Managing Risk using Futures

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What are futures?

Futures markets are derivative products. For grain they should be considered as the forward market, but in a formal and regulated environment. Around the world there are a number of these markets in Chicago, Paris and London.
In London, the market provides important liquidity to the UK wheat market. This market provides the benchmark for UK feed wheat pricing.

For UK feed wheat futures, one futures contract is equivalent to 100t of feed wheat delivered out of a registered UK futures store. A number of contract (delivery) months are available to trade. The first contract month of the season is November followed by January, March, May and July. The contract months of November and May are the most frequently traded and so provide the majority of UK market liquidity.

The UK futures market is a deliverable market, which means that contracts can be delivered against into registered futures stores, typically located in the surplus regions of the south and east. However, in reality the majority of futures contracts are traded out before delivery. It is the delivery mechanism though that maintains the close price relationship between futures and physical prices.

Physical prices in the regions of the UK have different relationships to the futures market. This reflects the differences in regional supply and demand. The difference between physical and futures prices is known as the ‘basis’.

For example in East Anglia, delivered feed wheat prices will trade at similar levels to futures prices. In the North and West delivered prices will be at varying premiums to the futures market. These price differences serve to move grain from the surplus to the deficit regions.

Hedging using futures

By using futures either directly, or via a feed supplier, a pig producer can fix the cost of the grain used. The main benefit of this is that the producer is protected against the price of grain rising. However, if the grain price were to fall, the producer would not benefit as the grain price is fixed.

£ per tonne November Futures Hedging Margin Physical wheat bought on spot market @ £2/t above futures Net wheat purchase price
Purchased in March Sold in November
2005 70 67 -3 69 72
2006 74 97 23 99 76
2007 88 150 62 152 90
2008 155 92 -63 94 157
2009 122 105 17 107 124
2010 103 167 64 169 105
A B C=B-A D=B+2 E=D-C

The table above shows examples from the past six seasons as to how using futures can mitigate a business’s exposure to volatile grain markets. In these examples, futures contracts are purchased in March for the following November. These were then sold in November, generating the hedging margin.

In the years of 2006, 2007 and 2010, the hedge makes money as markets increase between March and November. This generates a positive hedging margin which reduces to cost of the physical wheat.

In 2005, 2008 and 2009, the hedge loses money as markets fell between March and November. This gives a negative hedging margin, adding cost to the physical wheat. This is the biggest drawback of using futures as a hedge as the buyer is locked in to a price level and can’t benefit if the market falls.

More advanced strategies can use options, which allows the pig producer to fix a maximum wheat price, but can also benefit if the market falls. For more, see ‘Hedging using options’