Futures Markets and Hedging
The number of coffee futures being traded on the exchanges has grown consistently in recent years. Throughout the 1970s, however, high levels of inflation and exchange rate uncertainty were associated with a greater degree of nominal price volatility for primary commodities. This, in turn, gave a tremendous boost to futures speculation. The presence of speculators in the futures market enhances its liquidity, which is essential to avoid undue price distortions that can be caused through sudden changes in hedging and investment strategies.
Excessive speculation can lead to wider price fluctuations, and markets become ‘overdone on the upside and on the downside’ (prices move to greater extremes than expected). This continues until the excess of either the long or short positions is finally unwound.
Differences between hedging and speculation
Hedging is often confused with speculation. In both cases, operators are concerned with unforeseen price changes. They decide to buy or sell based on their expectations of how the market will move in the future.
However, where hedging is essentially a means to avoid or reduce price risk, speculation relies on the risk element. For instance, it would be irrational to sell futures for hedging purposes if the market was absolutely certain to rise. In the absence of absolute certainty about future market movements, hedging offers an element of protection against price risk. Speculation, on the other hand, involves deliberately taking a risk on price movements, up or down, in the hope of profiting.
The function of futures markets
Coffee futures exchanges were originally created to bring order to the process of pricing and trading coffee and to ease risks associated with chaotic cash market conditions. The futures prices that serve as benchmarks for the coffee industry are openly negotiated in the markets of the coffee futures exchanges.
To support a futures market, a cash market must have certain characteristics: sufficient price volatility and continuous price risk exposure to affect all levels of the marketing chain; enough market participants with competing price goals; and a quantifiable underlying basic commodity with standard grades or characteristics.
The futures exchange is an organized marketplace that provides and operates the facilities for trading; establishes, monitors and enforces trading rules; and stores and disseminates trading data. The exchange does not set the price. It does not even participate in coffee-price determination. The exchange market supports five basic pricing functions: price discovery, price risk transfer, price dissemination, price quality and arbitration.
The exchange establishes a visible, free-market setting for trading futures and options, which helps the underlying industry find a market price (price discovery) for the product. It also allows the transfer of risk associated with cash price volatility. As price discovery takes place, the exchange disseminates prices worldwide. Continuous pricing information availability contributes to wider market participation and to optimal pricing quality. This is because more buyers and sellers in the marketplace means better liquidity and, therefore, better pricing opportunities. To ensure the accuracy and efficiency of the trading process, the exchange also resolves trading disputes through arbitration.
Two main futures market centres serve the global coffee industry: New York and London. In New York, the Intercontinental Exchange (NYSE: ICE or ICE US), deals with Arabica coffee beans (the New York C contract – market symbol KC). In London, the market is also owned by the Intercontinental Exchange (NYSE: ICE or ICE EU) and deals with Robusta coffee beans (market symbol RM). Both can be consulted online at www.theice.com.
Useful tools and resources to navigate coffee’s industry
Here, you'll find valuable tools and insights on futures contracts, hedging strategies, price risk management, and market analysis.
Charts and spreadsheets showing the weekly commitments of traders and index funds:
A useful tool for following the development of market prices, also offering charts showing price movements over the last 20 years:
The Specialty Coffee Transaction Guide presents a valuable tool that summarizes recent transaction data based on actual premium and specialized coffee purchases:
Navigating Margin Calls: Lessons from the 1994 Coffee Market Crisis
An (extreme) example: On 24 June 1994, the ‘C’ contract closed at 125.50 cts/lb. Just two weeks later, the market closed at 245.25 cts/lb owing to frost damage in Brazil. This translated into a variation margin of $45,000 per lot, so an exporter with a short of 10 lots against physical stocks would have had to pay $450,000 to meet the margin call – and within 24 hours at that.
As a result of margin financing problems, the open interest at that time was halved within weeks. Of course, exporters would benefit from the increased value of their physical stocks in a situation like this, but might not always find it easy to convince any but the most experienced commodity finance banks of the validity of this argument.
Merchants and brokers are often willing to help producers and exporters overcome the problems that margin calls can create. Brokers will finance all the margin costs in some cases, but will expect a higher rate of commission or a discount on physical contracts in return. Brokers can be particularly useful in solving the additional problems connected to distant futures transactions. Often, a high premium can be picked up for forward physicals, but there is no liquidity for such far dates in the futures markets.
However, most if not all of today’s forward business in physicals is conducted on a price-to-be-fixed basis, which has reduced the need to enter into far forward futures deals.
Traders and others who pay their own margins are entitled to receive cash payments of all credit variation margins. If they pay the trading deposit in cash, they are also entitled to receive interest on that money.
Trade houses play an important role in aiding producers, exporters and industry to overcome margin requirements. When a trade house enters into a transaction for physical coffee, either on a price-to-be-fixed basis or on an outright price basis, it is usually also the trade house that takes up the obligation and risk of margin financing. This benefits the coffee trade significantly and plays an integral part in establishing long-term delivery contracts. Of course, the trade house itself must have strict financial and third-party (counter-party) risk controls in place to avoid any excess margin calls in times of increased market volatility.
Source: ITC
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