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Futures and options on agricultural commodities have been seeing phenomenal growth in trading volume in recent years, due to increased global demand and the expanded availability of electronic trading for these products. It is now more important than ever to understand how to incorporate these tools into the management of risk.

EXCHANGE FUNCTION

As the leading Pan-European marketplace, Euronext’s ambition is to serve the real economy by bringing together buyers and sellers in venues that are transparent, efficient and reliable. Their roots are deep:  for four centuries, the exchanges that now comprise Euronext have been at the heart of European capital markets.

The main economic functions of a futures exchange are price risk management and price discovery. An exchange accomplishes these functions by providing facility and trading platforms that bring buyers and sellers together. An exchange also establishes and enforces rules to ensure that trading takes place in an open and competitive environment.

You can make electronic trades directly through your broker or with pre-approval from your broker. Technically, all trades are ultimately made by a member of the exchange.

THE FUTURES CONTRACT

A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given commodity at a specific delivery location and time in the future. All terms of the contract are standardized except for the price, which is discovered via the supply (offers) and the demand (bids). This price discovery process occurs through an exchange’s electronic trading system.

All contracts are ultimately settled either through liquidation by an offsetting transaction (a purchase after an initial sale or a sale after initial purchase) or by delivery of the actual physical commodity. An offsetting transaction is a more frequently used method to settle a futures contract. Delivery usually occurs in less than 2 percent of all agricultural contracts traded.

MARKET PARTICIPANTS

Futures market participants fall into two general categories: hedgers and speculators. Futures markets exist primarily for hedging, which is defined as the management of price risks inherent in the purchase or sale of commodities.

The word hedge means protection. The dictionary states that to hedge is “to try to avoid or lessen a loss by making counterbalancing investments ...” In the context of futures trading, that is precisely what a hedge is: a counterbalancing transaction involving a position in the futures market that is opposite one’s current position in the cash market. Since the cash market price and futures market price of a commodity tends to move up and down together, any loss or gain in the cash market will be roughly offset or counterbalanced in the futures market.

Hedgers include:

• Farmers, livestock producers – who need protection against declining prices for crops or livestock, or against rising prices of purchased inputs such as feed;
  
  
• Merchandisers, elevators – who need protection against lower prices between the time they purchase or contract to purchase grain from farmers and the time it is sold;
  
  
• Food processors feed manufacturers – who need protection against increasing raw material costs or against decreasing inventory values;
  
  
• Exporters – who need protection against higher prices for grain contracted for future delivery but not yet purchased;
  
  
• Importers – who want to take advantage of lower prices for grain contracted for future delivery but not yet received

Since the number of individuals and firms seeking protection against declining prices at any given time is rarely the same as the number seeking protection against rising prices, other market participants are needed. These participants are known as speculators.

Speculators facilitate hedging by providing market liquidity – the ability to enter and exit the market quickly, easily and efficiently. They are attracted by the opportunity to realize a profit if they prove to be correct in anticipating the direction and timing of price changes.

These speculators may be part of the general public or they may be professional traders including members of an exchange trading on the electronic platform. Some exchange members are noted for their willingness to buy and sell on even the smallest of price changes. Because of this, a seller or buyer can enter and exit a market position at an efficient price.

Benefits resulting from participating in the exchange in performing a hedge.

1. Ability to choose sell/buy price at favorable moments throughout the year.
2. Having a confirmed price ahead of physical delivery can lead to greater financing from the banks.
3. Can be used as an investment vehicle due to the small financial requirements needed to open a position. (10-15% of the value of the contract)