Friday, 17 June 2016

Something else i don't understand

From Bloomberg:

Kenya, the world’s biggest exporter of black tea, is considering introducing the world’s first futures contracts for the leaves to help stabilize prices and enable growers to guarantee income from their production...

“The ability for farmers to be able to hedge out their pricing risk will be a big win,” Terrence Adembesa, head of derivatives at the bourse, said in an interview. “Another plus is the ability to provide a platform for investors who want exposure to a certain asset class that they currently don’t have.”


Firstly, who says that futures stabilise prices, they can smooth or exacerbate fluctuations in underlying prices, but long term do not affect them much.

Secondly, let's assume our farmer expects to harvest 100 units and is happy to sell them for $1 each, expected income $100. He can now, if he likes, sell his harvest forward (goes short).

If harvests are up ten percent and the price falls ten percent, he is even happier. He sells his first 100 units for the fixed $1 and the surplus ten units for $0.90. Total income $109.

If harvests are down ten percent and the price rises ten percent, he is knackered. He sells his 90 units for the fixed $1 and has to pay his counter-party the difference of $0.10 on the missing ten. Total income $90.

So what's in it for the farmer? Hasn't he just increased his upside and downside risks?

For the speculator who bought the 100 units forward, the calculation is the other way round. With the good harvest, he loses $10 and with the poor harvest he wins $10. Fair enough, he is just gambling with his own money, mainly against other speculators, but ultimately, all farmers' total gains/losses are the equal and opposite of all speculators' losses/gains.

6 comments:

Physiocrat said...

Presumably the farmer would need a purchase option against the possibility of a shortfall?

The end user benefits from the knowledge that he has an assured supply at a known price in the future. The manufacturer is presumably willing to pay a premium for delivery of, say, 1000 tons of chocolate, in six months' time. A middleman carries the risk.

Surely the point of these markets is to spread the risk?

Dinero said...

The benefit to the farmer is they protect their income against a large drop in prices at the particular time when they come to sell their harvest, such a large drop that it leaves them without the income to cover their production costs. Sure, over an accumulation of years the farmer might miss out on some high prices, but its a one off large drop in price for one single year that is advantages to avoid.
Interestingly there isn't a futures market used by dairy produces in the UK milk industry.

mombers said...

I don't think a farmer would ever hedge all of their crop - precisely to avoid not being able to deliver the quantity promised. It's a very useful tool for farmers in theory - it does take a lot of the risk off their hands. But the financial services industry has done it's usual and found a way to completely screw everyone over...

Lola said...

Crop futures contracts have a long and generally honourable history. They've been going for yonks. They have worked for farmers, speculators and end users.
The reason FS industry has messed them up is all the bad money washing about. If you have wads of cash washing about at the wrong price that came about out of thin air then it's going to go somewhere.

Mark Wadsworth (YPP) said...

Phys, he doesn't need a purchase option and that would just makes things worse. It would make more sense for the farmer to guess the lower range of his likely harvest, say 80 or 90 and sell that forward, and take his chances on the rest.

The worst risk is the unavoidable risk of the crop failing, you can insure against that, but futures contracts exacerbate things - in the "poor harvest" scenario, the farmer who sells forward has less income than if he hadn't done and the speculator is laughing. A proper insurer would be crying.

Din, yes, they reduce the downside if there is a good harvest/low prices but make things worse for themselves if there is a poor harvest/high prices. That's why I did the examples.

M, fair point about not selling all your harvest forward, that makes sense, but can you please do the two scenarios and show how the farmer's risk profile is reduced?

L, examples?

I don't think that the FS industry has messed it up, the system clearly works or people would;t do it and no farmers would ever sell forward - or perhaps they don't? Perhaps it the entire risk spreading is between customers like tea factories and speculators.

That makes more sense. I didn't say it didn't make sense, I said I don't understand it and to understand it I need examples and scenarios.

Mark Wadsworth (YPP) said...

Phys, he doesn't need a purchase option and that would just makes things worse. It would make more sense for the farmer to guess the lower range of his likely harvest, say 80 or 90 and sell that forward, and take his chances on the rest.

The worst risk is the unavoidable risk of the crop failing, you can insure against that, but futures contracts exacerbate things - in the "poor harvest" scenario, the farmer who sells forward has less income than if he hadn't done and the speculator is laughing. A proper insurer would be crying.

Din, yes, they reduce the downside if there is a good harvest/low prices but make things worse for themselves if there is a poor harvest/high prices. That's why I did the examples.

M, fair point about not selling all your harvest forward, that makes sense, but can you please do the two scenarios and show how the farmer's risk profile is reduced?

L, examples?

I don't think that the FS industry has messed it up, the system clearly works or people would;t do it and no farmers would ever sell forward - or perhaps they don't? Perhaps it the entire risk spreading is between customers like tea factories and speculators.

That makes more sense. I didn't say it didn't make sense, I said I don't understand it and to understand it I need examples and scenarios.