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What makes futures and options work?
CASH TIES

By Candice Bowman, vice president – marketing, Kansas City Board of Trade

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       This is the second in a series of articles written by the Kansas City Board of Trade for Crop Insurance TODAY about risk management and the use of futures and options. The first article highlighted the advantages of using exchange-traded products. This article explains why those products work for hedging purposes, and why an understanding of how they work is important for any risk management program.

      At the Kansas City Board of Trade, our president is fond of saying that if you want to gamble, you can head down to the gaming riverboats on the nearby Missouri River. If you want to hedge, the exchange is the place to be.

      What makes the night-and-day difference between using an exchange’s grain futures and options contracts to hedge and playing a slot machine? Quite simply, cash ties.

      The exchange was founded so that farmers, elevator operators, feedlots, flour millers, exporters and other grain merchants could help shed themselves of one of the greatest risks they face – price volatility. Why do exchange-traded futures and options work in that risk-reducing capacity, as opposed to existing purely as a vehicle for speculation? Because of their direct link to the cash market.

      An understanding of this link between the cash and futures markets is important for any risk management program in agriculture today, regardless of whether that program directly utilizes the futures markets or not. Virtually all commodity risk management programs deal with the cash market in one fashion or another, and the two markets – cash and futures -- are inseparable. Without an understanding of how they relate, one is left without a full understanding of how the market behaves, and thus without an understanding of how a risk management program may perform and how the different elements of that program may impact one another.

      The primary, underlying reason that futures work as a hedge against price risk quite simply is their relationship to the cash market. The most basic, fundamental part of this relationship starts with the futures delivery process – the point at which the cash and futures markets actually meet face to face.

      Ironically, the reality that a futures contract eventually could result in delivery of grain is seldom realized. As a general rule, less than two percent of the contracts traded in a given grain futures month actually result in physical delivery of the commodity. This is because most futures users are using the contract as a temporary substitute for the cash market, and not as a way to procure grain. But the fact that a futures contract could result in the physical delivery of grain is precisely what keeps it correlated to the cash market.

      This occurs through a process that we at futures exchanges call “convergence.” The price of a futures contract at any given time prior to its delivery period is a reflection of what the buyer and seller have agreed that grain is worth at that time in the future. It is not what they agree grain is worth at the time they trade.

      For example, a trade of July 2000 wheat futures at $2.99 per bushel, made in March, is a reflection of what traders in March believe that a bushel of wheat will be worth in July, and not what wheat is worth in March. However, as July approaches, the price of the July 2000 futures contract will move closer to the current cash price for wheat, because of the potential that the contract could be used to actually deliver wheat. Once July arrives, the July futures price and the cash market are the same, as the contract is being used to deliver wheat. The futures and cash markets have converged.

      If the cash and futures prices did not converge – for example if the futures price at delivery time was much higher than the actual cash market price – operators would use the futures contract to deliver wheat at a profit over the cash market. Through the natural market forces of supply and demand, the resulting deliveries would move the futures price back to convergence with the cash price. Thus, the delivery process keeps the futures price tied to cash.

      The more that futures and cash prices correlate, the more effective a futures hedge is as a risk management tool.  This same principle applies to options. Options give the holder the right, but not the obligation, to buy or sell the underlying futures contract at a specific price. Therefore, because options are keyed to futures prices, the correlation between futures and cash prices is key to the effectiveness of an options hedge as well.

      Of course, the cash price that correlates with the futures contract for many operators is not the same as the price in their local market. At the Kansas City Board of Trade, for example, our wheat futures are based on Kansas City delivery, with a 12-cent discount for Hutchinson, Kansas, delivery. Now in a perfect world, if I was a producer near, say, Garden City, Kansas, my local cash price would always be at the same differential to the KCBT wheat price — let's say 20 cents under. I could then achieve a perfect price hedge.

      But in reality, local conditions such as transportation availability, storage, and proximity to major markets are going to impact the Garden City price. The resulting cash price is often something that still correlates well with, but does not move identically with, the futures price.

      What point am I trying to make with all this? Actually, there are two. The first is that it is vitally important for an operator to know his basis and its historical relationship with the futures market. Only with this knowledge can he work to develop the most effective hedging strategy possible for his situation.

      The second point is perhaps even more important, and it is this: While futures and options may not present the perfect price hedge all the time for all people in any situation, their correlation with the cash market is critical to their usefulness as a hedging tool. And they do correlate well with many markets, offering a very good price hedge in many situations, much of the time.

      Even for those not using the futures markets directly to hedge, an understanding of how the futures and cash markets relate is important to help maximize selling price and minimize risk.

      The cash and futures markets have a symbiotic relationship, each affecting the other and, ultimately, each benefiting one another. An understanding of this relationship can be very beneficial when it comes to commodity risk management.

 

Last updated: April 28, 2004.

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