Risk Management in Agriculture: A Guide to Futures, Options, and Swaps

1. Risk Management in Agriculture:A Guide to Futures, Options, and Swaps Lowell B. Catlett James D. Libbin © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

2. Chapter 1Introduction © 2007 Thomson Delmar Learning, a part of the Thomson Corporation

3. General overview of agricultural risks and an introduction to the basic tools to manage market risk • Key Terms

4. Basic Agricultural Risk • Overview • Risks are everywhere: • positive and negative • evaluation and acceptance of proper risk to obtain a profit

5. Agricultural Risks • Weather risk and biological risk are universally known by farmers as production risk. • Marketing Risk • Policy Risk • Major goal is to frame marketing price risks within the larger framework of other agriculture risks.

6. Managing Agricultural Risks • Risks are managed either proactively or by accepting the outcomes. • accepting risks • management of risk

7. Production Risks • Weather and biological risks • can be proactively managed in some cases. • sometimes simply must be accepted in others.

8. Marketing Risks • Two major marketing risks: • Structural risks are associated with the market channel. • Price risk is the risk of price movement.

9. Tools of the Trade • Securitization is the procedure to identify, quantify, and structure a risk into a financial instrument (security) • Securitized Agricultural Risks

10. Forward Contracts • Two parties agree upon contract terms and set a price for the product. • If the contract has a retrade clause, it is considered strong; if it lacks a retrade clause, it is considered weak. • The risk of finding a market for the product is reduced. • A major risk of a forward contract is from a large move in the market price or a default risk. • One of the parties involved may not fulfill the terms of the contract.

11. Futures Contracts • Contracts are traded on a central exchange and are regulated by the Commodity Futures Trading Commission (CFTC). • Contract terms are prespecified and standardized. • All contracts are retradable (strong). (continued)

12. Futures Contracts (continued) • All contracts are leveraged. • margin • margin call • All contracts are very liquid due to being standardized and strong. • Offsetting frees parties of contract obligations. • roundturn

13. Futures Contracts and Managing Risk • Futures contracts are used to manage risk in two ways: • a way to sell or buy a cash commodity • hedging—allows business to operate within the normal cash markets and futures markets simultaneously, managing the risk of price change • Derivative: Futures contract is a derivative of the cash market. • directly tied = one-step derivative

14. Options Contracts • Buyer of an option has the right but not the obligation to do something. • The seller has the obligation to perform as specified in the agreement. • Buyer of a call has the right but not the obligation to buy. • Buyer of a put has the right but not the obligation to sell something. • Premium—what the buyer pays for this right. (continued)

15. Options Contracts (continued) • Strike price—the price at which the product or service is exchanged at some point in the future • Two types of options: • exchange traded options on futures contracts • options on physical commodities (over the counter) • If the buyer decides to buy the property, he exercises the option. • If the buyer decides not to exercise the option, he lets the option expire. • An option on a futures contract is double derivative, making it a two-step derivative.

16. Swap Contracts • A swap entails the exchange between two or more parties (counterparties) of the cash flows arising from other contracts or entities (notionals). • Swap dealers or brokers line up the counterparties and receive a fee for services rendered. • Swaps allow for the shifting of price risk via cash flow exchanges. • Swaps are not standardized contracts and are not exchange traded.

17. Hedging • Hedging is the process of using futures, options, and swaps to manage price risk. • Hedging is simply having two or more positions in different markets so that the loss in one is offset with a gain in another. • Corn hedging example: Refer to Figure 1-1. • The cash market and futures market tend to trend together, which allows the cash market to be managed with the futures market.

18. Speculation and Income Generation • Futures, options, and swaps can also be used to speculate market price direction. • Position or directional speculators are traders or businesses who try to guess in which direction prices will move. • Any business activity that has price risk and is not hedged is speculating. • Arbitragers are traders who attempt to profit from knowledge about the relationships between two or more markets.

19. The Role of Risk • Certain risks in agriculture can be directly managed, some only indirectly, and some not at all. • Managing risk is not only about offsetting potential loss but also producing potential gain. • Futures, options, and swaps can manage agricultural risk both for loss protection and income generation.