- What is a hedge?
- Types of hedges
- Agricultural Commodities With Futures
- Commodity arbitrage: Operations of a commodity exchange
- Where futures arbitrage occurs
- Buyers equal sellers
- Hedging: Transferring risk through arbitrage
- When to hedge
- The costs of hedging
What is a hedge?
Taking opposing positions in the cash and futures markets is the definition of hedging. First, be aware that there are two markets in order to comprehend what a hedge is.
- The cash market is the actual marketplace where agro commodities are bought and sold.
- The paper market where futures contracts are bought and traded is known as the commodities futures market.
For instance, a farmer wants to sow canola in a field. He invests in, or purchases, canola production even before seeding with the help of his land, labor, and inputs of fuel, fertilizer, seed, and chemicals. By purchasing these inputs, he has purchased a canola crop. He has thereby acquired a share of the cash canola market. If he hedges the crop by selling futures contracts at some point throughout the growing season. He will then hold an opposing position in both the cash market (purchased output) and the futures market (sells futures).
By taking the opposite position from what he has in the cash market (buy) in the futures market, the hedge locks in the price. If the sell hedge is in place, a decline in canola futures prices will decrease the value of the growing grain. But increase the value of the seller’s short futures hedge. The amount of money made in one market and lost in the other will be nearly equal. If you want to import A+ class agro commodities then you are at the right place. You can contact one of the agricultural commodities trading companies Vimpex Ltd.
Types of hedges
Two varieties of hedges exist:
- Short hedge: commonly referred to as a selling hedge
- Purchase a long hedge: often known as a hedge.
To guard against declining prices, the majority of grain growers would utilize a short hedge.
A feedlot proprietor seeking to lock in a price for career feeder cattle. A canola crusher who wants to lock in the forward price of raw canola seed. They may employ a buy or long hedge. A grain exporter who has sold grain to a foreign customer but hasn’t yet bought it on the open market would be another example of a buying hedge. Until contracts for purchases to cover the export sale are there in the cash market, the grain exporter would use a buying hedge in this scenario to protect against a cash market price increase.
The remainder of this section concentrates on selling hedges because crop growers utilize them the most frequently.
Although buy-and-sell hedges can reduce the likelihood of unfavorable price movements, or price risk, doing so comes with a direct cost. These expenses are the commissions and exchange fees that agro-commodity brokers charge for their services. The price varies depending on the futures market, the transacted futures contract, and the brokerage house.
Agricultural Commodities With Futures
Agro-commodity producers regularly deal with price and production issues. These risks have also increased as a result of expanded global free trade and adjustments to domestic agricultural policy. Producers are becoming more aware of the value of including risk management as a component of their management strategies. As the unpredictability of pricing increases the variability of revenue.
Using the commodity futures exchange markets is one way to lower these risks. Agricultural producers can use the agro-commodity futures markets to hedge the possible costs of agro-commodity price volatility. Similar to using auto insurance to hedge the potential costs of a car accident. The advantages of agro commodity hedging might not cover the expenses of hedging. Similar to how gains from an automobile insurance claim might not exceed the cost of the total sum of premiums. Hedging’s main goal is to reduce price volatility, not to maximize profit. To assist producers in assessing hedging prospects, this guide from one of the best agricultural commodities trading companies Vimpex Ltd. offers an overview of agro commodity hedging.
Commodity arbitrage: Operations of a commodity exchange
The act of concurrently buying and selling a commodity on two different markets is known as arbitrage. The goal is to profit from a difference in price between the two markets. For people interested in arbitrage, an agro-based commodities futures exchange serves as a market. The supply and demand factors that determine the equilibrium price at different locations, whether real or perceived, are the forces that drive arbitrage.
Through the exchange of paper promissory notes to sell or purchase a commodity at an agreed-upon price at a later date, arbitrage transactions are carried out for the futures market. Agro-based commodity prices are stable through the interaction of individuals with various viewpoints. On where supply and demand are at the moment and how they will change in the future. As fresh information hits the market, opinions shift and the arbitrage process restarts.
Participants in the market include traders and investors. In speculation, neither side actually owns a commodity, but each person thinks he can predict the market’s course. A person who owns the commodity and wants to transfer risk does so by using the commodity futures markets, which is further explained below.
Where futures arbitrage occurs
Chicago is home to the two primary futures exchanges where agricultural commodity futures market arbitrage takes place. Futures contracts for maize, soybeans, soybean oil, soybean meal, wheat, and rough rice take place on the Chicago Board of Trade (CBOT). Live cattle, feeder cattle, and lean hog futures are all traded on the Chicago Mercantile Exchange (CME). The CME group now includes both exchanges. Additionally, cotton futures are traded in New York at ICE Futures U.S.
Buyers equal sellers
The quantity and cost of contracts purchased equal the quantity and cost of contracts sold in a marketplace like the CBOT or the CME. However, there is no commitment between particular customers and sellers. As a result, a person may, at any moment, purchase or sell a contract within the exchange’s trading parameters. As the months go by, the market enters a month where all contracts expire, leaving no one with any contracts for that trading period. In other words, if you sell (or purchase) one contract, you have to buy (or sell) it back before the contract expires. However, since commodities are delivered physically, it is possible to replace the contract with the commodity.
Hedging: Transferring risk through arbitrage
A multitude of factors, such as drought, a production that is close to a record, an increase in demand, or decreasing global production, can lead to price risk for agro-based commodities. The commodity futures markets offer a way for hedgers—those who own the actual commodity—to transfer risk to other hedgers or market speculators. Futures markets exist and are effective based on the idea that speculators will have access to enhanced profit potential from assuming this risk and that hedgers may forgo some profit potential in return for less risk. Consider a scenario where a worker who works on commission is paid $2,000, $8,000, $5,000, and $13,000 over the course of four months, for an average pay of $7,000 per month. Instead, the employer would demand $1,000 per month to make up for the risk. It is now assumed that the employee is unmotivated to sell more.
Hedgers could be willing to forgo some income in exchange for a known price. Assume, for instance, that Joe Farmer plants 500 acres of corn in April. Joe Farmer realizes at this point that he can forward price a portion of his corn production through the futures market at a price of $4.00 per bushel. He is willing to price one-third of his anticipated production at $4.00 per bushel knowing that his cost of production is $3.50 per bushel. Joe is willing to price one-third of his anticipated production at $4.00 per bushel knowing that his cost of production is $3.50 per bushel.
That is, in order for agricultural producers to lock in a price floor, hedging typically entails selling the agro-based commodities at the commodity exchange market (a minimum price they will receive). Agricultural firms (grain elevator operators and others trying to lock in a price ceiling for the grain they are forward contracting) or speculators concurrently buy and sell the corn futures contracts that Joe sells. Three alternative outcomes for Joe are described in the scenarios below.
If the futures price goes higher
When Joe is prepared to harvest the crop, the cash and autumn futures prices of corn increase to $4.20 per bushel. Joe loses $0.20 a bushel in the futures market, but thanks to the concurrent rise in the cash price and the futures price, he wins this back in the cash market. Joe’s earnings in the cash market will depend on the differential (basis) between the cash market and the futures market. Joe’s hedged grain will at worst be paid $4 per bushel, fewer commissions.
If the futures price goes lower
When Joe is prepared to harvest the crop, the corn cash and futures prices drop to $3.70 per bushel. Due to the simultaneous decline in the cash price and the futures price, Joe makes $0.30 per bushel in the futures market but loses in the cash market. Once more, how the basis behaves at this point will decide how much money Joe makes in the cash market. Joe’s hedged grain will at worst be paid $4 per bushel, fewer commissions.
If the futures price doesn’t change
When Joe is prepared to harvest the crop, the cash and autumn futures prices for corn remain at $4.00 per bushel. Except for potential basis gain or loss, Joe does not benefit from either the cash market or the futures market. Joe’s hedged grain will at worst be paid $4 per bushel, fewer commissions.
What do these scenarios have in common
In these situations, Joe typically knows what price he will get for the corn crop that is hedged. In order to perform a cash-flow analysis, he knows roughly how much of a revenue stream he will have. Because he does not need to worry about a price reduction that might affect sales. Futures, however, cannot cover all production risks. For instance, producers who worry about production risks put on by natural disasters may want to consider crop insurance to fill in any production shortfalls.
The basic part of agro commodity hedging was not covered in these instances. Net price decreases or increases from hedging may grow or decrease depending on the basis.
When to hedge
Knowing Joe’s cost of production allows one to estimate the prices at which he would consider forward pricing some of his output. In order to hedge a commodity, producers must understand their cost of production. For instance, Sue is aware that her cost of production for 400-pound feeder calves is $140 per hundredweight. She may think about pricing a portion of her calf crop through the futures market. If the price on the futures market enables her to do so while also making a profit.
The costs of hedging
Although the costs of hedging are simple, they can grow significantly over time. Brokers receive commissions for administrative expenses as well as for running and overseeing the futures exchange. For either a buy or sell order, these fees can run anywhere from a few dollars to $35 or more per contract. As a result, the total price to join and leave the market might be as high as $70 for each contract.
Only futures positions receive margin payments; option position purchases do not. The earnest money put into a brokerage account as insurance against possible losses is the margin. To begin trading, you need an initial margin. The initial margin requirement for a futures position is frequently between 3 and 10% of the actual cost of the commodity. The futures exchange chooses the precise percentage.
To maintain a minimum level of equity in the margin account, the maintenance margin is helpful to step-up the margin account. Consider the case when the corn contract’s maintenance margin is $900 per contract. A margin call is issued whenever the margin account balance falls below $900. As a result of “paper” losses in the futures market, necessitating that more funds be deposited to the account in order to restore the balance to the initial margin level of $970. There is no cap on the number of margin calls. However, if you need any kind of information or want to buy any agricultural commodity, feel free to contact one of the best agricultural commodities trading companies Vimpex Ltd.