A guide for farmers to hedging, futures markets, and risk management

Professor Joost M.E. Pennings of Maastricht University and Wageningen University in the Netherlands offers an insight into the uses of commodity risk management for farm businesses.

Visit the Farmers Weekly futures course and dashboard online to learn more.

What is risk management?

Risk management in the financial domain refers to managing the volatility in the net cash flow and understanding the value at risk and the measures that one can take to mitigate those risks.

How can risk management help to improve financial performance and resilience?

The value of a farm is, amongst others, driven by the net cash flows that a farm can generate over time and the volatility in those net cash flows. Both these factors determine the net present value.

When the volatility in net cash flows is relatively high, so is the cost of capital, reducing the value of the farm operation (i.e. the net present value).

The reason is that if net cash flows are more unpredictable and volatile, the probability of default increases and, as a result, attracting capital will be more expensive.

By managing the risk and hence volatility in net cash flows, the capital costs are reduced and therefore the value of the farm increases.

The most important reason is because the reduction in capital costs allows the farmer to finance farm innovations that otherwise would not have been possible.

What are futures markets?

Futures markets are organised exchanges in which futures are traded.

A futures contract is a standardised contract that specifies the amount, quality, place of delivery and time of delivery of the underlying commodity, often in the future.

A futures contract price is negotiated at the exchange by supply (sell offers) and demand (bid offers).

The price is for delivery of the underlying commodity in the future set by the contract specification, but the price is negotiated today.

Interestingly most futures contracts do not mature; meaning there is almost no actual delivery in the futures markets; the futures contract is offset prior to maturing by an opposite transaction.

The result of that transaction (cashflow) complements the cashflow of selling or buying the commodity in the local spot market.

Using a futures market to manage cash flow volatility does not replace the spot/delivery relationship that a farmer has; rather, it complements that relationship.

To find out how the hedging mechanism works, please visit the FW futures courses available online.

How can knowledge about futures markets enhance financial performance?

Knowledge is key. Understanding futures markets means that you are to understand price formation and price relationships better.

Every farmer needs to understand the information that is embedded in futures prices. However, this does not mean all farmers need to use futures markets.

Understanding the information that futures provide is crucial in managing risk and improving farmers’ financial results.

For example, when a grain merchant makes a farmer an offer for their wheat, the farmer needs to evaluate whether the offer is realistic and reflects the market.

By being able to read futures prices, understanding the basis (difference between spot and futures) and understanding relationships in those markets, a farmer can objectively evaluate whether the price is realistic.

In addition, a farmer can use the information embedded in the relationship between two different maturing months of futures, such as September compared with December, to decide whether to continue storing wheat.

Finally, price relationships between commodities (e.g. wheat versus barley) can be helpful for arable farmers when making planting decisions or for livestock farmers when sourcing proteins.

Moreover, together with your grain merchant, farmers can make agreements that are based on the futures market.

What is hedging?

We use the term hedging to refer to managing risk by means of futures and options. The hedging mechanism refers to the fact that a loss or gain in the spot market is offset by a gain or loss in the futures market.

Hence, by using futures markets, farmers can ‘counter’ volatility.

How well this mechanism works is reflected in what we call the hedging effectiveness; a measure that indicates how much volatility as a percentage a business can reduce by completing a spot relationship with a futures contract.

In reality that hedging effectiveness is not 100%, but lower because of the so-called basis risk; the fact that at maturity the futures price does not equal the spot price because of space and quality differences between spot commodity and futures contract specifications.

What are the key things businesses need to understand to be able to benefit from futures markets?

The key parameters that farmers need to understand are hedging effectiveness and the optimal hedging ratio.

The hedging ratio refers to what percentage of the underlying commodity you produce or source that needs to hedged in the futures market.

That will only be 1 if the hedging effectiveness is 100%, which is seldom the case because of the aforementioned basis risk.

How can farm businesses evaluate a risk management strategy?

A farm can evaluate the risk management strategy by measuring the hedging effectiveness.

What makes farmers persistently perform better?

Our research with 1,500 farmers, for which we had farm records for 15 years, clearly shows that it is not the technical capabilities that are the defining factor for whether farmers perform persistently better than others but risk management.

The volatility in prices contributes much more to financial volatility than technical performance when ranking farmers’ financial performance.

As a result, farmers that have the knowledge to manage volatility in prices/margins are outperforming farmers that do not have that skill set, and they do that consistently over the years.

Interestingly, we find that this is not only driven by the fact that the farmer’s capital costs reduce by having a risk management strategy in place but also because of the fact that in engaging with futures markets and being able to understand them and capitalise on the information embedded in futures prices, farmers can become better marketers and, as a result, achieve on average higher output prices and lower input prices.