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.
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