How to hedge your business against price fluctuations

One of the most difficult challenges for Kenyan farmers is the contradiction of output during the harvest period, which floods the markets with supply, resulting in lower harvest prices.

Attempts to build storage facilities so farmers can store their output and sell when supply is low have greatly increased crop value. However, not all agricultural products can be stored for an extended time, and some products have the highest value when they are fresh.

Farmers require a stable market with stable prices for their crop output to run a sustainable agricultural business. This assists them in optimising output by planning and leveraging their farming operations.

Futures contracts are one of the most efficient ways of hedging against output price volatility. A farmer, for example, who wants to produce one tonne of coffee in six months may enter an equivalent short-selling position in coffee futures in international markets. This allows them to lock in a price for their output ahead of harvest.

If the price of coffee goes down by say 20 percent between when the farmer entered the short selling position and when the farmer harvests, the farmer will sell the product at 80percent of the locked price and the short selling position in the futures market will have gained 20percent thereby compensating for the price change.

This may appear to be a complicated process at first, but it is quite simple. All a farmer has to do is open an online trading account with CMA-regulated brokers, deposit funds, and enter a short selling position on, say, coffee equivalent to their expected output for the season.

But first, let us define a futures contract.

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

A futures contract is a type of a derivatives contract. A derivatives contract is a standardised 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 derivatives contract in coffee, they are not purchasing actual coffee, but rather a derivatives contract that is settled on the difference between the entry and exit prices. Take note that the contract holder at expiry receives the delivery, even though most speculators choose to roll over to the next contract.

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

Licensed warehouses issue certificates after testing the grade of the coffee beans to ascertain that they are of standard quality.

Kenyan farmers can lock prices for maize, sugar, coffee, tea, cotton, soya beans, and milk. To achieve this, the farmers must learn the international standards and get certifications to avoid the rejection of their output based on standardisations issues.

While online traders generally speculate on futures contracts to make a profit, firms that process or manufacture agricultural products may also seek to protect themselves from volatile prices by hedging using the futures contracts.

For instance, a coffee processor faces the challenge of high supplier prices off-season. To make sure they get a locked price off-season, a processor may enter a long (buying) position on coffee futures when prices are low.

If prices go higher during the off-season, the futures contract will be in profit thereby helping the processor offset the change in prices.

The opposite is also true. If coffee prices go lower during the off-season, the futures contract will be at a loss but the low prices will offset the loss thereby assuring the processor a locked price.

Hedging agricultural supply on the futures markets can help a manufacturer to plan their business with a set supply price locked in thereby facilitating easier business valuation, optimisation, and leveraging.

Without this hedge, the manufacturer is exposed to fluctuating supply prices and rising supply prices as a result of storage costs.

The developed world has fully adopted this technique and used it to strengthen their agricultural sectors. With digitisation and global integration of financial markets products, Kenyans can now strengthen their agricultural sectors by tapping this risk management technique and focusing on what they do best, production.

Rufas Kamau is the lead markets analyst at FXPesa