One of the most difficult challenges for Kenyan farmers is the production contradiction during the harvest period, which floods supply markets, driving down crop prices.
Attempts to build storage facilities so farmers can store their produce and sell when supplies are low have dramatically increased the value of crops. However, not all agricultural products can be stored for an extended period, and some products have the highest value when fresh.
Farmers need a stable market with stable prices for their agricultural production in order to run a sustainable farming business. This helps them optimize production by planning and leveraging their farming operations.
Futures contracts are one of the most effective ways to hedge against producer price volatility. A farmer, for example, who wants to produce a ton of coffee in six months can enter an equivalent short position in the coffee futures markets in international markets. This allows them to set a price for their production before harvest.
If the coffee price drops say 20% between the time the farmer entered the short sell position and the time the farmer harvests, the farmer will sell the product at 80% of the locked price and the position short selling in the futures market will have gained 20% thus offsetting the price change.
It may seem like a complicated process at first, but it’s quite simple. All a farmer has to do is open an online trading account with CMA regulated brokers, deposit funds and enter a short sell position on, say, coffee equivalent to its planned production for the season.
But first, let’s define a futures contract.
A futures contract is a standardized legal contract between a buyer and a seller to buy or sell an underlying asset at a predetermined price for delivery at a specific time in the future.
A futures contract is a type of derivative contract. A derivative contract is a standardized 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 coffee derivative contract, he is not buying actual coffee, but rather a derivative contract that is settled on the difference between the entry and exit prices. Note that the holder of the contract at expiration receives delivery, even though most speculators choose to move to the next contract.
Futures contracts are traded on an exchange such as the Intercontinental Exchange (ICE). The exchange specifies contractual specifications for each asset class. For example, the standard for an Arabica coffee contract is 37,500 pounds (about 250 bags).
Approved warehouses issue certificates after testing the quality of coffee beans to ensure that they are of standard quality.
Kenyan farmers can lock in prices for maize, sugar, coffee, tea, cotton, soybeans and milk. To achieve this, farmers must learn international standards and obtain certifications to avoid rejection of their production based on standardization issues.
While online traders typically speculate in futures contracts to make a profit, companies that process or manufacture agricultural products may also seek to hedge against price volatility by hedging with futures contracts.
For example, a coffee processor faces the challenge of high off-season supplier prices. To ensure a fixed off-season price, a processor can take a long (long) position in coffee futures when prices are low.
If prices rise during the off-season, the futures contract will be profitable, helping the processor to compensate for the price change.
The reverse is also true. If coffee prices fall during the off-season, the futures contract will be at a loss, but the low prices will offset the loss, thus assuring the processor of a locked-in price.
Hedging agricultural supply in futures markets can help a manufacturer plan their business with a fixed supply price locked in, making it easier to evaluate, optimize and leverage the business.
Without this hedging, the manufacturer is exposed to fluctuating supply prices and rising supply prices due to storage costs.
The developed world has fully embraced this technique and used it to strengthen its agricultural sector. With the digitalization and global integration of financial market products, Kenyans can now strengthen their agricultural sector by harnessing this risk management technique and focusing on what they do best, production.
Rufas Kamau is the Principal Markets Analyst at FXPesa