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Futures trading and hedging
Futures trading and hedging
Warren W. Lebeck
In
this
leading value
article, of
outlines trading
Lebeck, the
futures
scope
industry
use
for its rapid hedging
futures some growth. and
speculation, to international
a and
markets,
of the
and explains
discusses
benefits, relation
for
the the
of the reasons He
Warren
advocate
and
its their
commodity
agreements. Warren Vice
W. Lebeck
President
Trade,
Lasalle
60604,
USA.
is Senior
of the Chicago at
Jackson,
Executive Board
of
Chicago
‘This exchange’s 2.2 M contracts were ‘mini-contracts’ -one-fifth to one-half the size of the contracts traded, for example, on the Chicago Board of Trade or the Chicago Mercantile Exchange. These small lots provide an important service for the small speculator or the small farmer, but they give a rather misleading impression in the volume reports. If the mini-contracts are converted to the size of most others, the Mid-America is left with about 1.5% of the volume. ZMetals, the second most popular area, accounted for 23% of all contracts last year. Some of the other areas of futures trading include lumber, plywood, foreign currencies, and interest rates, ie, credit is a raw commodity in modern America. Several of these areas have only recently developed, so they compose a relatively small percentage of total volume at present. But I believe they hold a great deal of promise for the future.
FOOD
POLICY
February
1978
The 1970s have been a period of major change in American financial circles. Led by eight consecutive years of record volume at the Chicago Board of Trade, the commodity futures industry has grown to become, in my opinion, the paramount part of US finance, or by anyone’s standards, at least a worthy rival for the other more widely understood and publicized financial sectors. In 1976. volume in commodity futures trading totalled 36.9 M futures contracts. Those contracts are of various sizes. For grains, for example, the general size is 5000 bushels, which is about 127 metric tons for maize or 136 metric tons for wheat or soybeans. For silver, the usual contract unit is 5000 ounces, or about 155.5 kg. In many cases, such as plywood or hogs, the contract size is essentially a railroad carload. Whatever the exact specifications, a contract is a fairly large unit. Contracts currently are traded on 10 different exchanges in the USA. The Chicago Board of Trade is the largest, with about 51% of the volume in 1976. The Chicago Mercantile Exchange was second in 1976 with 17%, and the Commodity Exchange, Inc, located in New York. was third with 15% of the futures volume. The MidAmeri~a commodity Exchange in Chicago was fourth, accounting for 6% of the volume. ’ Also contributing from l-3% of the total are six other exchanges: the New York Coffee and Sugar Exchange, the New York Cotton Exchange, the Kansas City Board of Trade. the New York Mercantile Exchange, the Minneapolis Grain Exchange, and the New York Cocoa Exchange. In December 1976, 57 different types of futures contracts were traded on these exchanges. Silver was the single most active commodity in 1976 with over 5.8 M contracts traded at three exchanges. Soybeans were second, with 5.6 M contracts, and maize was third with about 4.7 M contracts traded. In volume, most futures contracts are agricultural in nature. Last year, food, fibre or ordinary beverage materials such as coffee and cocoa constituted 74% of the 36.9 M contracts.2 According to the Commodity Futures Trading Commission, the regulatory agency of the US Government, the total dollar value of contracts traded in 1976 was almost $820 000 M.
Commodity futures outstrip equity markets The commodity equity markets,
futures industry I believe. No
is now more important than the single. fair, accurate means of
29
Futures trading and wedging
comparison point. 0
0
0
0
exists, but several standards might be used to iflustrate my
Dollar value. In 1975, the value of shares traded on all US stock exchanges was about $157 000 M. The value of commodity futures contracts traded on all futures exchanges was about $597 000 M. The weaknesses of this comparison are that futures positions are more lightly margined and usually are held for shorter periods of time, so a dollar-to-dollar comparison is, in a sense, misleading. Even so, the Chicago Board of Trade’s $322 000 M vatue was more than double that of all US stock exchanges in 1975. Volume. There is no direct way to compare a bushel of grain to a share to stock. But if one compares each market to itself in a common base year, some interesting growth comparisons emerge. From 1970 to 1975, volume on all commodity exchanges increased 136%, while volume on all stock exchanges grew only 37%. Using 1960 as the base year, all-exchange commodity volume grew 730% by 1975 and all-exchange stock volume grew 349%. Public participation. There is no consistent record of nonmember traders in each industry, but a second-best means of gauging public activity would be to compare the number of persons registered to do business with the public. The Chicago Board of Trade currently has about 21 800 registered representatives; the most recent figure for the New York Stock Exchange was about 35 700 in December 1975. The entire commodity industry has about 25 600; the entire securities industry, 72 000. However, that 72 000 figure includes persons And in and over-the-counter business. handling options commodities, among the most important participants are the major commercial firms who use the market as a hedging mechanism. Since most of these firms are members, much of the most important commodity business does not go through registered commodity representatives. Exchange membership prices. Seats on not one but two commodity exchanges now surpass in value those on any security exchange.
These are some of the comparisons most frequently made; none of them alone would be fair, but all of them together indicate that futures trading is a valid rival to its more widely publicized cousin, the securities industry.
Nature of contracts traded The contracts traded on commodity exchanges are standardized, transferable contracts for future delivery of the commodity, binding on both sides of the agreement. Each side of the contract must satisfy its terms, either by an offsetting transaction prior to delivery time, or by making delivery (for the seller) or taking delivery (for the buyer). Commodity options are not traded in America, with two exceptions. First, some firms buy London options and retail them in America, but this is not done on a central market of any kind. Secondly, the federal government may allow a pilot programme in options on commodity futures positions in central markets such as the
30
FOOD
POLICY
February
1978
Futtrrrs trading atrd ~ed~~)z~
Chicago Board of Trade. However, that will not include the major agricultural commodities because federal law prohibits options in them. So, for the most part, the traditional, two-sided contract that carries both the right to take a profit and the obligation to make up the loss is traded in the USA,
Trading Trading is done on margin, ie, only a portion of the value of the contract is deposited at the time it is made. Margin in commodities is not a down payment or a payment in equity, but is in the nature of a performance bond posted by traders to guarantee their ability to live up to the financial commitments of the contract. The difference is significant, because: 1.
2. 3.
Roth buyers and sellers post margin in commodities. The remainder of the contract value is not borrowed from anyone and does not have to have interest paid upon it; While initial margins are low (usually 510% of the value of the contract), if the price moves against one’s position so that the protection represented by the original deposit is no longer adequate, additional margin must be posted to maintain the position. It is this system of margining which provides financial integrity to this contracting system.
Hedging The primary purpose of these markets is to allow commercial users such as farmers, food processors, and grain dealers - a means of protecting themselves from adverse price changes. This use of the market is called hedging. Hedging is not an especially difficult concept to understand, though many people successfully attempt to make it so. Basically, if you can understand why men buy fine wine but don’t want to drink it, or fine art but don’t want to look at it, or good land but don’t want to farm it, then you can understand hedging. These three purchases are among the most prominent means of ‘hedging’ against inflation. These ‘hedges’ are based on the simple premise that if general prices go up, the price of fine wine, fine art, or good land will go up with them, so that after an inflationary spiral one can se11the wine, land or art and receive the extra dollars necessary to have the same purchasing power as before. The concept being used in such transactions - the logic of what the buyer is trying to do - is precisely the same as that of a long hedger when he buys soybean contracts on the Chicago Board of Trade. He does not want to go to Chicago and take delivery of the soybeans, but wishes to protect himself from the inflation of soybean prices at his point o~~~~r~hffs~, which could be Chicago, but more likely is New Orleans, and could even be Rotterdam. The hedger’s purchase of futures contracts is based on the premise the two prices will be linked. Thus, if soybean prices do go up, the hedger can sell the Chicago futures at a profit that will help to offset the higher price he has to post at New Orleans or Rotterdam. Two differences should be pointed out, however. between the soybean buyer and the buyer of wine, say. First, in the hedge against
FOOD
POLICY
February
i 978
31
Futures trading and hedging
inflation, there is really little reason to say that land, art or wine prices would have to change with general prices. They may have in the past, but no one can say they have to in the future. In commodity futures hedging, however, there is quite a strong and definite link between the two prices - for the price of a contract for future delivery of the commodity in Chicago is going to be strongly affected by the price of that actual commodity in other major markets. However, the two prices will not move in perfect harmony, and for good reasons, which hedgers need to understand. Secondly, in commodity futures, one can hedge against price decline. If one owns a stock of inventory, and falling prices would endanger its value, a futures contract can act as a temporary, substitute ‘sale’ for the one that will eventually be made. If prices have gone down by the time the real sale is made, money will be lost on the actual inventory, but the futures position will probably show a profit, which will be the ‘hedge’ against downward prices just as the wine owner’s profit is his ‘hedge’ against upward prices. More difficult definitions of hedging may be required for some purposes, such as government regulation, but for most practical purposes a simple test will do for the potential user. Each time a futures transaction is planned the following question should be honestly answered: ‘Is this futures transaction truly designed to rnirzimize some price risk that threatens my position in the cash commodity? If a futures transaction is not tied to some position in the cash commodity, then it is not hedging. Without this connection, to enter the futures market is to take a risk, not minimize it, and one should be prepared to accept the consequences of such an act. However, not just any connection between the futures transaction and the cash commodity is enough. Some farmers who are growing corn because they are bullish on corn prices go out and buy corn futures contracts and call them hedges. Certainly, there is a connection between the two positions, but the futures transaction is not designed to minimize the risk on corn prices, in fact, it doubles it. I am not suggesting that all hedges have to be classic textbook hedges, or that everything one does has to be aimed at keeping the two sides of a mythical ‘T’ chart perfectly balanced. What I am suggesting is that when one does something that means accepting risk (and that includes holding an unhedged inventory) one should be aware of what one is doing.
Speculation Speculation in commodity futures is much maligned and little understood. Somehow the word speculation has taken on an adverse connotation. I like the way John Steinbeck dealt with it when he said, ‘I don’t know where speculation got its bad name, since I know of no forward leap which was not fathered by speculation’. Speculation is the assumption of a risk which naturally exists, as opposed to one which is created for the purpose of wagering. The farmer speculates when he plants; he speculates that his crop will grow and will bring a price that will return him a profit. Processors speculate when they build a new plant: they speculate there will be demand for its products, and that they will be able to deliver them at a profitable price. I’m sure the average citizen would not criticize either
32
FOOD
POLICY
February
1978
Frrfures trading and hedg~~?g
the processor or the farmer, yet both are speculating as surely as anyone who buys a grain futures contract in the hopes that it can be sold later at a higher price. It is the speculator who is willing to assume the price risk that merchants, processors and other hedgers do not want. The speculator is an essential part of any futures market that works. To banish the speculator, as some misguided individuals propose from time to time, is the surest way to kill the entire market. Commercials want him and need him to take the other side of the trade when their orders come into that market. The liquidity which speculators provide in the Chicago futures markets is a matter which European agribusinessmen should seriously consider. The agricultural commodities traded on the Chicago exchanges are world commodities - in terms of production, grain merchant or consumption, and price trends. A European processor, just as much as his American counterpart, faces tremendous price risks as a result of his needs to buy or sell these commodities. While innovative European firms have been hedging in Chicago for many years, now is the time for more European agribusinesses to consider following the innovators’ lead. Americans’ hedging strategies may be a little more simple because prices at their cash markets may correlate somewhat more closely with the Chicago futures than those in European cash markets. But anyone who has watched the markets of this decade knows that there is a substantial link between prices in markets an ocean apart. In general, the risks of change in the basis (the relationship between the cash market price and the Chicago futures price) are less, even between Rotterdam and Chicago, than is the risk of being totally unprotected in the cash market alone. Moreover, the link between prices becomes even stronger if the European’s pricing point is an American port, as many are.
Benefits of hedging Hedging provides a number of advantages, both to the firm doing it and to the society that firm serves. To the firm, it provides a valuable means of evening out earnings and avoiding feast-or-Famine trends that can be literally devastating to a firm when it’s the latter. For society, it means the firm need not demand so large a profit margin in order to justify the risks it is taking. These are direct benefits of hedging, ie, they flow directly from the price safety hedging provides. But there are indirect benefits, too, and these can be significant. A processor who, because of hedging, is confident he will be able to get and to afford the grain or soybeans he will need in the coming months, can attain a higher degree of operating efficiency than he would if price uncertainty made iongrange planning impossible. Hedging can help him avoid having to pay overtime one month and unemployment costs the next. Hedging also makes financing an easier task. IF a firm knows it will need large amounts of a commodity in Future months, the practical alternative to hedging often is to buy the actual commodity. But to do this ties up large amounts of capital, and requires either additional capital in the form of storage facilities or expenses to be paid to someone else who stores the grain. Hedging, because it is done on
FOOD
POLICY
February
1978
33
Futures trading and hedging
margin, provides the same kind of protection at a fraction of the advance outlay. A second alternative for a firm in that situation is to forward contract in the cash market to buy the grain at a future time. If the other side of such a contract did not hedge, it would not enter into such a contract except on terms very favourable to it and commensurate with the risk it is accepting by the contract. To the degree to which firms are able to get forward contracts at prices which are fair, it largely is because firms on the other side of the contract are able to pass on their forward contract risks to speculators who take the other side of hedge orders in the futures market. Another important financial aspect of hedging is how it’s viewed by bankers. A sophisticated banker who understands futures knows that a company which hedges is a safer risk than one which does not. Thus, a company which wants a loan to finance inventory costs, or to expand its operation, will frequently find that a systematic hedging programme is a big plus to wary potential lenders.
International
commodity
agreements
A question arises as to whether hedging on an international scale might be a better policy approach than international commodity agreements. When the goals, prospects of success, and end-results of these two approaches are properly understood, I believe hedging does indeed come out on top. First, from what I’ve already said, it is obvious that a prudent hedging programme can remove a lot of the need for such an arrangement by providing a means by which firms can deal with some of the major effects of price volatility. Secondly, when one considers international commodity agreements, one has to start with a realization that such agreements have never worked in the past, and, in my opinion, the improved prospects currently attributed to them by some are little more than wishful thinking. Moreover, it is significant that hedging does not require increased politicization of economic affairs, with all the inefficiency, short-term expediency, and red tape which politics usually bring. Yet hedging is not a total, interchangeable substitute for such an agreement. It is not, I believe, because the goals of the two approaches are quite different. Hedging does not attempt to repeal the laws of supply and demand; rather, it facilitates and interfaces with them. Futures markets allow price to change and to speak to the producer and consumer, saying cut back production when price is too low and increase it when price is high. International pricing agreements, such as are being discussed, basically do attempt to effect such a repeal. They would prop up prices when they are low, thus providing little incentive for production to be brought into balance with demand (unless, as has been the history in the USA, those propped-up prices are accompanied by artificial production controls). A policy of accumulating government stockpiles of reserves further increases downward pressure on the market, and the release of those reserves as the demand-supply ratio moves upward has just the opposite effect of what the world really needs: it helps keep the price
34
FOOD
POLICY
February
1978
Futures trading and hedging lower
than what it should be and thus does not prod farmers to increase production as they should. Moreover, two noted economists have pointed out additional chinks in the armour of stockpile benefits. First, D. Gale Johnson of the University of Chicago notes that in countries that consume approximately half of the world’s grain, prices are not permitted to increase as an incentive for consumers to economize and farmers to produce. He says that with this degree of government interference in the pricing of grain in these nations, the quantity of stocks required to achieve a reasonable degree of price stability is much greater than stockpiling advocates realize. Second, Paul Samuelson of MIT says the effect of such stockpiles is likely to be small because experience shows that it will pay industry to hold less in private stocks when government is known to be holding more in public stocks. ‘Thus, the promise of a real Pharaoh’s store for the lean years would be largely illusion’, according to Samuelson. Free markets, with the hedging mechanism of the futures markets, are in my view a much better route to take. The goals of this approach are more modest - to allow a means of dealing with price risks, yet to allow price to perform the economic functions it is supposed to. These more modest goals are reachable, and, because of the efficiency which this approach encourages and demands, the longterm effect is of more benefit to all involved than if we take the more aggressive approach of inter-governmental economic manipulation, which is doomed to fail.
FOOD
POLICY
February
1978
35
Warren W. Lebeck
In
this
leading value
article, of
outlines trading
Lebeck, the
futures
scope
industry
use
for its rapid hedging
futures some growth. and
speculation, to international
a and
markets,
of the
and explains
discusses
benefits, relation
for
the the
of the reasons He
Warren
advocate
and
its their
commodity
agreements. Warren Vice
W. Lebeck
President
Trade,
Lasalle
60604,
USA.
is Senior
of the Chicago at
Jackson,
Executive Board
of
Chicago
‘This exchange’s 2.2 M contracts were ‘mini-contracts’ -one-fifth to one-half the size of the contracts traded, for example, on the Chicago Board of Trade or the Chicago Mercantile Exchange. These small lots provide an important service for the small speculator or the small farmer, but they give a rather misleading impression in the volume reports. If the mini-contracts are converted to the size of most others, the Mid-America is left with about 1.5% of the volume. ZMetals, the second most popular area, accounted for 23% of all contracts last year. Some of the other areas of futures trading include lumber, plywood, foreign currencies, and interest rates, ie, credit is a raw commodity in modern America. Several of these areas have only recently developed, so they compose a relatively small percentage of total volume at present. But I believe they hold a great deal of promise for the future.
FOOD
POLICY
February
1978
The 1970s have been a period of major change in American financial circles. Led by eight consecutive years of record volume at the Chicago Board of Trade, the commodity futures industry has grown to become, in my opinion, the paramount part of US finance, or by anyone’s standards, at least a worthy rival for the other more widely understood and publicized financial sectors. In 1976. volume in commodity futures trading totalled 36.9 M futures contracts. Those contracts are of various sizes. For grains, for example, the general size is 5000 bushels, which is about 127 metric tons for maize or 136 metric tons for wheat or soybeans. For silver, the usual contract unit is 5000 ounces, or about 155.5 kg. In many cases, such as plywood or hogs, the contract size is essentially a railroad carload. Whatever the exact specifications, a contract is a fairly large unit. Contracts currently are traded on 10 different exchanges in the USA. The Chicago Board of Trade is the largest, with about 51% of the volume in 1976. The Chicago Mercantile Exchange was second in 1976 with 17%, and the Commodity Exchange, Inc, located in New York. was third with 15% of the futures volume. The MidAmeri~a commodity Exchange in Chicago was fourth, accounting for 6% of the volume. ’ Also contributing from l-3% of the total are six other exchanges: the New York Coffee and Sugar Exchange, the New York Cotton Exchange, the Kansas City Board of Trade. the New York Mercantile Exchange, the Minneapolis Grain Exchange, and the New York Cocoa Exchange. In December 1976, 57 different types of futures contracts were traded on these exchanges. Silver was the single most active commodity in 1976 with over 5.8 M contracts traded at three exchanges. Soybeans were second, with 5.6 M contracts, and maize was third with about 4.7 M contracts traded. In volume, most futures contracts are agricultural in nature. Last year, food, fibre or ordinary beverage materials such as coffee and cocoa constituted 74% of the 36.9 M contracts.2 According to the Commodity Futures Trading Commission, the regulatory agency of the US Government, the total dollar value of contracts traded in 1976 was almost $820 000 M.
Commodity futures outstrip equity markets The commodity equity markets,
futures industry I believe. No
is now more important than the single. fair, accurate means of
29
Futures trading and wedging
comparison point. 0
0
0
0
exists, but several standards might be used to iflustrate my
Dollar value. In 1975, the value of shares traded on all US stock exchanges was about $157 000 M. The value of commodity futures contracts traded on all futures exchanges was about $597 000 M. The weaknesses of this comparison are that futures positions are more lightly margined and usually are held for shorter periods of time, so a dollar-to-dollar comparison is, in a sense, misleading. Even so, the Chicago Board of Trade’s $322 000 M vatue was more than double that of all US stock exchanges in 1975. Volume. There is no direct way to compare a bushel of grain to a share to stock. But if one compares each market to itself in a common base year, some interesting growth comparisons emerge. From 1970 to 1975, volume on all commodity exchanges increased 136%, while volume on all stock exchanges grew only 37%. Using 1960 as the base year, all-exchange commodity volume grew 730% by 1975 and all-exchange stock volume grew 349%. Public participation. There is no consistent record of nonmember traders in each industry, but a second-best means of gauging public activity would be to compare the number of persons registered to do business with the public. The Chicago Board of Trade currently has about 21 800 registered representatives; the most recent figure for the New York Stock Exchange was about 35 700 in December 1975. The entire commodity industry has about 25 600; the entire securities industry, 72 000. However, that 72 000 figure includes persons And in and over-the-counter business. handling options commodities, among the most important participants are the major commercial firms who use the market as a hedging mechanism. Since most of these firms are members, much of the most important commodity business does not go through registered commodity representatives. Exchange membership prices. Seats on not one but two commodity exchanges now surpass in value those on any security exchange.
These are some of the comparisons most frequently made; none of them alone would be fair, but all of them together indicate that futures trading is a valid rival to its more widely publicized cousin, the securities industry.
Nature of contracts traded The contracts traded on commodity exchanges are standardized, transferable contracts for future delivery of the commodity, binding on both sides of the agreement. Each side of the contract must satisfy its terms, either by an offsetting transaction prior to delivery time, or by making delivery (for the seller) or taking delivery (for the buyer). Commodity options are not traded in America, with two exceptions. First, some firms buy London options and retail them in America, but this is not done on a central market of any kind. Secondly, the federal government may allow a pilot programme in options on commodity futures positions in central markets such as the
30
FOOD
POLICY
February
1978
Futtrrrs trading atrd ~ed~~)z~
Chicago Board of Trade. However, that will not include the major agricultural commodities because federal law prohibits options in them. So, for the most part, the traditional, two-sided contract that carries both the right to take a profit and the obligation to make up the loss is traded in the USA,
Trading Trading is done on margin, ie, only a portion of the value of the contract is deposited at the time it is made. Margin in commodities is not a down payment or a payment in equity, but is in the nature of a performance bond posted by traders to guarantee their ability to live up to the financial commitments of the contract. The difference is significant, because: 1.
2. 3.
Roth buyers and sellers post margin in commodities. The remainder of the contract value is not borrowed from anyone and does not have to have interest paid upon it; While initial margins are low (usually 510% of the value of the contract), if the price moves against one’s position so that the protection represented by the original deposit is no longer adequate, additional margin must be posted to maintain the position. It is this system of margining which provides financial integrity to this contracting system.
Hedging The primary purpose of these markets is to allow commercial users such as farmers, food processors, and grain dealers - a means of protecting themselves from adverse price changes. This use of the market is called hedging. Hedging is not an especially difficult concept to understand, though many people successfully attempt to make it so. Basically, if you can understand why men buy fine wine but don’t want to drink it, or fine art but don’t want to look at it, or good land but don’t want to farm it, then you can understand hedging. These three purchases are among the most prominent means of ‘hedging’ against inflation. These ‘hedges’ are based on the simple premise that if general prices go up, the price of fine wine, fine art, or good land will go up with them, so that after an inflationary spiral one can se11the wine, land or art and receive the extra dollars necessary to have the same purchasing power as before. The concept being used in such transactions - the logic of what the buyer is trying to do - is precisely the same as that of a long hedger when he buys soybean contracts on the Chicago Board of Trade. He does not want to go to Chicago and take delivery of the soybeans, but wishes to protect himself from the inflation of soybean prices at his point o~~~~r~hffs~, which could be Chicago, but more likely is New Orleans, and could even be Rotterdam. The hedger’s purchase of futures contracts is based on the premise the two prices will be linked. Thus, if soybean prices do go up, the hedger can sell the Chicago futures at a profit that will help to offset the higher price he has to post at New Orleans or Rotterdam. Two differences should be pointed out, however. between the soybean buyer and the buyer of wine, say. First, in the hedge against
FOOD
POLICY
February
i 978
31
Futures trading and hedging
inflation, there is really little reason to say that land, art or wine prices would have to change with general prices. They may have in the past, but no one can say they have to in the future. In commodity futures hedging, however, there is quite a strong and definite link between the two prices - for the price of a contract for future delivery of the commodity in Chicago is going to be strongly affected by the price of that actual commodity in other major markets. However, the two prices will not move in perfect harmony, and for good reasons, which hedgers need to understand. Secondly, in commodity futures, one can hedge against price decline. If one owns a stock of inventory, and falling prices would endanger its value, a futures contract can act as a temporary, substitute ‘sale’ for the one that will eventually be made. If prices have gone down by the time the real sale is made, money will be lost on the actual inventory, but the futures position will probably show a profit, which will be the ‘hedge’ against downward prices just as the wine owner’s profit is his ‘hedge’ against upward prices. More difficult definitions of hedging may be required for some purposes, such as government regulation, but for most practical purposes a simple test will do for the potential user. Each time a futures transaction is planned the following question should be honestly answered: ‘Is this futures transaction truly designed to rnirzimize some price risk that threatens my position in the cash commodity? If a futures transaction is not tied to some position in the cash commodity, then it is not hedging. Without this connection, to enter the futures market is to take a risk, not minimize it, and one should be prepared to accept the consequences of such an act. However, not just any connection between the futures transaction and the cash commodity is enough. Some farmers who are growing corn because they are bullish on corn prices go out and buy corn futures contracts and call them hedges. Certainly, there is a connection between the two positions, but the futures transaction is not designed to minimize the risk on corn prices, in fact, it doubles it. I am not suggesting that all hedges have to be classic textbook hedges, or that everything one does has to be aimed at keeping the two sides of a mythical ‘T’ chart perfectly balanced. What I am suggesting is that when one does something that means accepting risk (and that includes holding an unhedged inventory) one should be aware of what one is doing.
Speculation Speculation in commodity futures is much maligned and little understood. Somehow the word speculation has taken on an adverse connotation. I like the way John Steinbeck dealt with it when he said, ‘I don’t know where speculation got its bad name, since I know of no forward leap which was not fathered by speculation’. Speculation is the assumption of a risk which naturally exists, as opposed to one which is created for the purpose of wagering. The farmer speculates when he plants; he speculates that his crop will grow and will bring a price that will return him a profit. Processors speculate when they build a new plant: they speculate there will be demand for its products, and that they will be able to deliver them at a profitable price. I’m sure the average citizen would not criticize either
32
FOOD
POLICY
February
1978
Frrfures trading and hedg~~?g
the processor or the farmer, yet both are speculating as surely as anyone who buys a grain futures contract in the hopes that it can be sold later at a higher price. It is the speculator who is willing to assume the price risk that merchants, processors and other hedgers do not want. The speculator is an essential part of any futures market that works. To banish the speculator, as some misguided individuals propose from time to time, is the surest way to kill the entire market. Commercials want him and need him to take the other side of the trade when their orders come into that market. The liquidity which speculators provide in the Chicago futures markets is a matter which European agribusinessmen should seriously consider. The agricultural commodities traded on the Chicago exchanges are world commodities - in terms of production, grain merchant or consumption, and price trends. A European processor, just as much as his American counterpart, faces tremendous price risks as a result of his needs to buy or sell these commodities. While innovative European firms have been hedging in Chicago for many years, now is the time for more European agribusinesses to consider following the innovators’ lead. Americans’ hedging strategies may be a little more simple because prices at their cash markets may correlate somewhat more closely with the Chicago futures than those in European cash markets. But anyone who has watched the markets of this decade knows that there is a substantial link between prices in markets an ocean apart. In general, the risks of change in the basis (the relationship between the cash market price and the Chicago futures price) are less, even between Rotterdam and Chicago, than is the risk of being totally unprotected in the cash market alone. Moreover, the link between prices becomes even stronger if the European’s pricing point is an American port, as many are.
Benefits of hedging Hedging provides a number of advantages, both to the firm doing it and to the society that firm serves. To the firm, it provides a valuable means of evening out earnings and avoiding feast-or-Famine trends that can be literally devastating to a firm when it’s the latter. For society, it means the firm need not demand so large a profit margin in order to justify the risks it is taking. These are direct benefits of hedging, ie, they flow directly from the price safety hedging provides. But there are indirect benefits, too, and these can be significant. A processor who, because of hedging, is confident he will be able to get and to afford the grain or soybeans he will need in the coming months, can attain a higher degree of operating efficiency than he would if price uncertainty made iongrange planning impossible. Hedging can help him avoid having to pay overtime one month and unemployment costs the next. Hedging also makes financing an easier task. IF a firm knows it will need large amounts of a commodity in Future months, the practical alternative to hedging often is to buy the actual commodity. But to do this ties up large amounts of capital, and requires either additional capital in the form of storage facilities or expenses to be paid to someone else who stores the grain. Hedging, because it is done on
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margin, provides the same kind of protection at a fraction of the advance outlay. A second alternative for a firm in that situation is to forward contract in the cash market to buy the grain at a future time. If the other side of such a contract did not hedge, it would not enter into such a contract except on terms very favourable to it and commensurate with the risk it is accepting by the contract. To the degree to which firms are able to get forward contracts at prices which are fair, it largely is because firms on the other side of the contract are able to pass on their forward contract risks to speculators who take the other side of hedge orders in the futures market. Another important financial aspect of hedging is how it’s viewed by bankers. A sophisticated banker who understands futures knows that a company which hedges is a safer risk than one which does not. Thus, a company which wants a loan to finance inventory costs, or to expand its operation, will frequently find that a systematic hedging programme is a big plus to wary potential lenders.
International
commodity
agreements
A question arises as to whether hedging on an international scale might be a better policy approach than international commodity agreements. When the goals, prospects of success, and end-results of these two approaches are properly understood, I believe hedging does indeed come out on top. First, from what I’ve already said, it is obvious that a prudent hedging programme can remove a lot of the need for such an arrangement by providing a means by which firms can deal with some of the major effects of price volatility. Secondly, when one considers international commodity agreements, one has to start with a realization that such agreements have never worked in the past, and, in my opinion, the improved prospects currently attributed to them by some are little more than wishful thinking. Moreover, it is significant that hedging does not require increased politicization of economic affairs, with all the inefficiency, short-term expediency, and red tape which politics usually bring. Yet hedging is not a total, interchangeable substitute for such an agreement. It is not, I believe, because the goals of the two approaches are quite different. Hedging does not attempt to repeal the laws of supply and demand; rather, it facilitates and interfaces with them. Futures markets allow price to change and to speak to the producer and consumer, saying cut back production when price is too low and increase it when price is high. International pricing agreements, such as are being discussed, basically do attempt to effect such a repeal. They would prop up prices when they are low, thus providing little incentive for production to be brought into balance with demand (unless, as has been the history in the USA, those propped-up prices are accompanied by artificial production controls). A policy of accumulating government stockpiles of reserves further increases downward pressure on the market, and the release of those reserves as the demand-supply ratio moves upward has just the opposite effect of what the world really needs: it helps keep the price
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than what it should be and thus does not prod farmers to increase production as they should. Moreover, two noted economists have pointed out additional chinks in the armour of stockpile benefits. First, D. Gale Johnson of the University of Chicago notes that in countries that consume approximately half of the world’s grain, prices are not permitted to increase as an incentive for consumers to economize and farmers to produce. He says that with this degree of government interference in the pricing of grain in these nations, the quantity of stocks required to achieve a reasonable degree of price stability is much greater than stockpiling advocates realize. Second, Paul Samuelson of MIT says the effect of such stockpiles is likely to be small because experience shows that it will pay industry to hold less in private stocks when government is known to be holding more in public stocks. ‘Thus, the promise of a real Pharaoh’s store for the lean years would be largely illusion’, according to Samuelson. Free markets, with the hedging mechanism of the futures markets, are in my view a much better route to take. The goals of this approach are more modest - to allow a means of dealing with price risks, yet to allow price to perform the economic functions it is supposed to. These more modest goals are reachable, and, because of the efficiency which this approach encourages and demands, the longterm effect is of more benefit to all involved than if we take the more aggressive approach of inter-governmental economic manipulation, which is doomed to fail.
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