Hedging your crop through futures
ECONOMIST AT GRAIN SA
This article will focus on futures hedging. Hedging is a marketing strategy done through futures or options. People who want to limit their risk of price movement must hedge, which includes producers and commodity users.
A hedge is an instrument used to reduce or cancel price risk. A futures contract is traded on Safex for delivery of grain at a future date. The contract specifies the item to be delivered and the terms and conditions of delivery.
SHOULD I HEDGE?
Before hedging, two questions need to be answered:
- Firstly, the choice of an underlying instrument. If the profit and loss profile of the underlying instrument is the same or exactly the opposite of the commodity, the choice is naturally easy. If not, the hedger must search for an underlying instrument, the profit and loss profile that is close to that of the hedged instrument.
- Secondly, choice of contract. Producers should choose a contract month while harvesting or just after the harvest. For example, farmers in Free State that harvest most of their maize in June/July should use July as their hedging month.
Table 1 indicates an example of a producer in North West who is worried that prices of yellow maize may drop during harvest season and would like to hedge against that price risk.
- He plants 1 500 ha of yellow maize, with an expected yield of 5,5 tons/ha.
- The area differential and handling costs amount to R280/ton, with trader costs and silo certificate costs at R4/ton and JSE trading fee at R17,64/contract (R0,17/ton). He expects to harvest in June.
Suppose the producer takes a futures contract in January with July yellow maize trading at R2 100/ton. For a producer to determine the quantity of maize to hedge, the best thing to do would be to determine the percentage of his expected harvest at a certain price level required to cover the crop costs.
BENEFITS AND DRAWBACKS
Advantages of hedging include:
- No default risk.
- Basis cannot weaken more than the location differential.
- The price is known in advance.
- Unless basis changes and it helps with the planning and budgeting.
Disadvantages of hedging include:
- Payable margins.
- Additional delivery costs required by the exchange.
- Transaction costs.
- Price fluctuations.
Publication: November 2021