EXPLORING the futures market

May 2024

JOHAN TEESSEN, AGRICULTURAL ECONOMIST INTERN, AND LERATO RAMAFOKO, APPLIED ECONOMICS INTERN, BOTH AT GRAIN SA

In the fourth and final article, the futures market and its distinctions from the forward market will be explored. Additionally, a practical example will be provided to illustrate the functioning of a futures contract. 

EXPLAINING THE FUTURES MARKET
A commodity futures market is simply a public space (JSE-Safex) where commodities are contracted for buying or selling at an agreed-on price and on a specified date, regulated by a standardised contract. The contract is standardised for the quality, quantity, delivery date and place of delivery, with the only variable being the price decided on through an auction process between the buyer (farmer) and sellers (silo or miller) on a futures market. 

The main reason futures markets were created, is so that farmers (who are hedgers) can use futures contracts to offset their positions in the cash market. This helps farmers to manage the risk of price changes, as they can transfer this risk from the cash market to the futures market.

Futures markets involve various participants, including: 

• Hedgers: Those are typically crop farmers who use futures contracts to protect themselves from price changes.
• Speculators: Those are people or groups who try to make money from changes in futures prices without needing the actual product.
• Contracts: Futures contracts are standard agreements for buying or selling goods in the future, with the above-mentioned standards. 
• Margin: It is the required deposit (money) upfront as collateral. This helps to reduce the risk of not being able to fulfil contractual obligations.
• Price discovery: Factors linked to supply and demand dynamics, economic indicators, geopolitical events and market sentiment influencing prices.
• Settlement: Futures contracts are settled in two main ways. One is by exchanging the actual asset. The other is by just exchanging cash, based on the difference between the agreed price and the market price.

Factors that differentiate between the forward and futures contracts:

• Standardisation: Futures contracts are like ready-made packages traded on organised exchanges. They have fixed terms, such as a set quantity and expiration date. Forward contracts, on the other hand, are like custom-made deals between two parties. They can be adjusted based on what the parties agree on, making them more flexible and personalised.
• Trading venue: Forward contracts are traded directly between parties, like private deals. There is no central place for trading (JSE-Safex), so it is like a one-on-one negotiation.
• Counterparty risk: In futures contracts, buyers and sellers do not directly transact with each other. Instead, they transact through the clearinghouse (JSE). When a trade occurs, the buyer’s obligations are matched with the seller’s obligations, and the clearinghouse becomes the counterparty to both sides of the trade. This setup helps to reduce the risk that one party won’t be able to meet his obligations, because the clearinghouse guarantees that everyone sticks to the deal. 
• Margin and marking to market: In futures contracts, traders must put up some money upfront called the initial margin. This money acts like a safety net to cover any potential losses. Also, every day, the value of the futures contract is adjusted based on the current market price. This helps to keep things fair and ensures that traders have enough money to cover any changes in the contract’s value. Forward contracts, on the other hand, don’t usually have these requirements, although parties may still agree to put up some money, depending on their creditworthiness.

Overall, while both futures markets and forward contracts serve similar purposes, they differ in terms of standardisation, liquidity, counterparty risk, flexibility, regulation and marking to the market, making each suitable for different types of market participants and trading strategies.

PRACTICAL EXAMPLE 
Figure 1 illustrates the payoff diagram of the transaction about to be explained. 

• The line labelled FShort represents farmer John’s short position, while the line labelled St represents the future price. 
• Farmer John, who harvested 100 t of maize at the beginning of May, aims to sell it via the July 2024 future contract. Given that one contract size on the JSE equals 100 t, he will initiate one short future position to sell his maize. Assuming the current market price for maize in May is R2 000/t, he utilises this as his strike price (X).

Making a profit
Should the market price between the day he entered the July 2024 contract and the expiry date in July decrease and close at R1 900/t, farmer John would make a profit of R100/ton. This profit was realised because he sold his maize at R2 000/t, which is R100/t more than the prevailing market price of R1 900/t.

Making a loss
Should the market price between the day he entered the July 2024 contract and the expiry date in July increase and close at R2 200/t, farmer John would make a loss of R200/t. The loss was realised because he sold his maize for R2 000/t, which is R200/t less than the prevailing market price of R2 200/t. 

CONCLUSION FOR THE SERIES
This series of articles was crafted with the intention of providing readers with comprehensive knowledge on various methods of selling maize. This information is crucial, as it equips farmers to make informed decisions regarding the sale of their maize. To summarise: 
In article 1, Grain hedging can save costs, which was published in the January/February issue, the fundamentals of hedging were examined, elucidating its significance. A concise overview of the different grain-selling methods was provided. 
Article 2, Navigating options: Choosing a put or call, which can be found in the March issue, the disparities between call and put options were navigated, along with guidance on when to employ each. 
In article 3, Ensure optimum grain marketing, published in the April issue, the concept of the spot price was expounded, elucidating its significance and appearance. 
Lastly, article 4 (this article) ventured into futures market exploration, offering insights into forthcoming trends.

By adhering to these guidelines, a farmer can tailor a marketing strategy designed not only to generate profits but also to ensure longevity on the farm.

Publication: May 2024

Section: Pula/Imvula