capital 44

THEEDGE MAL AYSIA | JUNE 16, 2014

DERIVATIVES WORLD

In our everyday lives of coping with financial markets and hom

to keep us going. But brewing in the corner is a steady, drama
the start of the year.
shows prices of the DEC 2014 Ara
the ICE Futures in the U.S. Since January, the prices have incre

Will you be paying more for your coee soon?

ICE FUTURES US

very day, to cope with the

financial markets and home
life, we need our coffee to
keep us going. But brewing
in the corner is a steady, dramatic rise in coffee prices
since the start of the year. The chart
shows the prices of the December
2014 Arabica coffee futures listed on
ICE Futures US. Since January, the
prices have increased more than 50%.
A futures price reflects the reactions of thousands of market players hedgers and speculators who
buy and sell the contracts to the
expectation of spot coffee prices in
the future. Taking the example of
the KCZ12 futures contract as shown
in the chart, the expectation is that
the price of coffee by end-December will be 177.95 cents per pound.
In comparison, the spot or physical

BY
JASV I N D E R J OS E N

price is gathered by agents from numerous localised auction markets in

coffee-producing countries. Futures
tend to be a preferred source for commodity prices than the spot market
for its better liquidity, standardisation
and stability of market conditions.
The main explanation for the rise
in coffee prices in 2014 is the coffeeleaf-rust epidemic in Central America, compounded by a severe drought
that swept Central America and Brazil.
Although coffee prices have been
increasing since January,we only gradually feel the hit now as retailers and
coffee outlets use up their coffee stocks.

24x4

It is almost definite that we

will be paying more for coffee
in supermarkets and coffee
stations, but there may be
some exceptions.
JM Smucker, one of the
leading coffee roasting companies
worldwide,announced an increase in its
retail coffee prices by an average of 9%.
However,Starbucks said it had locked in
its coffee costs for 2014 as well as 40% of
its needs for 2015,and is insulated from
the impact of this years price surge
(Source: Financial Times, June 3, 2014).
How can this be? Reports claim that
Starbucks practises long-term hedges
with its coffee bean prices.

Latest price and chart for coee

Commodity hedging with

long-term forward and futures
contracts

Commodity suppliers as well as manu-

Source: ICE,
USA themselves from over short-term futures contracts.This
facturers
can protect
price volatility by entering into forward means if a buyer, in January, wants to
12 months
forward(hedgers
for
and
futures contracts.
For example,
in hedge his
A futures
price reflects
thousands
ofcost
market
players
the case where the commodity is cof- December, instead of entering into a
fee,
a
coffee
manufacturer
such
as
Starsingle
12-month
futures
contract,
sell the contracts) reactions towards the expectation ofhethe sp
bucks buys long-term futures contracts enters into a three-month contract
Taking
the example
ofprice
thetoKCZ12
contract
from
the exchange
at a certain
(whichfutures
is more liquid).
Comeabove,
March, the e
fix the cost it will pay for the coffee. If he sells the March contract and enters
of
coffee
by
end-December
will
be
177.95
cents
per
pound. In
the futures contract rises in price, the into another three-month contract
buyer
will profit
on the
contract. This
expires
in June.
He keeps rolling
physical
price
is gathered
by that
agents
from
numerous
localized a
profit will offset the higher price the over until he arrives at the December
producing pays
countries.
Futures
tend to
be a preferred
source for
Although
he achieves better
manufacturer
for the coffee
in contract.
liquidity, he faces rollover risk where
the spot (physical) market.
spot
market
for
its
better
liquidity,
standardization
and
Besides futures contracts, coffee if the price of three-month futuresstabilit
manufacturers also enter into forward keeps increasing throughout the year,
contracts
with
planters directly.
ends upcoffee
paying aprices
higher fixed
price is the
The main
explanation
forAttheherising
in 2014
the expiry of these forward contracts, for the commodity.
Central
by
severe
draught
thatinswept
the
planterAmerica
will delivercompounded
the coffee to
Theathird
issue is
the challenge
the manufacturer at the fixed price hedging costs when price volatility
they agreed on at the time the con- lasts too long.A hedge is very effective
Although
coffee
increasing
since
we
tract
was entered
into.prices have been
when prices
are volatile
for a January,
certain
time
then
go
back
to
normal.
But
in
Why
long-term
contracts?
These
now as retailers and coffee outlets run down their old coffee s
contracts are preferred as they ena- situations where price volatility stays
ble
planters
to fit their
hedge directly
orcoffee
worse, if the
price climbs gradu-and co
that
we will
be paying
more for
in supermarkets
into the harvest time of the commod- ally for a long time then the futures
there
may
be
some
exceptions.
ity when it needs to be sold, or for the contracts will get more expensive
manufacturer, when the commodity and hedgers will ultimately have to
is needed in the factory.
absorb the price increase. Of course,
this hinges on the cause of the price
Diculties in performing a hedge climb; in the case of coffee, the quesHedging commodity prices is not with- tion will be,is it just a temporary comout its challenges. The first and most bination of bad weather and a plant
common issue is basis risk.Basis is the disease or is it a permanent outcome
difference between the price of the of the well-known (but often ignored)
spot and the price of the futures. For global climate change?
example, if we buy a futures contract
at 170 cents (per pound) when the spot Conclusion
is at 175 cents per pound, the basis is If Starbucks can keep the price of coffive cents. (Note: One futures contract fee down for consumers by hedging,
on ICE is 37,500 pounds.) If the futures we wonder why the other manufacprice moves,so will the spot price; but turers cannot do so.The art of hedging
the prices need not move in tandem.Say has been practised in the commodity
the futures price rises to 178 cents and market for hundreds of years. Howevwe decide to sell the futures to realise er, the practice is still underutilised.
a gain of eight cents.At the same time, With the pressure of sudden rises in
say the spot price of coffee moves to 185 the prices of agricultural commodicents.We would have made a profit of ties in many parts of the world due to
eight cents per pound with the futures natural calamities, many industries
contract but we have to spend 10 cents may now start to consider hedging
more to buy coffee in the spot market. their costs to remain competitive and
E
We managed to hedge the rising cost survive in the new world.
of coffee in the physical market but
only with 80% accuracy. This is a real Jasvinder Josen is an exproblem faced by hedgers.Fortunately, investment banker from Europe,
hedges can counter this risk with basis specialising in valuation and
swaps offered by investment banks. risk in financial derivatives. She
The second issue is low liquidity is currently back in Malaysia,
in long-term futures contracts. In the providing consultancy and
absence of a liquid market, the player training. Readers can follow her at
pays a wide spread between buying http://derivativetimes.blogspot.
and selling his contract. To deal with com or send their comments to
this issue, some hedgers prefer to roll Jasvin@souqmatters.com.