Management Risk in Agriculture:
Risk
A Guide to Futures, Options, and Swaps
Lowell B. Catlett
James D. Libbin
Chapter 1
Chapter
Introduction
General overview of agricultural risks and an
General
introduction to the basic tools to manage
market risk
market
Key Terms
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Basic Agricultural Risk
Overview
Risks are everywhere:
positive and negative
evaluation and acceptance of proper risk to obtain
evaluation
a profit
profit
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Agricultural Risks
Weather risk and biological risk are universally
Weather
known by farmers as production risk.
known
Marketing Risk
Policy Risk
Major goal is to frame marketing price risks
Major
within the larger framework of other agriculture
risks.
risks.
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Managing Agricultural Risks
Risks are managed either proactively or by
Risks
accepting the outcomes.
accepting
accepting risks
management of risk
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Production Risks
Weather and biological risks
can be proactively managed in some cases.
sometimes simply must be accepted in others.
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Marketing Risks
Two major marketing risks:
Structural risks are associated with the market
Structural
channel.
channel.
Price risk is the risk of price movement.
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Tools of the Trade
Securitization is the procedure to identify,
Securitization
quantify, and structure a risk into a financial
instrument (security)
instrument
Securitized Agricultural Risks
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Forward Contracts
Two parties agree upon contract terms and set a price
Two
for the product.
for
If the contract has a retrade clause, it is considered
If
strong; if it lacks a retrade clause, it is considered
weak.
weak.
The risk of finding a market for the product is
The
reduced.
reduced.
A major risk of a forward contract is from a large
major
move in the market price or a default risk.
default
One of the parties involved may not fulfill the terms of the
One
contract.
contract.
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Futures Contracts
Contracts are traded on a central exchange and
Contracts
are regulated by the Commodity Futures
Trading Commission (CFTC).
Trading
Contract terms are prespecified and
Contract
standardized.
standardized.
All contracts are retradable (strong).
(continued)
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Futures Contracts (continued)
(continued)
Futures
All contracts are leveraged.
margin
margin call
All contracts are very liquid due to being
All
standardized and strong.
standardized
Offsetting frees parties of contract obligations.
roundturn
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Futures Contracts and Managing Risk
Futures contracts are used to manage risk in
Futures
two ways:
two
a way to sell or buy a cash commodity
hedgingallows business to operate within the
hedgingallows
normal cash markets and futures markets
simultaneously, managing risk the of price change
simultaneously,
Derivative: Futures contract is a derivative of
Derivative:
the cash market.
the
directly tied = one-step derivative
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Options Contracts
Buyer of an option has the right but not the obligation
Buyer
to do something.
to
The seller has the obligation to perform as specified
The
in the agreement.
in
Buyer of a call has the right but not the obligation to
Buyer
call
buy.
buy.
Buyer of a put has the right but not the obligation to
Buyer
put
sell something.
sell
Premiumwhat the buyer pays for this right.
(continued)
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Options Contracts (continued)
(continued)
Options
Strike pricethe price at which the product or
the
service is exchanged at some point in the future
service
Two types of options:
exchange traded options on futures contracts
options on physical commodities (over the counter)
If the buyer decides to buy the property, he exercises
If
the option.
the
If the buyer decides not to exercise the option, he lets
If
the option expire.
the
An option on a futures contract is double derivative,
An
double
making it a two-step derivative.
two-step
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Swap Contracts
A swap entails the exchange between two or more
swap
parties (counterparties) of the cash flows arising from
other contracts or entities (notionals).
other
Swap dealers or brokers line up the counterparties
Swap
and receive a fee for services rendered.
and
Swaps allow for the shifting of price risk via cash
Swaps
flow exchanges.
flow
Swaps are not standardized contracts and are not
Swaps
exchange traded.
exchange
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Hedging
Hedging is the process of using futures, options, and
Hedging
swaps to manage price risk.
swaps
Hedging is simply having two or more positions in
Hedging
different markets so that the loss in one is offset with
a gain in another.
gain
Corn hedging example: Refer to Figure 1-1.
The cash market and futures market tend to trend
The
together, which allows the cash market to be
together which
managed with the futures market.
managed
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Speculation and Income Generation
Futures, options, and swaps can also be used to
Futures,
speculate market price direction.
speculate
Position or directional speculators are traders or
Position
businesses who try to guess in which direction prices
will move.
will
Any business activity that has price risk and is not hedged
Any
is speculating.
is
Arbitragers are traders who attempt to profit from
Arbitragers
knowledge about the relationships between two or
more markets.
more
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The Role of Risk
Certain risks in agriculture can be directly managed,
Certain
some only indirectly, and some not at all.
some
Managing risk is not only about offsetting potential
Managing
loss but also producing potential gain.
loss
Futures, options, and swaps can manage agricultural
Futures,
risk both for loss protection and income generation.
risk
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