In this 3-part series of articles on futures markets we have looked at how they came to exist, the basic mechanics of how the market works and, in this final article, we will look closer at the main function of a futures market: to hedge price risk for producers, buyers and other sellers of commodities.
Hedging is meant to reduce the risk of adverse price movements, and the futures market allows parties to do this in various ways depending on their situation. Good business practices are not about speculating and hoping to win big; they are about producing a consistent profit, year-on-year. In a certain way, you can think of hedging as insurance. This is why hedging is so important for all players in industries like coffee.
Using the futures market to hedge against risk can be carried out by any part of the chain. But as mentioned in the first article, there are certain barriers to entering this market, mainly related to volume. A producer who is large enough could do it themselves; but for small scale producers it is practically impossible. Roasters can also do this, but again it would depend on their size. Exporters and importers who move significant amounts of coffee typically hedge all their trades, because if they didn’t hedge their businesses would be unsustainable. Those who hedge actually make the entire chain more sustainable as it reduces the risk of defaulting on buying and selling coffee, creating a more secure environment for roasters and producers who will need to buy and sell coffee no matter what.
For companies like Caravela, there are two main risks that we are hedging against:
Firstly, that we have bought coffee without a buyer and the price changes. We know that we will have to sell a certain amount of coffee in the future and we are constantly buying coffee to cover our future needs. However, the market price at which we are buying the coffee may not be the same when we finally sell it. If there is a drop in price after we have bought coffee from producers, then we might not be able to cover the cost of the coffee in the sale.
Secondly, that we have forward contracted coffee with a roaster and the market price changes. This is the opposite problem, where we have a commitment to sell coffee at a future point in time at an agreed price. When the harvest starts, if the price changes then we need to pay producers the new price which might not be covered by the agreed upon selling price.
Let’s look at some concrete examples of these two scenarios:
Let’s say Caravela is buying from coffee producers a container’s worth of green coffee for $1.05 a pound. This coffee will be sold and shipped in three months’ time. To protect ourselves from adverse price change we will sell a futures contract of 37,500 lbs., which conveniently happens to be about the amount of a container of coffee, at the market price ($1.05).
By the time we have a buyer for that coffee, the price has dropped to $1.00, so we end up exporting and selling the coffee with a loss of $1,875 ($0.05/lb x 37,500 lbs). However, in conjunction with this sale we also buy a futures contract (for the same delivery month as the other) at the new market price.
As discussed in the second article, these two opposing contracts balance each other out with the difference in price either being received or paid. In this case we agreed to sell a futures contract at $1.05 and bought one at $1.00, which gives us a $0.05 profit per pound or $1,875 in total, therefore covering the loss on the physical coffee. It is true that if the price had risen, we would have made more on the physical coffee and would have lost on the futures, but the end result would have been the same as we are not interested in speculating.
Caravela agrees to sell a container of coffee to one of our roaster partners at the current market price of $1.00 per pound plus the differential for delivery in six months’ time. However, we do not have possession of this coffee as it is still growing on the coffee trees. When we sign the forward contract with the roaster, we also buy a futures contract (again conveniently in this example, the quantity stated in the futures contract is about the same amount as the container of coffee), for delivery in six months’ time at the market price of $1.00.
Fast forward five months when the coffee is now picked and processed and the market price has increased, and we end up paying the producers $1.20 plus the differential for their coffee. Almost immediately, we sell a futures contract for the same delivery date at the current market price of $1.20.
So how have we done? We sell the physical coffee to our roaster for $1.00 plus the differential but have to buy the coffee from the producers for $1.20 plus the differential, resulting in a physical loss of $7,500 ($0.20/lb x 37,000 lbs). On the futures contracts however, we agreed to buy at $1.00 and sell at $1.20 for delivery in the same month, balancing each other out and making a financial profit of $7,500 ($0.20/lb x 37,000lbs.). Hence, the financial gain covers our losses on the physical coffee.
As seen in both examples above, the idea is to reduce price risk though hedging against the futures market. The idea being that a loss on the physical coffee should be compensated by a gain on the futures transaction, or vice versa.
What about differentials?
The differential risk is something that cannot be hedged against and for this reason knowing your local markets is so important. Although not insignificant nor always true, the differential risk is normally seen as “less risky” than the underlying price risk which is why hedging is essential. Although in the last decade the differential risk has increased significantly in most washed coffee origins, as the supply of washed coffee has not grown at the same pace as the demand.
If the coffee futures market did not exist, there would be no way to effectively and efficiently manage these risks. Hence, it would be impossible or extremely risky for Caravela (or any other green coffee trader) to operate, which would most likely make green coffee a lot more expensive than it is today as profit margins would need to be much higher than they are to compensate for the higher risk and lower liquidity. Likewise, the risk for roasters would also be even higher, as they could find themselves in situations where coffee prices would suddenly and dramatically increase – for example, due to a frost in Brazil, and they might be left without coffee to roast – unless they agreed to pay a much higher price.
As mentioned in the introduction, companies like Caravela do not exist to gamble in the futures market. On the contrary, they exist to balance out the interests of roasters with those of coffee producers. And thanks to the existence of the futures market, and through it the ability to hedge the sale and purchase of green coffee, the entire chain can be sustainable, allowing roasters and producers to commit long-term without having to worry about the day-to-day volatility of the market.
Was this interesting? Grab a coffee and pick another from the articles below