Agricultural Derivatives: What are they, and how do they help manage risk?
Learn what agricultural derivatives are, how they work, and what their importance is for risk management in commodity markets.
Today, we’d like to clarify what agricultural derivatives are. To do this, we need to think about the origin of the word itself: derivative is associated with derivation – that is, something that is formed from something else.
Thus, agricultural derivatives refer to the family of financial instruments in which deals based on future liquidity are carried out. Their prices are derived from the physical markets handling their respective agricultural products. Through hedging operations, they make it possible to manage risks related to the value of various agricultural assets, like commodities such as coffee, soy, corn, and sugar.
In this text, you’ll come to understand what agricultural derivatives are, what the main types are, and how they function to manage risk in commodity markets.
Keep reading to find out more on the subject!
What exactly are agricultural derivatives?
For us to understand better what agricultural derivatives are, first we need to know what agricultural commodities are. Commodities are goods that come from various activities, such as agriculture and livestock and are sold raw or with only a small degree of industrialization.
As a rule, commodity production is on a large scale and destined for foreign trade. Prices are determined by international supply and demand in the economy. Hence, producers and industries have no control over commodity price fluctuations. In this precise context, the importance of using derivatives arises.
To understand clearly, let’s look at a very practical example. Imagine that John, a corn producer, starts planting. After the whole corn cycle, he harvests and hires a cooperative to negotiate the price of a bag. After completing the operation, he delivers the corn to the cooperative and receives the agreed payment.
The agricultural derivative works in much the same way. The difference is that, with its use, John can fix the price of corn before negotiating the physical product. To do so, he must sell a derivative contract on the exchange, or close a contract for future delivery. In this contract, the date on which he agrees to deliver the amount of corn and the specified amount are included.
The price lock here that John performs is a financial operation called hedging. To carry it out, one option is to resort to the use of agricultural derivatives, which are essential to ensure that the negotiation takes place.
So, you can see that agricultural derivatives work like contracts, whose reference is an agricultural product in the physical market. Thus, they act to guarantee protection against price fluctuations related to these products.
What are the main types of agricultural derivatives, and where are they traded?
There are three main types of derivatives:
- Forward Contracts: An asset is sold or bought in advance at a price and term previously agreed between the parties. The contract must provide information on price, the settlement date, and the quantity negotiated, since this choice requires the physical delivery of the product.
- Futures Contracts: The obligation to buy or sell an asset at a future date is negotiated at a previously agreed price traded on the stock exchange.
- Option Contracts: These are contracts in which a party, by paying an amount called a premium, acquires the optional right to buy or sell the asset at a future date, at a predetermined price.
Derivatives are usually traded on a stock exchange, which defines the rules for trading these contracts, and establishes reference prices according to supply and demand.
To directly purchase or sell contracts on stock exchanges, buyers and sellers must be approved in a bureaucratic process. This sometimes makes these exchanges inaccessible to small and medium-sized traders.
As a result, not all derivatives trading takes place on exchanges. Many trades take place in the over-the-counter market, also called the OTC. This expression goes back to the days when financial securities were traded at physical exchange counters and brokerage houses.
In the OTC market, trading offers less bureaucracy and can be adapted to the traders’ needs. Thus, there’s much greater flexibility in terms and volumes traded. The biggest advantage here is the possibility of trading assets and derivatives that aren’t qualified for trading on the stock exchange, which lowers costs and makes financing possible.
What’s the importance of agricultural derivatives for risk management in commodity markets?
It’s safe to say that derivatives are important tools in risk management. Whoever trades derivatives isn´t necessarily buying the product or asset itself, but rather enters a transaction contract that grants rights related to price fluctuations on these assets.
Consequently, agricultural derivatives are used to eliminate or reduce apprehension regarding market prices, bringing peace of mind to the trader. Commodity traders are price fixers who seek mechanisms capable of eliminating or reducing the risks stemming from future price variations.
In this scenario, agricultural derivatives have some basic purposes:
- Hedging: Tools applied in commodity markets, such as agribusiness, so that producers and consumers can protect themselves against price fluctuations.
- Speculation: Carried out by those who don´t have the physical product or aren´t necessarily producers or consumers. This occurs when the purchase or sale of a derivative takes place with a view to its resale or repurchase at a later date. Prices are thus expected to change so as to provide profit.
- Arbitrage: This technique takes advantage of price differences between assets and their respective derivatives, which are traded in different markets.
How can you start to use agricultural derivatives?
If you’re in the commodities industry, you know how volatile this market can be. It’s vital to rely on the use of derivatives to ensure more protection for your business.
At hEDGEpoint, we offer hedging tools for a variety of commodities. We put together technology, market intelligence, and insight that allow clients to assess risks and decide the best strategies for their businesses.
Get in touch with us to find out how to use this instrument to favor your business. Talk to a hEDGEpoint professional today.
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