Hedging Strategies for Ag Businesses

By way of the definition of the term: Ag hedging strategies can include virtually anything a company does in the financial markets in its anticipation and mitigation of uncertainties and risks.

Ag business risks fall within five broad categories:

Production Risk (as a drought)
Market Risk (as a sharp price increase for a necessary input)
Financial Risk (rising interest rates or currency moves)
Institutional Risk (uncertainty regarding government/regulatory action)
Personal Risk (the illness or death of a key figure within a farm or firm).

Let’s focus on the Market or Financial risks, though hedge strategies that apply there may also function well in other categories. We’ll explore three perspectives on hedging strategies:

The use of offsetting futures trades to mitigate market risk
How a firm may combine put and call options to create a “window strategy”
The broad issue of currency risk in a global market

Three Derivatives

We need first to define three sorts of derivatives: Futures Contracts, Forward Contracts, and Options.

A futures contract is a legally binding agreement to buy or sell an asset at a specific price on a specific future date. These contracts are traded on futures exchanges by both speculators and traders. So, naturally, as the price of the underlying (let us suppose, a grain) rises and falls over time, the value of the right to receive a defined quantity of the grain on a specified date for a predetermined price will also fluctuate.

Most traders and speculators on futures exchanges liquidate their futures positions or offset them before the delivery date, so they aren’t responsible for physical delivery. Futures contracts are regulated through a system supervised by the Commodity Futures Trading Commission.

A forward contract is rather different from a futures contract. A forward contract is a private and customizable agreement that may trade hands over the counter but stays outside the exchanges. Consequently, forward contracts are unregulated.

Finally, options are different from either forward or futures contracts. An option is a choice acquired by an investor to execute a contract either to buy or to sell at a pre-specified price. An option holder is not obligated either to buy or sell. This element of choice itself limits the Risk involved.

First Perspective: Off-setting Futures Trades

It is straightforward to enter offsetting futures trades to protect against price moves.

Consider corn, a grain that is commonly used for feedstock for pigs. It may be the product of one farm but an input for another. The pig feeder, for example, might protect itself from price increases by long hedging. This means that it could buy futures contracts to match anticipated requirements but meet its need for corn not from the settlement of the corn futures transaction but from the cash market. It can sell the futures contracts as its needs are met.

In this situation, any loss the pig-feeding firm experiences from a price increase is at least partially offset by gains in the value of the futures position it is selling.

Second Perspective: Building a Window with Options

The hedge can fit the risk more snugly when options are introduced. Suppose corn is selling for $4.87 a bushel, and our pig feeder is concerned that corn futures will rise over a given period between now and the following spring. It might buy a call option with a “strike price” of $4.90. This means it is entitled to purchase a futures contract on corn for that price per bushel. Of course, if the spot price remains below $4.90 between August and February, if the firm is wrong about this concern/prediction, it will allow the option to expire unexercised. It will not be obligated to buy $4.87 corn at $4.90.

If it allows the contract to expire unused, its loss is precisely the amount of money it spent to buy that option. This, we may suppose, was $0.45 per bushel. Purchasing a call option creates a price ceiling of the strike price. This is valuable. Our firm has insured itself against the possibility of a spike before February that could carry the spot or futures price well above $4.90.

This transaction does not create a floor for the corn price. And you may think that is natural: why would a buyer want to create a floor? Wouldn’t it be happy to benefit from any price collapse in the time period?

A Window has a Bottom and a Top

Options often come in pairs, the so-called “window.” The apparent reason our pig feeding firm accepts a floor for the corn price is the offset of the option premium it allows. Selling the put (accepting the low-end strike price) raises the money employed to buy the call (creating a high-end strike price).

This effective hedging strategy takes its name from the difference between the strike price for the call and the put, a “window” that establishes both a ceiling and a floor for our breeder’s price of corn.

As we’ve just outlined, a problem with the window strategy is that it leaves the local basis unhedged. As noted above, there will likely be a difference between the futures and the spot price, the local basis price, for the corn. This difference fluctuates, for example, for reasons of quality or transportation issues. The difference may be a positive or negative basis — that is, selling the futures position and buying from the cash market may reduce the price of the corn or may increase it.

When one takes account of all these considerations, then the arithmetic of a given bushel of corn may look like this:

$4.87 a bushel [futures contract price]

-0.20 [negative basis],

+0.45 premium for call option],

-0.43 [premium for put option], netting out to

$4.69.

Let’s shift our focus, assuming that our firm has fed and slaughtered its pigs and is in the process of marketing pork.

Third Perspective: Exchange Rate Hedging

Agriculture is a very globalized market, and farms in the export business need to protect themselves from exchange rate fluctuations.

Assume, for example, that our firm has agreed to receive 7000 rupees (INR) for a shipment of pork to India. The agreement stipulates execution in two months.

At the time of the agreement (we stipulate), the rupee-for-dollar exchange rate is 70 to 1. So, the deal supposes that if there is no change in that rate, the exporter will receive US$100. But if the rupee falls against the dollar in those two months and settles at 80 to 1, the exporter will receive $87.77. So, in that case, the exchange rate shift has cost the exporter more than $12.

Currency Futures and Options

How can an ag exporter employ financial instruments to protect itself against that situation?

It can turn to currency futures contracts, buying them from an exchange such as, in India, the National Stock Exchange (NSE) or the Multi Commodity Exchange (MCX). One drawback is that futures contracts may not offer the exact exchange rate that the party, our pig feeder, desires when the contract reaches its maturity date.

For greater flexibility, the pork exporter can turn to options. Again, as with the options on commodity futures discussed above, currency options create an opportunity to buy or sell a set amount of currency at a fixed price on or before expiration. This allows the option buyer to lock in a rate that it expects will be at least as beneficial as the actual rate when the contract or the option comes up.

A Final Thought

Farmers, and indeed all parties in agriculture, are familiar with uncertainty which is why hedging strategies and agricultural cooperatives help farmers mitigate risk.

Ag businesses need to be able to use the financial markets to develop an effective hedging strategy. We have discussed three suggestions:

Hedging through futures
Using options to create a “window” producing predictability
Utilizing instruments to protect against exchange rate shocks.

These ideas should offer more than a taste of the opportunities for businesses in the ag industry who are willing to look at matters both long term and short term, to employ hedging strategies and secure optimal results.

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