loader image

 

 

July 15, 2020      4 Minute Read


 

 

Futures Contracts: 
What, Why, How
Part one: Futures 101

Over many centuries, farmers have used futures contracts to hedge against adverse price movements and manage the risks that such movements could have on their bottom line.  Among the different products hedged, there are multiple commodities (e.g., cocoa, cotton, orange juice, oil), financials, shares, and even tulips! Coffee futures have been traded in New York since 1882, first on the New York Cocoa Exchange, then on the New York Board of Trade and now on the ICE. The price of coffee has been extraordinarily volatile over the years, both in current – and constant – dollar terms, as coffee is subject to supply disruptions. In the past, major supply disruptions have been caused by frosts or droughts in the Brazilian highlands, as Brazil is by far the largest producer of coffee in the World. The intraday volatility of coffee “C” futures, as the contract is known in the trade, is just as high, which has made the contract a favorite for day-traders over the years, something which although looked down on by many in the coffee industry, is a key component for any futures market to work.

 In this series of articles, we will be focusing on futures contracts. This first article starts with a general introduction about what exactly is a futures contract and why futures markets exist. Next we will look at how and why it is possible to sell coffee that “doesn’t exist”, and we will finish with one of the major uses of futures contracts for companies like Caravela – to hedge risk against forward contracted coffee.

Forward and futures both deal with buying and selling coffee at a point in the future, but how are they different? A futures contract is a type of forward contract that is traded on an exchange. A forward contract is an agreement between a seller and a buyer to buy or sell something, for a specified price, quantity, quality and at a specified point in time in the future. Any two parties can make a forward contract with their own specifications to buy or sell anything. However, what denotes a futures contract and allows it to be traded on an exchange, is standardization. Only certain homogenous commodities can be traded using futures contracts; the quantities and qualities are standardized, as are the delivery months or the expiration of the contract. Unlike forward contracts, these contracts cannot be customized. In the case of coffee, there is a standard quality that the coffee must meet, a standard contracted quantity of 37,500 pounds, and a fixed set of delivery months.

 

The coffee futures market exists for the purposes of price discovery and risk transfer. For buyers and sellers of coffee, the transfer of risk is why futures are used, with price discovery being more the territory of day traders. Trading coffee futures takes place in a clearing house where buyers and sellers can meet in an open, competitive and neutral marketplace. The prices resulting from each transaction signal to other traders what a given commodity might be worth. The role these traders play is not just isolated to their own economic loss or gain, as for futures markets to work efficiently there need to be enough buyers and sellers with opposing interests at any given time.

The price risk that both buyers and sellers of coffee must contend with is not the only thing that needs to be considered. The role of the exchange or clearing house is something which makes buying and selling coffee less risky for all parties involved and this surprisingly has nothing to do with price. This other risk is known as counterparty risk, which is the risk that either party will default on their side of the agreement. Basically, that the seller won’t deliver, or the buyer won’t pay. This is the main reason why futures markets came into existence.  Imagine relying on someone you had never met before from a different continent who says they will buy or sell you something in the future, would you trust them?

Futures markets, and by definition clearing houses, create a guarantee for the buyer or seller, an insurance against counterparty risk. If one party doesn’t comply with their side of the agreement, then the clearing house will complete the transaction, either by delivering the goods or by delivering the funds to pay for the goods. Clearing houses achieve this by setting rules, minimum quality standards, contract standards, agreed delivery locations and months. They also vet all the transacting parties and request a margin to buy or sell and a margin on price variations, which allows them to cover operational costs. As most farmers and roasters do not have their own trading account, Caravela provides this service to ensure all parties risks are covered as much as possible.

The somewhat complex nature of the futures market means it is not for everyone. In fact, the majority of people who buy and sell futures these days are not there to buy the physical coffee, and we will look at how this is possible the following article. Those buying or selling futures contracts are normally doing so either to speculate on price change or to hedge their risk against other coffees that have been forward contracted, the price of which is based on the futures market (the topic of the final article in this series). This all being said, the original creation of these exchanges in history marks an important moment of risk mitigation for everyone wanting to trade a certain good.

Futures contracts have played and still play a very important role in the coffee industry. They mitigate price and counterparty risk for large buyers and sellers of standard quality coffee. The futures market is also a tool for other players looking to manage their risk of other forward contracted coffee and for speculative traders. But how is it possible to use these contracts to speculate or hedge risk? And what happens to coffee you buy with a futures contract if you actually don’t want to receive it? We will discuss all this in the following articles, but for now we can say that without futures contracts, for many people in the industry, past and present, working with coffee would have been and would still be just too risky.

2 Comments
  1. Roger Hernandez

    I am interested making business with you. I live in Honduras. Could you please contact me or could you give a number where to call. Thanks

    Reply
  2. David Goldstein

    Volatility, more than a “key component for any futures market to work” is the result of low levels of liquidity.

    Futures markets with high liquidity can operate with less volatility, however as you mention day-traders may seek highly volatile markets as they “move more” and thus offer different type of trading opportunities.

    Without volatility, speculation is pointless.

    Reply

Submit a Comment

Your email address will not be published.

Was this interesting? Grab a coffee and pick another from the articles below

A Take on Long-standing Relationships: Hasbean and Pedro Claros

A Take on Long-standing Relationships: Hasbean and Pedro Claros

Futures Contracts: What, Why, How  Part Three: Futures 103 How Hedging Works

Futures Contracts: What, Why, How Part Three: Futures 103 How Hedging Works

Futures Contracts: What, Why, How Part Two: Futures 102

Futures Contracts: What, Why, How Part Two: Futures 102

Futures Contracts: What, Why, How Part One: Futures 101

Futures Contracts: What, Why, How Part One: Futures 101

Grade Expectations: Finding Versatility and Value in A and AA Coffees

Grade Expectations: Finding Versatility and Value in A and AA Coffees

A Presentation on Cost of Production In Latin America

A Presentation on Cost of Production In Latin America

Meso-American Producer Survey: The Pandemic Will Leave Long-Lasting Scars

Meso-American Producer Survey: The Pandemic Will Leave Long-Lasting Scars

Invisible Barriers for Moving Coffee

Invisible Barriers for Moving Coffee

Caravela at 20: The Journey is Only Getting Started

Caravela at 20: The Journey is Only Getting Started

Certifiably Awesome: Passion and Persistence Turn Promise into Parchment in Mexico

Certifiably Awesome: Passion and Persistence Turn Promise into Parchment in Mexico

Harvest Arrives, Along with a Pandemic

Harvest Arrives, Along with a Pandemic

Minga From Field To Filter: Coffee Reacts and Adapts to the Covid Era

Minga From Field To Filter: Coffee Reacts and Adapts to the Covid Era

Mother Nature Turns The Volume Down in Nicaragua

Mother Nature Turns The Volume Down in Nicaragua

LOTSA Potential: The Long-Term Supply Agreement as a Tool for Financial Stability and Building Relationships

LOTSA Potential: The Long-Term Supply Agreement as a Tool for Financial Stability and Building Relationships

Progress in a Picture-Perfect Coffee Setting

Progress in a Picture-Perfect Coffee Setting

The Price and Value of Consistency

The Price and Value of Consistency

Looking Back and Leaping Forward

Looking Back and Leaping Forward

Womxn-Powered Coffee: Why It Matters

Womxn-Powered Coffee: Why It Matters

Behind the Scenes in Peruvian Coffee

Behind the Scenes in Peruvian Coffee

Unpoppable Opportunities for the Future

Unpoppable Opportunities for the Future

Equipping the Equipo: Playing to win in Guatemala and El Salvador

Equipping the Equipo: Playing to win in Guatemala and El Salvador

Agronomy to Keep the Microlots Coming

Agronomy to Keep the Microlots Coming

Evolution in a Land of Revolution

Evolution in a Land of Revolution

Cupping as Meditation

Cupping as Meditation

Origin Revelations

Origin Revelations

Avoiding the Poverty Trap: Choosing Stories Instead of Emotional Marketing

Avoiding the Poverty Trap: Choosing Stories Instead of Emotional Marketing

I’ve Bean Everywhere, Man

I’ve Bean Everywhere, Man

Have Yourself a Mara Little Christmas

Have Yourself a Mara Little Christmas

All Roads Lead to Coffee

All Roads Lead to Coffee

How Coffee can Complement Food

How Coffee can Complement Food

Building Projects at Origin

Building Projects at Origin

Shining a Light on Defect Detection: How a $9 UV torch could be one of the best investments for the coffee value chain

Shining a Light on Defect Detection: How a $9 UV torch could be one of the best investments for the coffee value chain

Coffee: Culture or Business?

Coffee: Culture or Business?

Café: ¿Cultura o Negocio?

Café: ¿Cultura o Negocio?

A Study on Costs of Production in Latin America

A Study on Costs of Production in Latin America

Fermentation Experiments in Nicaragua – How We Managed to Go from RTB to AAA

Fermentation Experiments in Nicaragua – How We Managed to Go from RTB to AAA

Constantly Adapting to Change

Constantly Adapting to Change

Mind the Gap: A Growing Gray Area Between Market and Production

Mind the Gap: A Growing Gray Area Between Market and Production

Embracing Technology to Create New Pathways in Coffee

Embracing Technology to Create New Pathways in Coffee

Forward Contracting to Secure Quality, Quantity and Relationships

Forward Contracting to Secure Quality, Quantity and Relationships

Caravela Sponsors Seven Small-holder Coffee Producers to attend the Producer and Roaster Forum in Guatemala

Caravela Sponsors Seven Small-holder Coffee Producers to attend the Producer and Roaster Forum in Guatemala

Colombian Specialty Coffee Scene. A Perspective from Café Quindío

Colombian Specialty Coffee Scene. A Perspective from Café Quindío

Coffee Sampling  Increases Farmers Profitability Opportunities

Coffee Sampling Increases Farmers Profitability Opportunities

Caravela From a Newcomer’s View

Caravela From a Newcomer’s View

Water Activity: Predictive insights Changing Processes and Profits

Water Activity: Predictive insights Changing Processes and Profits

Blending Experience with Passion in Mesoamerica

Blending Experience with Passion in Mesoamerica

Coffee in Galapagos: Evolving To Thrive

Coffee in Galapagos: Evolving To Thrive

What Traceability Offers Farmers

What Traceability Offers Farmers

The Specialty Coffee Transaction Guide – Setting the Bar on Prices

The Specialty Coffee Transaction Guide – Setting the Bar on Prices

A Tale of Two Customers: Caravela Coffee and the Rethinking of the Coffee Import Model

A Tale of Two Customers: Caravela Coffee and the Rethinking of the Coffee Import Model

Arriving at a price

Arriving at a price

Rich Farmer, Poor Farmer

Rich Farmer, Poor Farmer

Low Prices, Risky Times

Low Prices, Risky Times

Making it Work as Well as it Can

Making it Work as Well as it Can

Discovering the Source

Discovering the Source

A Mutual Evolution: Caravela Nicaragua’s William Ortiz, on helping people grow coffee, and how coffee helps people grow

A Mutual Evolution: Caravela Nicaragua’s William Ortiz, on helping people grow coffee, and how coffee helps people grow

The High Price of Getting the Best from Ecuador

The High Price of Getting the Best from Ecuador

Victims of Exchanging Currencies – Who Should Take on this Risk?

Victims of Exchanging Currencies – Who Should Take on this Risk?

A Pilgrimage to the Future

A Pilgrimage to the Future

Why We’re Investing in World Coffee Research?

Why We’re Investing in World Coffee Research?

The Making of a Champion

The Making of a Champion

Peru, an Unpolished Diamond in Coffee Production

Peru, an Unpolished Diamond in Coffee Production

Investing in Education: Investing in People

Investing in Education: Investing in People

How Roasters Can Influence the Supply Chain

How Roasters Can Influence the Supply Chain

Aromas: More than Just a Coffee Competition

Aromas: More than Just a Coffee Competition

FOB vs. EXW – Two Buying/Shipping Methods for Your Green Coffee

FOB vs. EXW – Two Buying/Shipping Methods for Your Green Coffee

Sample Roasting vs. Profile Roasting

Sample Roasting vs. Profile Roasting

How to Keep Records of your Costs of Production?

How to Keep Records of your Costs of Production?

Why and How to Estimate Costs of Production in a Coffee Farm?

Why and How to Estimate Costs of Production in a Coffee Farm?

Supply Chain Logistics – The Clockwork of Coffee

Supply Chain Logistics – The Clockwork of Coffee

Forecasting Green Coffee Purchasing

Forecasting Green Coffee Purchasing

What is specialty Coffee

What is specialty Coffee

Drying in Peru: the Final Step in Quality Improvement

Drying in Peru: the Final Step in Quality Improvement

FOB vs: EXW – Two Buying/Shipping Methods for Your Green Coffee

FOB vs: EXW – Two Buying/Shipping Methods for Your Green Coffee

When is it time to harvest?

When is it time to harvest?

Just In Time Inventory

Just In Time Inventory

Spectrum Purchasing and How it Impacts Sustainability

Spectrum Purchasing and How it Impacts Sustainability

CONNECT WITH US

© Caravela Limited, 2020
SUBSCRIBE TO RECEIVE OUR LATEST NEWS

  • This field is for validation purposes and should be left unchanged.

Pin It on Pinterest

Share

Share this content with your coffee community!