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How do farmers use futures when they are not physically settled

I was wondering how farmers use futures when they have a production ability but cannot sell what they produced ? Is the exchange not used for physically delivering products, then how does the farmer sell his prdouct?

Quantitative Finance Asked on November 13, 2021

1 Answers

One Answer

Delivery Not Necessary

Delivery is not necessary for futures to provide a price hedge. Most futures are specified so that they settle to a cash price at expiry. If a contract is not physically-settled, then any trader in the physical good could make easy money if the futures traded far from the cash settle.

Near to Expiry

Suppose it is one hour before expiry. Futures are trading at 50 while cash is at 100. In this case, futures are going to settle to somewhere near 100, so I would buy the futures and expect them to rise in value. Were futures selling far above cash, I would short them. Obviously, as we get further from expiry, this relationship becomes more tenuous. One big problem is I am exposed to changes in the cash price.

Far From Expiry

Now suppose it is two months from expiry. Futures are trading at 50, cash is trading at 100. I can agree with someone to sell physical to them at the current price plus some accounting for interest and convenience yield. Thus I sell the physical two months forward at $F_{t,T} = S_t e^{(r-y_c)(T-t)}$ where $S_t$ is the cash price of 100 right now (time $t$). At the same time, I buy futures at 50. (For ease of explanation, we'll assume $y_c=0$.)

Two months later

If cash stayed at 100, I make 50 on the futures contract when it expires to cash settle. I also earned interest on my 100 which sat in the bank for 2 months. My sale of the physical happens at the already-agreed-upon price of $100 e^{(r-y_c)frac{2}{12}}$. I am richer by 50 than if I had just sold physical forward.

If cash went to 50, I make 0 on the futures contract when it expires to cash settle. I earned interest on my 100 which sat in the bank for 2 months. My sale of the physical happens at the already-agreed-upon price of $100 e^{(r-y_c)frac{2}{12}}$ -- 50 higher than the cash market+interest. I am richer by 50 than if I had just sold physical forward.

If cash went to 150, I make 100 on the futures contract when it expires to cash settle. I also earned interest on my 100 which sat in the bank for 2 months. My sale of the physical happens at the already-agreed-upon price of $100 e^{(r-y_c)frac{2}{12}}$ -- 50 lower than the cash market+interest. I am richer by 50 than if I had just sold physical forward.

Physicality Issues

Since we are talking about physical goods, this can break down. For example, I may want to do the physical arbitrage as outlined above. However, sometimes delivering the physical commodity is complicated: I may not be able to find a nearby Jones Act-compliant barge to deliver gasoline inside the US; there may be congestion in a pipeline or power transmission network that prevents me from delivering into an acceptable node; or, I may not be able to get a ship or railcar to the agreed-upon destination in time to satisfy the terms of the physical trade. In that case, we do see divergences from futures and cash.

Supply Chains/Summary

The key point to remember is that futures allow a commodity producer (or consumer) to hedge with respect to benchmark prices. That lets them lock in the benchmark price. The remaining risk may be due to the grade of commodity they buy/sell, their location or both. However, that risk is much smaller than the overall benchmark price risk. Furthermore, by using a benchmark price, the futures attract many more market participants and are thus more liquid. (How many farmers want to call around to brokers looking for forward contracts when they can just hit their DTN, trade some futures, and go back to what they do best, i.e. farming?)

When commodity producers (like farmers) or commodity users go to sell or buy, they are going to use their normal supply chain. That lets them supply or buy the particular grade of commodity they have or want in their location. Furthermore, supply chain agreements are relationships and there can be other benefits to sticking with your usual supply chain. Finally... many supply chain agreements specify the prices which will be paid relative to those benchmark futures prices.

Answered by kurtosis on November 13, 2021

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