Futures markets and contracts: an application

Spot markets, forward contracts and futures markets: let us bring together these ideas with an example on cocoa beans.

Consider a Brazilian cocoa farmer with main harvest between October and March. Suppose it is June 2018 and the farmer is thinking how to sell their cocoa beans at a price that will cover farming, harvesting, and transportation costs, and produce a profit.

Spot market

The farmer could choose to sell the crop at the spot market price in March 2019. This is an unhedged position. The farmer would not be protected from the risk that cocoa prices fall between June 2018 and March 2019. The spot price on 1 June 2018 was $2436 per metric ton (www.icco.org), but in August 2018 the spot price had fallen to $2082.

Forward contract

The farmer could enter a forward contract with a chocolate producer, at an agreed price, for delivery on a specified date in March 2019. For this example let us suppose the price agreed in the forward contact is equal to the March 2019 futures price on 1 June 2018, which was $2539 (www.theice.com). What are the risks for the farmer from this strategy? If the spot price falls significantly the buyer may have an incentive to default on the forward contract.

Futures contract

The farmer could sell futures contracts for delivery in March 2019. One June 1 2018 the price of March 2019 futures was $2539. On the Intercontinental Exchange each cocoa futures contract is for 10 metric tons. The farmer would need to place a margin with the clearance house, which is currently around $1900 per contract.

Let us also examine the marking to market process. On the next trading day, 4 June 2018, the price of March 2019 cocoa futures fell to $2451. On that day sellers of futures contracts receive per contract

($2539 – $2451) (times) 10 tons = $880

Buyers of futures contracts have to pay the clearance house $880 per contract.

If the farmer delivered the cocoa on 4 June 2018 at the price of $2451 per ton (we say ‘if’ because the cocoa beans are still growing), the net effect of marking to market is they would receive the futures price they initially agreed to

($24510 + $880) (div) 10 = $2539

March 2019

Imagine the cocoa spot price in March 2019 is $2300. (At end August 2018 the price was $2281. You can check the current spot price at www.icco.org.)

The farmer can inform the clearance house of their intention to deliver on a day in March 2019. This will be at the existing futures price. We do not know that price now, but we do know futures prices converge towards spot prices in the delivery period, otherwise there would be opportunity to make a riskless profit by trading in the futures contract and the underlying asset. So in March 2019 the futures price will be equal to the spot price we have assumed, $2300. Daily marking to market between June 2018 and March 2019 means the farmer receives total net payments per contract of

($2539 – $2300) (times) 10 = $2390

So their total receipts per contract will be

$23000 + $2390 = $25390

Overall, the farmer receives $2539 per ton, the futures price existing on 1 June 2018. They have successfully hedged against price falls.

Futures contracts require delivery at a few specified locations. It would be more convenient for the farmer to close out their position by purchasing futures contracts in March 2019, and to deliver their cocoa beans to their existing purchasers for the spot price. They sold March 2019 futures in June 2018 at a price of $2539. They buy an equal number of futures contracts in March 2019 at the price of $2300, generating a profit of $239 per ton, offsetting the fall in price of cocoa beans.