Risk Management Goes to Grad School

Before 1848 farmers brought wagons of grain to Chicago, and took the price a buyer offered or returned home. Some opted to dump their grain in the Lake when prices got too cheap. The system was easy, but not very useful. The 1848 launch of the CBOT introduced forward cash prices, which evolved over the years into standardized ag futures contracts at Chicago, Kansas City and Minneapolis. Managing risk became more complex but the results were worth the effort for farmers, as well as for buyers that needed grain throughout the year. The first formal clearing system was established by the CBOT in 1883 to further improve efficiency and ease of entry and exit with futures.

Not a lot changed out in the country until well into the 20th century. Elevator managers bought cash grain, sold futures between 9:30 and 1:15 p.m., and sometimes pre-hedged on the close against expected afternoon purchases. Buyers took “protection” if bearish news came out in the afternoon by lowering their cash price against a lower opening on futures the next morning.

Then options on ag futures were launched in 1985, paving the way for greater pricing flexibility, especially for farmers. The risk-management universe was slowly expanding and becoming more challenging. By the mid 1990s, serial options joined the mix. These are short-term options for which there is no underlying futures month, and offer the advantage of relatively low premiums due to the short time until expiration. (An October corn serial option would trade from late July until late September, for example, with December corn futures as the underlying instrument.)

By 1993 China’s Dalian futures exchange appeared on the scene, followed in 1996 with the CBOT adding overnight electronic trading of full-size ag futures contracts to accommodate global trade. The trading world was speeding up. Since then the changes and new products have come even faster:

• The subsequent adding of “side by side” electronic and open-outcry trading (2006),
• Adding mini-futures (2007) and eventually options contracts to the electronic platform.
• From 2008 through 2011 the exchanges raised daily price limits several times as prices rose,
• Amended the delivery procedures and terms on wheat contracts, and
• Launched “Weekly Grain Options” in 2011. (WGO’s ensure an option expiration every Friday.)

But more tools were needed. The CME responded in 2011 with Calendar Spread Options (CSO). These are put and call options on an underlying futures spread. Buying a December12/July13 corn call CSO gives the buyer the right to set a new-crop corn carry at a certain value, for example. CSOs are now listed on corn, soybeans and wheat, as well as on certain livestock futures.

By the end of 2011, merchandisers could hedge price risk using futures, as well as by using conventional options, Serial Options, and Weekly Grain Options — depending on the length of time a firm wants to cover price risk. An end user might buy an inexpensive WGO on corn, for example, ahead of major government reports in the summer for some protection against higher input costs. Or an elevator can offer minimum price contracts to farmers using any of the short- or long-term options. Country elevators can use CSOs to protect carrying charges on inventory.

New in 2012

Rising consumption of grains and oilseeds and declining world inventories have only increased volatility in price and spreads, adding even more merchandising risk for ag businesses. The futures exchanges continue to evolve to meet these needs.

As of March 2012, merchandisers can trade options on the volatile Minneapolis/Chicago wheat spread, called a protein-spread. With a range of almost $1.70 over the last two years, this is an inter-commodity spread where options seem well-suited to manage that trading risk.