Viewpoint

Futures markets, hedging and international commodity agreements

In the February 1978 issue of this journal, Warren Lebeck discussed the private and social benefits of futures trading in commodities and suggested that hedging on an international scale could be an alternative to international commodity agreements (ICAs).’

In a critique which followed, David Evans* argued that hedging on futures markets only reduced the (private) risks of capital owners, as represented by agribusiness and merchants, and not the (social) risks faced by wage earners in agribusiness, by small farmers and by consumers. While capital owners were able to trade away their price risks by hedging, agricultural labour faced the risk of unemployment, small farmers faced the risk of natural disasters (such as weather) and consumers faced the risk of price variation. Evans admitted that his contribution was at the level of a critique and did not offer an alternative approach to moderating such risks.

I believe that hedging on futures

markets as now practised has severe limitations with respect to the risks faced by labour, small farmers and consumers. However, it is neither as limited as Evans suggests nor the panacea seen by Lebeck. In this note I intend to seek a middle road in the debate and to propose a quite different kind of international trade in distant futures which could replace the ICAs and serve the interests of both exporting and importing nations.

Critique of Lebeck

Lebeck defines hedging as any futures transaction truly designed to minimize a price risk which threatens someone holding a commitment in the cash commodity. Any other futures transaction (ie an acceptance of a price risk by buying or selling futures) is

FOOD POLICY November 1978

speculation. While the private benefit from hedging, namely the transfer of risk, is obvious, the social benefits are not so obvious. Lebeck is misleading in this matter. First, he says that firms require lower profit margins if they hedge their positions, which is correct. However, hedging is not costless to the firm, so that a firm’s prices are not likely to be lower if it hedges than if it does not. The lower profit margin required is compensated by higher costs.

Second, I agree that the main social gain from futures trading is the indirect benefit from more accurate pricing decisions by firms. However, it is not true that it is usually cheaper to buy a futures contract than to buy the actual commodity and store it. The purchaser of a future often has to provide someone else in the market with the incentive to store between periods so, again, there is no social gain in terms of direct costs.

Third, both Lebeck and Evans suggest that the current crop of international commodity agreements is not likely to be very successful. Lebeck implies, however, that futures trading by exporting nations (including less developed countries - LDCs) would provide protection against price risks. The markets do not provide the kind of insurance which is desired by the LDC exporters. Few of the markets have contracts which extend more than a year ahead; consequently it is only possible to buy insurance for such a period.

The situation is actually worse, because the markets are only active for contracts relating to a few months ahead. To obtain insurance by selling up to a year ahead can prove very costly since there are so few buyers. Speculators do not commit themselves for a year ahead; they make their profits by trading on the basis of very short run information.

As an example, consider a country which wishes to develop its cane sugar industry for the export market. The delay between commitment of funds and first output will be a minimum of three years, and the investment will be expected to last for many years. The country would like to guarantee the price of its product for several years forward, but the markets do not provide for this kind of hedging. Empirical evidence that US futures markets do not interest LDCs is given by Powers and Tosini.3 From a survey of the US markets they concluded that ‘very little of the foreign participation came from the LDCs, with the exception of coffee in which an average of 16.1% of the long-open interest emanated from Central and South American accounts’.

My final disagreement with Lebeck is over his belief that the goals of hedging and buffer stock agreements are quite different. He says:

Hedging does not attempt to repeal the laws of supply and demand; rather, it facilitates

and interfaces with them. Futures markets allow price to change and to speak to the producer and consumer, saying cut back production when price is too low and

increase it when price is too high. International pricing agreements, such as

are being discussed, basically do attempt to

effect such a repeal. They would prop up prices when they are low, thus providing little

incentive for production to be brought into balance with demand.. .A policy of ac-

cumulating government stockpiles of

reserves.. .has just the opposite effect of what the world really needs.‘4

I would argue that the goals of the two approaches are exactly the same - the insurance of price risks - but there are apparent differences in the methods. At present the market fails to provide the necessary kind of hedging. If it did provide hedging in, for example, five year contracts, the price of these contracts would be such that storage would occur between periods. The results of such ‘distant’ hedging and a buffer stock scheme would therefore be quite similar. The difference in effectiveness of the two approaches would depend on who was better at forecasting price - the buffer stock agency or the traders in a futures market.

Although the benefits from price stabilization for producers and

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consumers are not necessarily positive when measured by consumers’ and producers’ surplus,5 these are not accurate measures of underlying utility.6 The expressed dislike of extreme price fluctuations by both exporting and importing nations lends empirical support to the view that both parties may gain from more stable prices. With respect to government stockpiles having ‘the opposite effect of what the world really needs’, Lebeck seems to be considering US and European Economic Community (EEC) domestic stockpifes which are not self-liquidating and which serve domestic interests. This experience has limited relevance to the establishment of an international buffer stock which is intended to balance prices around some long run equilibrium.

Critique of Evans

David Evans attacks futures markets from a radical standpoint. He rightly says that it is only under capitalism that speculators have a social function. Under socialism one may assume that there would be no price risks, hence no need to insure. He also says that futures markets fail to give protection against natural risks, such as weather. Such protection is a function for the state under both socialism and western capitalism, although the levels differ.

Evans sees ‘agribusiness’ as the only agricultural producer to gain from hedging. Traditionally, as he says, ordinary farmers and consumers have not entered the futures markets. However, as Lebeck points out, the fact that futures markets exist makes forward contracting, by farmers of whatever size, much more feasible. Without hedging on a futures market,

merchants are usually unwilling to make forward contracts. A survey by the US Commodity Futures Trading Commission in 1977’ showed that only 5% of US grain farmers with sales in excess of $10 000 per annum actually traded futures, but that 20% of such farmers made forward contracts and 40% used futures’ prices as a guide when making decisions. A survey in the UK8 gave a broadly similar indication that farmers did not use grain futures but did make forward contracts, and were aware of futures’ prices.

Evans believes that futures markets have no relevance to agricuitural labour. Wage workers or small farmer contractors may, in his view, be relegated by the ‘free market’ to a ‘vegetated existence, unemployed on the scrap-heap of history’. This is a charge against capitalism, more than against just futures markets. Consider, however, a farmer who is able to forward contract a proportion of his expected output each year. His income is likely to be more stable than if he did not make such contractsg Whether this income is sufficient for his survival is a different matter, but the existence of a futures market had led, indirectly, to a more stable income which surely increases his chances of surviving.

The price boom of 1972-5 spread among commodities and from currency and stock markets as capitalists diversified their portfolios. The ‘speculative’ part of this event was probably short lived. The reasons for a boom were real, including the demand effect of a coordinated business cycle in the developed countries, cyclical supply of some commodities (eg sugar) and random events such as the effect of weather on Soviet grain crops. Professional spectdators make profits and it is difficult to show that their activities are destabilizing with respect to price, while amateur speculators make losses and may destabilize price. A wave of amateur ~outside’) speculation often occurs at peak prices, but it is very short lived; perhaps a few days in length. Whatever the causes of the 1972-5 boom, the evidence for an argument that increased commodity prices drive up the rate of inflation and subsequent low prices do not reduce the rate of inflation (the ‘ratchet effect’) is very weak.‘”

Futures markets and ICAs

It has already been suggested that the trading of distant (say five year) futures would provide the kind of hedging which commodity exporters would like. How do such futures compare with buffer stocks and how ought they to be organized?

The conventional international commodity agreement is very difficult to negotiate, mainly because of differences between nations about what

There remains the question of how to organize FFMs. The traditional commodity traders would not be interested in such contracts. ICAs are made between governments, and five year futures contracts would have to be similarly based. Let us assume that an international Futures Market Agency (FMA) would be responsible for the contracts (the IMF could assume this role). Suppose, for example, that the UK has purchased 20 000 tonnes of cocoa from Ghana for delivery in June 1983. During the next &ur years the UK or Ghana could close out their

is a reasonable price corridor, what export quotas (if any) there should be, and who is to pay for the stocks. A five year futures market (FFM) would be entirely voluntary in operation. Importing and exporting nations could hedge whatever quantities they thought desirable at the going price.

The success of an ICA depends on most of the major countries joining it so that stocks and quotas may influence prices. An FFM could be successful for participants with a smaller proportion of trade accounted for, because it need not affect price. It only has to allow countries to make reasonable insurances.

The manager of an ICA’s buffer stock needs excellent foresight if he/she is going to make a profit. Speculators may periodically trade against the buffer stock if they disagree with its forecasts. Under an FFM, nations or traders would each have an incentive to collect information and make commitments. The flow of information about future supply and demand would probably be much greater than under a centralized buffer stock system.

International Commodity Agree- ments are notoriously unstable.” Unexpected events make quotas and price ranges rapidly obsolete. For example, the price of cocoa has continuously exceeded the upper limit envisaged in the international agreement of 1976. Agreements are often formed in periods of glut and disintegrate in periods of shortage. Changes in comparative advantage or the development of synthetic substitutes also put pressure on agreements. A market solution via distant futures trading could more easily accommodate all of these difficulties.

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positions by making offsetting transactions through the FMA. If the position had not been terminated after four years, delivery would have to be made in the fifth year. The UK may now do one of two things. Either the government sells its June 1983 cocoa forward to the traders, who take delivery at that time, or it sells cocoa on the cash market in June 1983. Because the FMA contracts are only tradable between countries up to one year prior to their expiration, the existing futures markets would continue to operate as they do now.

These ideas are in their infancy. I intend to develop them further. However, it is interesting to note that multilateral contracts were an important part of the integrated programme of the UN Conference on Trade and Development, before the Nairobi meeting in 1976, but now seem to have been overlooked. FFMs would be tradable, mulitlateral contracts. It is also interesting that Turnovsky,*2 among others, favours long range forecasts as a means of stabilizing markets. Five year futures require not

Report

just that long range forecasts be made, but that governments commit

themselves financially to these forecasts. They could be an important part of planning for a more stable future.

Gordon Gemmill,

City University

Business School,

London, UK

’ w. Lebeck, ‘Futures Trading and Hedging’, Food Policy, Vol 3, No 1, 1978, pp 29-35. 2 D. Evans, ‘Hedging against the interventionists’, Food Policy, Vol 3, No 1, 1978, pp 36-38. 3 M.J. Powers and P. Tosini, ‘Commodity futures exchanges and the north-south dialogue’, American Journal of Agricultural Economics, Vol 59, No 5. 1977, pp 977-985. 4 Lebeck, op cit. Ref 1, p 34. 5 See, for example, S.J. Turnovsky, ‘Stabilization rules and the benefits from price stabilization’, Journal of Public Economics, Vol 9. No 1, 1978, pp 37-58; and E.M. Brook, E.R. Grilli and J. Walbrook. Commodity Price Stabilization

Centre for European Agricultural Studies

Conceived in 7972. established in 1974, and housed in its new building by

September 7 975, the Centre for European Agricultural Studies at Wye College

aims to provide research and seminar programmes focused on the study of the

food and agriculturalindustries of Europe.

As the Centre’s approach is interdisciplinary and international, it aims to bring together farmers, business executives, scientists, politicians, administrators, consumers and academics for an exchange of ideas, information and experience. The Centre also aims at providing sabbatical facilities for personnel not only of other research and academic institutions but also of government and commercial organizations. Since it is the intention of the Centre to be a European, and not a British, forum it is already working in

harness with the Universities of Bonn, Louvain and Padua and is administered by a Council whose members at the moment are drawn from eight out of the nine EEC nations.

Although over the past 200 years or so UK agriculture has operated within a structure and an economic philosophy which was different from those of most of the EEC member states, the future confronts all of us with several common phenomena. Broadly stated, they are:

0 The increasing pressure of technical

and the Developing Countries: The Problem of Choice, Staff Working Paper No 262, World Bank, Washington DC, 1977. 6 See P.A. Samuelson. ‘The consumer does benefit from feasible price stability’, Quarterly Journal of Economics, Vol 86, No 3, 1972, pp 476-493; and C. Tisdell. Does Price Instability Increase Consumers’ Welfare as Waugh and Massell Suggest?, Research Report or Occasional Paper No 30, 1976, Department of Economics, University of Newcastle, NSW, Australia. 7 Commodity Futures Trading Com- mission, 1977 Report on Farmers’ Use of Futures Markets and Forward Contracts, CFTC, Washington DC, 1978.

* I.M.T. Stewart, Information in the Cereals Market, Hutchinson, London, 1970. ‘See, for example, A. Peck, ‘Hedging and income stability: concepts, implications and an example’, American Journal of Agricultural Economics, Vol 57. No 3. 1975,pp410-419. la A critique of this argument is given by ‘M. Finger and D. De Rosa, ‘Commodity price stabilisation and the ratchet effect’, The World Economy, Vol 1, No 2, 1978, pp 195-204. ” See A.D. Law, International Commodity Agreements, Heath Lexington Books, Lexington, MA, 1975. “Turnovsky, op cit. Ref 5.

development with its implications for inexorably rising costs and increasing yields. The increasing urbanization and industrialization of European society. The need for ‘managed markets’. The social restructuring of agriculture and of the countryside. An acceptance of our obligation to help in the development of Third World countries.

is against this background of common problems and yet diversity of experience that the Centre has set its research and seminar programmes to serve both consumers and producers.

Studies are currently being carried out into the marketing systems for live- stock and for potatoes in various EEC member states. This work contains much comparative description of what is going on and what will have to change to meet the changing market specifications. Another study is

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