The need to hedge investments against the uncertainties coupled with a drive to make profits have seen the derivative market expand immeasurably in the 21st century. A derivative can be defined as a contract or agreement that derives most of its principal value from the value of something else, often called the ‘underlying’ (Kollo & Overdahl, 2003; Stulz, 2005). Individuals and institutions invest in derivatives to hedge against losses that may arise from the underlying instruments (Hashmian, 2001). In most instances, a financial asset, rate, or index is used as the ‘underlying’ to give the contract its principal source of value. However, other derivatives such as commodity derivatives exist, and are as equally effective as the financial derivatives. It is the purpose of this paper to demonstrate how the futures derivatives could be used to hedge against the risk or uncertainty associated with the vagrancies of weather/
Hashemian (2001) posits that “…futures are binding contracts between the sellers and the buyers creating an obligation for the seller to deliver a certain amount of goods at a certain time and at a fixed price to the buyer” (p. 80). The buyer of the futures contract is obligated to pay the contract price at the transaction time to receive the commodities at the agreed time. According to Hashemian, the price of the contract is primarily determined through the employment of competitive bidding. Farmers and traders dealing with large-scale production and sale of agricultural commodities such as tea, coffee, and wheat are increasingly using the futures market to hedge against losses that may be initiated by the vagrancies of weather or the effects of global warming (Geman, 2005).
It is a well known fact that trading in tea as a commodity is a very lucrative business, globally. However, tea is affected by the vagrancies of weather, and quality of the commodity, which is of fundamental importance in global markets, is virtually dependent on the prevailing weather. It is also known that much rainfall or too much sunshine means that the grade will definitely go down, necessitating international traders to buy the commodity at low prices (Geman, 2005). Under such circumstances, the local marketers of the commodity and the international traders can enter into a futures contract using tea as the underlying commodity. It is imperative to note that the prices for the tea are agreed upon at the exchange, where sellers initiate asking prices and buyers set the bidding prices (Hashemian, 2001). The agreed price for the contract is called the going price.
When the above contract is entered into, farmers and their local representatives will have successfully hedged their commodity (tea) against the risks and uncertainties associated with weather, and they wont really mind if the quality of the tea went up or down depending on the weather since the contract is sealed and payment made even before the delivery of the commodity. The traders, on their part, may make huge profits or incur losses depending on how the commodity would be able to fetch at the actual time of delivery (Hashemian, 2001). The traders luck depends on the forces of demand and supply prevailing at the time of delivery.
List of References
Geman, H (2005). Commodities and Commodity Derivatives: Modelling and Pricing for Agriculturals, Metals, and Energy. West Sussex: John Wiley & Sons Ltd
Hashemian, R.V (2001). Financial Markets for the Rest of Us: An Easy Guide to Money, Bonds, Futures, Stocks, Options, and Mutual Funds. Lincoln, NE: Writers Club Press
Kolb, R.W., & Overdahl, J.A (2003). Financial Derivatives, 3rd Ed. Hoboken, New Jersey: John Wiley & Sons, Inc
Stulz, R.M (2005). Demystifying Financial Derivatives. Web.