Storage, financing, risk bearing and market intelligence are important marketing

functions. Commodity futures markets are marketing tools for farmers and food
marketing firms that can aid in the performance of these functions.

Risk: Risk is inherent in the ownership of goods. And as with the other functions
of marketing, risks must be borne by someone and they can’t be eliminated.

Types of Marketing Risk: Kinds of risk may be classified as follows-

1. Product destruction from natural hazards such as fire, wind, pests, spoilage
and so on.

2. Product deterioration in value resulting from-

a) Quality deterioration

b) Price variations.

Product Destruction: Food marketers must face the possibility that fire, pests or
other forces may suddenly damage or destroy the products they have on hand or in
storages. A marketing firm, especially if it is a large one, may build up its own
funds to cover such a possibility or transfer the risk to insurance companies which
are specialized risk bearers that spread the risk over a wide area and groups of
people or businesses for a fee.

Product deterioration in value: Every marketer runs the physical deterioration of

a product while it is owned or stored. A rapid change in temperature or a break
down in equipment are possibilities. Such factors increase the marketing cost of
perishables.

• Risks from changes in consumers’ preference or acceptance is greatest in

fashion lines.

• Price changes that occur because of large annual shifts in production and in
the general price situation are common for agricultural products.

• Wide and unpredictable fluctuations in the volume of available products

cause food processors, handlers and retailers additional and costly
uncertainties.
Many devices are used either to minimize this risk or to shift it from one person
to another.

• Much of the government price-supporting activity is a mechanism for

transferring price risks from producers and handlers to the tax roles of
society.

• The efforts toward vertical integration of the marketing channel also

attempt to reduce or transfer risk.

• Products are often sold ‘in advance’; the price is fixed in the present for
delivery at a specified future date.

The Futures Market: The futures market is a mechanism for trading promises
of future commodity deliveries among traders. It is a unique risk management
process and profit tool for farmers and food marketing firms.

Futures Market Exchanges: Commodity exchanges are marketplace s

designed to facilitate trading in futures contracts. There are 12 organized
commodity exchanges in operation in the USA and several more operating in
other countries.

The commodity Exchanges are somewhat like the stock market. They are
composed of member-traders, trading floor, a governing board and a clearing
house. Most commodity exchanges are found in cities that are major
transportation centers and through which a substantial portion of the product
moves.

Commodity exchanges are quite close to the perfectly competitive market.

Prices are established through open trading on the floor of the exchange, where
all buyers and sellers are represented either personally or via electronic
communication through their brokers.

The Futures Contract: The futures contracts are promises to deliver or accept
delivery of a specific commodity at a specified time in the future. Deliveries are
made against the contract when it matures in the month for which it is named
not when the contract is traded and priced. Payment for delivery of the
commodity is at the price determined when the original trade was made, often
several months prior to delivery. In this way, futures contracts allow forward
pricing of commodities deliveries.

Trading and Pricing of Futures Contracts: There are two kinds of futures
market traders-

1. Speculators: traders attempting to anticipate and profit from futures price

movements.

2. Hedgers: traders doing the same but they usually can take or make
delivery of the commodity at contract maturity.

Futures contract promises can be fulfilled in either of two ways-

• The commodity can be delivered or accepted at contract maturity.

• The promises can be nullified by an offsetting futures market transaction

prior to contract maturity.

For every futures contract traded, there must be a bull (traders who feel prices
will rise) and a bear (traders feel prices will fall); a long (commitment to take
delivery of the product) and short (owing the commodity) trader, and a winner
and a looser (unless the price stays constant).

The attraction of futures market speculative trading lies in the potential for
frequent, large, and somewhat unpredictable, commodity price swings. A
futures contract price is determined by how much buyers are willing to buy it
for, and how much sellers are willing to sell it for. In turn, these attitudes
toward buying and selling futures contracts reflect the expected value of the
actual product represented in the contract at maturity.

Futures trading involves two costs-

• Brokerage fee for executing orders.

• Margin requirement which is a form of earnest money.

Relationships Between Cash and Future Prices: The difference between a
cash and a future price is called the basis. Agricultural commodity prices are
often described by their basis and commodity traders often are more interested
in the level or change in basis than in actual cash prices.

There are three normal relationships between cash and futures prices for a
storable commodity like grain-

1. The cash price of a commodity at the delivery point will be almost the
same as the future price at that time. That is, the basis will approach zero
at contract maturity, when “the future becomes the present.”

2. Future prices are normally above cash prices by the cost of holding the
commodity until contract maturity. Therefore, the basis is said to
“narrow” (or strengthen) as the contract matures.

3. Cash and futures prices tend to move up and down together because both
are affected in the same way by changes in supply and demand.

One other important point is that the basis level and the basis changes tend to
follow predictable patterns from year to year.

Hedging and Risk Management: Price risk is inherent in the ownership and
handling of agricultural commodities. By the nature of their activities, farmers
and food marketing firms are exposed to unpredictable price swings.

Farmers and food marketing firms can make profits by speculating in cash
prices or by performing utility-adding marketing functions.

A futures market hedge is such a risk management device or a protective

mechanism that involves the temporary substitution of a futures market
transaction for a cash transaction.

The Hypothetical Perfect Hedge: The perfect hedge is the process where the
gain in one market exactly offsets the loss in the others. In this process, most
hedgers do not deliver against their contracts but turn their hedges in the same
manner as speculators, buying back a previously sold position.
There are two reasons why this hedge was effective-

• The cash and futures prices both declined. Therefore, the opposite
positions provided compensating gains and losses.

• The basis remained constant at 50cents on both days.

If the basis changes during the hedge, it will not be a perfect hedge. So basis
changes are an important influence on the success of hedges. Two types of
perfect hedge are-

• Short hedge-when a sale of futures made as a temporary substitute for the

cash sale of a commodity.

• Long hedge-is used when the firm makes a promise today to deliver
commodities, not yet owned, to the cash market at a specified future
time.

The Storage Hedge: In the real business world, hedging is both a risk-
management and a profit making tool. Businesses normally use the storage
hedge when commodities are to be held for a period of time during which the
basis is expected to narrow. This hedge has two purposes-

• To protect the firm against adverse cash price movements.

• To assist the firm in earning carrying charges (storage cost, interests and
insurance) during the storage period.

The storage hedge is based on the expectation that the basis will narrow for a
storable commodity as the futures contract matures.

The Pre-harvest Hedge: This hedge is appropriate for farmers during the
period between planting and harvesting a crop. The pre-harvest hedge requires
that the farmer be knowledgeable regarding the local harvest basis-the
difference between local cash prices and the nearby futures price at harvest
time. The success of the pre-harvest hedge hinges on an accurate prediction of
the harvest basis.
Forward Contracts and Futures Contracts: Many producers prefer to forward
price their purchases or sales using contracts rather than hedges. In the spring,
farmers can sign these contracts with local elevator owner for the delivery of
the grain at harvest time; at a prearranged price. This is a forward contract.

The forward contract has two disadvantages when compared with the pre-
harvest hedge-

• The farmer is in effect asking the elevator owner to do the hedging and
the charge for this service is reflected in the contract price.

• Farmers have less flexibility with forward contract than with hedges.

Agricultural Options: Option another marketing tool that can provide price
insurance and marketing flexibility for farmers refers to the right to do
something with the futures contract.

An option gives the owner the right, but not the obligation, to buy or sell a
futures contract at a certain price for a specified period of time. It includes-

• Strike price: the guaranteed price at which the contract can be bought or
sold.

• Put option: conveys the right to sell a designed futures contract at a

specified strike price.

• Call option: conveys the right to purchase a designed futures contract at a

specified strike price.

• Premium: the price that must be paid for these option rights and is
determined in the option markets by what buyers and sellers of options
feel they are worth.

The buyer of an option has three alternatives:

1. Exercise the option.

2. Allow the option to expire without exercising it.

3. Offset the original purchase with an option sale.

Future Markets Participants: There are several different kinds of traders in
futures markets-

• Speculators in futures prices.

• Speculators in basis (hedgers).

• Traders who wish to assume risks.

• Traders who wish to avoid risks.

• Hedgers who fulfill their contracts.

• Hedgers who nullify their contracts.

The reasons farmers give for not using the futures markets are-

• Lack of familiarity with trading.

• Farm too small.

• Trading too risky.

• Lack of capital for trading.

• Lack of understanding about the contracts.

• Distrust.

The Futures Market Controversies: The controversy occurred due to-

• The speculative activity of these markets.

• The close relationship of cash and future prices.

• More commodities are traded than are produced.

• Occasional stories of futures markets manipulation.

The alleged criticisms and contributions of these markets are-

• Are Speculators Necessary?

• Do Futures Prices Determine Cash Prices?

• Effects of Marketing costs.

• Is Speculation A Fair Game?

• Does Hedging work?

• Can Futures Prices Be Manipulated?

Public Regulations of Futures Trading: Public concern with futures markets

and especially alleged “excessive” speculations-has resulted in state and federal
regulation of these markets. The Grain Futures Act of 1922 was the initial
federal regulation of futures markets. In 1936, this law was amended to the
Commodity Exchange Act. From 1936 to 1975, futures trading was regulated
by the Commodity Exchange Authority (CEA), a division of the U.S
Department of Agriculture. Every year new laws and regulations are passed to
insure that the futures markets operate fairly and honestly.
 Chapter:20

RISK MANAGEMENT
AND THE FUTURES
MARKET

GROUP NAME: VERSATILE

• MD. Hafijur Rahman (group leader) 69
• A.T.M Omor Faruq 21
• Fahmida Rashid 23
• Saied Uddin Ahmed 35
• Sayma Reza 111
• Nur E Elahi 125