How to hedge your business against price fluctuations

personal finance

This is how you protect your company against price fluctuations


vegetable growing. PHOTO | SHUTTERSTOCK

One of the toughest challenges for Kenyan farmers is conflicting production during harvest season, which floods markets with offers, resulting in lower crop prices.

Attempts to build storage facilities to allow farmers to store and sell their crops when supply is low have greatly increased crop value. However, not all agricultural produce has a long shelf life and some produce is most valuable when fresh.

Farmers need a stable market with stable prices for their crops in order to run a sustainable farming operation. This helps them optimize performance by planning and utilizing their farms.

Futures contracts are one of the most efficient ways to hedge against producer price volatility. For example, a farmer who wants to produce a ton of coffee in six months can take a corresponding short position in coffee futures in international markets. This allows them to set a price for their production before harvest.

For example, if the price of coffee falls by 20 percent between the time the farmer entered the short position and harvest, the farmer sells the product at 80 percent of the price set and the short position in the futures market has gained 20 percent, thereby compensating for the price change.

This may seem complicated at first glance, but it is quite simple. All a farmer has to do is open an online trading account with CMA-regulated brokers, deposit funds, and take a short position on say coffee equal to their expected production for the season.

But first, let’s define a futures contract.

A futures contract is a standardized legal contract between a buyer and a seller to buy or sell an underlying asset at a predetermined price, with delivery at a specified time in the future.

A futures contract is a type of derivative contract. A derivative contract is a standardized contract between a buyer and a seller that derives its value from the value of an underlying asset, such as coffee.

So when a farmer buys or sells a derivative contract on coffee, he is not buying actual coffee, but a derivative contract that is settled on the difference between the entry and exit prices. Note that at expiration, the contract holder receives delivery, although most speculators choose to move to the next contract.


Young man pushing a wheelbarrow at the farm. PHOTO | SHUTTERSTOCK

Futures contracts are traded on an exchange such as the Intercontinental Exchange (ICE). The exchange sets the contract specifications for each asset class. For example, the standard for a contract Arabica coffee is 37,500 pounds (approximately 250 bags).

Licensed warehouses issue certificates after testing the quality of the coffee beans to ensure they meet standard quality.

Kenyan farmers can set prices for corn, sugar, coffee, tea, cotton, soybeans and milk. To achieve this, farmers must learn the international standards and obtain certifications to avoid rejection of their production due to standardization issues.

While online traders generally speculate on futures contracts to make a profit, companies that process or manufacture agricultural products can also hedge against volatile prices by hedging with the futures contracts.

For example, an off-season coffee processor faces the challenge of high supplier prices. To ensure they get a fixed price off-season, a processor can take a long (buy) position on coffee futures when prices are low.

If prices rise during the off-season, the futures contract will make a profit and help the processor offset the price change.

The opposite is also true. If coffee prices drop during the off-season, the futures contract will suffer losses, but the low prices will offset the loss, guaranteeing the processor a fixed price.

Hedging agricultural supply in the futures markets can help a manufacturer plan their business with a set bid price, allowing for easier company valuation, optimization and leverage.

Without this protection, the manufacturer is exposed to fluctuating purchase prices and rising purchase prices due to storage costs.

Developed countries have fully adopted this technique and used it to strengthen their agricultural sectors. With the digitization and global integration of financial market products, Kenyans can now empower their agricultural sectors by utilizing this risk management technique and focusing on what they do best, production.

Rufas Kamau is Lead Markets Analyst at FXPesa

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