Potential Risk Management Benefits of Rice Futures Markets for developing countries – lessons from the US
Professor Andrew McKenzie, Department of Agricultural Economics and Agribusiness at the University of Arkansas, USA
BOX 1. What is a futures contract and how is it traded?A commodity futures contract is a standardized agreement to buy or sell a commodity at a date in the future. The fixing of a future price makes futures contracts similar to forward contracts, which are simply agreements negotiated between two parties to trade a commodity at a fixed price sometime in the future. The most important difference between a futures contract and a forward price contract is that futures contract performance is guaranteed by futures exchanges—and unlike forwards do not contain counterparty risk. Futures trades are transacted at prices determined by matching bids and offers on either the pit floor or the electronic platform of a Futures Exchange. It is important to understand that exchanges do not set trading prices but merely provide the opportunity for prices to be determined in an auction-type setting. When a trader buys futures contracts, he or she opens a long futures position. At that point, the trader is committed to accepting delivery of the underlying commodity at contract maturity time. The underlying commodity is the cash commodity upon which the futures contract derives its value. At the maturity of the futures contract, the futures in essence become the cash commodity and the two market prices converge to the same value, ensuring that cash and futures prices will correlate over the life of the contract. The trader can liquidate or close the long futures position through only two ways:
The vast majority of futures contracts are settled by taking an offsetting position. This two-step transaction will generate returns if the futures price at the time the contracts are sold is greater than the price at which the contracts were initially bought—the per unit return being the price difference. For example, a trader who bought one November CME rough rice futures contract at $14/cwt and later sold it at $14.50/cwt, the per unit return would be $0.50/cwt and the total return would be the per unit return multiplied by the number of contracts and the number of units in each contract ($0.50/cwt x 1 x 2,000 cwt), or $1000 One of the least understood concepts of futures trading is that contracts can be initially sold and then bought back to offset a position even though the trader may not own the physical cash commodity. In this case, the trader is said to be opening a short futures position and is obligated to deliver the underlying commodity at the contract maturity time (unless the contract specifies cash settlement). The notion of selling something you do not own may seem odd, but when you sell a futures contract, the obligation of actually delivering on the contract is usually not required as the initial short position will typically be offset by buying the position back, or going long futures, prior to contract maturity. In contrast to the long futures trade described above, a short futures position will generate returns when prices fall and contracts are bought back at a lower price. (Source: McKenzie, 2012) |
Economic benefits
The economic benefits of the US rice futures market are twofold. First, it provides a trading forum by which the collective actions of buyers and sellers result in fair and transparent futures prices that efficiently reflects expected supply and demand conditions for a range of future time periods. This function, known as price discovery, allows all participants in the US rice industry, from farmers to rice mills, dryers and elevators, to make informed marketing decisions about when to buy, sell, and store rice. Second, the US rice futures market provides a risk management or hedging tool by which rice mills, dryers and elevators can offset the daily price risk associated with storing rice. The economic benefits bestowed by the US rice futures market have made the US rice marketing system the most efficient in the world with tight handling, storing and milling margins. A natural question to ask is “To what extent can this US futures success story be replicated in developing countries?” To this end, a recent study by McKenzie (2012) examined the feasibility of developing a successful rice futures contract for the Association of Southeast Asian Nations (ASEAN) region. One part of the study highlights the salient features of how futures contracts are used to manage risk in the US rice marketing system and how transferable these features are to developing Asian rice markets.
Lessons
There are two very important lessons to be taken from the use of futures contracts in US rice marketing system. First, although the risk management benefits of futures contracts are often explained by textbooks in terms of farmers, most US farmers do not directly use commodity futures markets to hedge their grain. The primary users of rice futures contracts are the merchandising sector, which includes rice mills, dryers and elevators. These firms are involved in the procurement of rice from farmers, the processing or milling of rice, the storage of rice, and the sale of rice to end users in domestic and international markets. Many of these firms are large farmer owned co-operatives. Instead of directly using futures, farmers typically market their rice through forward contracts with these elevators and co-operatives. However, without a rice futures market the merchandising sector would be unable to offer forward contracts and to store rice on behalf of farmers. So in this sense the rice futures market provides large indirect benefits US rice farmers.
Second, the US rice and grain merchandising sector use futures contracts not simply to remove price risk, but also to compensate them for storing rice. Specifically, merchandisers apply a marketing strategy known as “basis trading” to earn returns storage and enhance their profit margins. Merchandisers remove price uncertainty by selling futures contracts to hedge harvest-time purchases of cash grain.
About Futures, Hedging and Basis Risk
The basic idea behind hedging is to take the opposite position in futures to the actual current or anticipated cash position. Futures contracts are traded on Chicago Board of Trade for rice and all major grains. Each futures contract represents the price of a specific commodity (e.g. US No. 2 or better long-grain rough rice with a total milling yield of not less than 65%, including head rice of not less than 48%), for a specific quantity (e.g. 2,000 cwt or hundredweight, which is about 91 metric tons), for a specific future delivery period (e.g. January, March, May, July, September, and November), and for a specific delivery location (e.g. designated elevators in Eastern Arkansas). By selling a November rice futures contract a merchandiser is obligated to deliver 2,000 cwt of rice in November at a fixed price, established today. Hedging rice in this manner leaves the merchandiser with a basis position. Basis is defined as a local cash price less a futures price for the same commodity. For example, if the cash bid for rice at an elevator in Arkansas is $14.50/cwt and the November rice futures contract at the Chicago Board of Trade is valued at $14.75/cwt, then the Arkansas basis is -$0.25 November, or 25 cents under the November futures. Basis patterns (changes in basis over time) are much more predictable than price patterns (changes in price over time). Typically, basis tends to increase after harvest-time through the next calendar year. This seasonal pattern in basis is explained by “The theory of storage” and convergence of cash and futures prices at futures contract delivery time. The theory of storage – a concept first explained by Working (1953) – states that futures contracts for later delivery periods will be traded at higher prices relative to futures contracts for nearer delivery periods. The higher priced contracts provide merchandisers with a profitable return for storing rice and this pattern of relative futures prices is referred to in the industry as a carry market structure.
To continue the example, for a merchandiser who has hedged and then stored harvest-time rice purchases, any increase in basis adds to the merchandiser’s bottom line or merchandising margin. So if basis increases from -$0.25 November to +$0.05 November over the storage period the basis the merchandiser will be able to sell rice, at the end of the storage period, will be 30 cents higher than the price he/she could have sold the rice for at the beginning of the storage period. However, storing rice and other grains is not costless, and storage costs accumulated over the storage period will subtract from the end selling price. Thus basis trading will benefit merchandisers when basis movements exceed storage costs. In effect the futures market is paying merchandisers to store rice until the market needs rice.
Mckenzie (2012) shows that the US rough rice futures contract does a good job of performing its risk management role in terms of providing the carry market structure for merchandisers to basis trade and earn adequate returns to storage. Figure 1 shows average futures spreads (the price difference between two futures contracts for different delivery dates) for the crop marketing years from 2004–2005 to 2010–20011. The average spreads are positive for all months except July–September, indicating that, on average, the rice futures market compensates merchandisers for storing in a systematic way over time. The average negative July–September spread is characteristic of all US grain markets which have a tendency to invert at the end of the crop year in anticipation of the forthcoming harvest. Note that the July–September spread has a wide 95% confidence band, which shows the greater market uncertainty (price volatility) that takes place as markets transition from one crop year to the next.
Thus, the US rice futures experience would suggest from a developing country standpoint that policies should focus on promoting the economic development of the merchandising sector. An active and well developed merchandising sector is important to the successful development of any grain futures contract. US merchandisers provide the US rice futures contract with a consistent trading volume through their hedging activities, and in turn a liquid futures contract provides the whole marketing system from farmers to elevators with price discovery. From a risk management standpoint, rice and other grain futures contracts provide merchandisers with the tools to perform their critical marketing function—buying rice and other grains when farmers want to sell, and storing rice and other grains until users want to buy it. To the extent that a new rice futures contract – established and traded in a developing country – would allow merchandisers in that developing country to exploit seasonal patterns in rice prices, the greater the chance that the economic benefits of price discovery and price risk management could be realized.
Figure 1: Average Rice Futures Spreads 2004–2005 to 2010–2011 Rice Marketing Years
Source: CRB Bridge futures data
References
McKenzie, A. M. 2012. Prefeasibility Study of an ASEAN Rice Futures Market. ADB Sustainable Development Working Paper Series No. 19 March 2012.
Working, H. 1953. Futures Trading and Hedging. The American Economic Review 43:314–343.