One of the difficulties in explaining about futures and options is that they can seem detached from reality--just games that rich people play with money. However, the farm sector offers some extremely practical examples of how these tools are used. Daniel Prager, Christopher Burns, Sarah Tulman, and James MacDonald explain in "Farm Use of Futures, Options, and Marketing Contracts" (US Department of Agriculture, Economic Information Bulletin Number 219, October 2020).
I'll walk through a few of their examples, but of course most of us aren't farmers. Thus, I'll raise a question of greater relevance to many of us: Why can't homeowners (and banks and mortgage-lenders) use futures and options to hedge against the risk of large shifts in housing prices, like what occurred in the lead-up to the Great Recession of 2008? Frank J. Fabozzi, Robert J. Shiller, and Radu S. Tunaru tackle this question of why such financial instruments barely exist in . "A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?" (Journal of Economic Perspectives, Fall 2020, 34: 4, pp. 121-45).
As the USDA economists point out, farmers face a problem that they can't know in advance what prices they will receive for their crop after it is harvested. What options to farmers have to protect themselves against a fall in crop prices?
Farmers may use on-farm strategies, such as commodity diversification, to manage such risks, and they may also draw on Federal risk management support programs, including commodity support programs, Federal crop and livestock insurance, and disaster assistance. Market mechanisms are also available to farmers who can use agricultural derivatives—such as futures and options contracts—and marketing contracts to protect against price fluctuations. These tools can help guarantee producers an established price before harvest.The USDA report goes into some detail on how farmers use these different approaches. For those who are a little rusty on just what the financial terms mean:
• A futures contract is an agreement to buy or sell a commodity or an asset at a predetermined price at a specific date in the future. Futures contracts are traded on organized exchanges and are standardized by quantity, delivery date, and location. Organized futures trading is often used for major agricultural commodities, where traders can opt for futures trading as a way of hedging against price risks for a commodity. ...It turns out that "[s]ince the mid-1990s, between 33 and 40 percent of U.S. agricultural production has been produced under contract ..." Meanwhile, larger farms tended to be the ones who use futures and options contracts: "Among corn and soybean producers, 17 percent of midsize farms and 27 percent of large farms used futures contracts. ... Those corn and soybean farms that used futures or options hedged a substantial share of their production through such instruments. For example, while only 10 percent of all corn producers hedged using futures contracts, those that did hedged 41 percent of their corn production in 2016."
• Options. Options offer the right (but do not carry the obligation) to purchase or sell an instrument at a set price, regardless of the market price at the time of sale. ...
• Marketing contracts. Marketing contracts are agreements to exchange a specified asset for a certain price on a future date. They are neither standardized nor tradeable, as futures and options are, but are customized to the needs of specific buyers and sellers. They often include features such as price adjustments for quality, and they sometimes include commodity-specific features. Marketing contracts also reduce market risk by securing a buyer and a delivery window for the farmer’s output.
• Production contracts. Production contracts are agreements under which a farmer agrees to raise livestock or crops for a contractor, which may or may not be another farm. The farmer is paid a fee for growing services, while the contractor provides key inputs and markets the product. Most input and output price risks are transferred to the contractor.
It's also important to note that that there are a number of parties who want protection against farm prices unexpectedly rising higher than expected: for example, companies that buy crops for animal feed, or to produce human food, or to produce other products using agricultural inputs, all have reason to use futures and options to protect themselves against large rises in the price of such products.
So why can those worried about fluctuations in farm prices use financial tools to protect themselves, but those worried about fluctuations in home prices cannot easily do so? Fabozzi, Shiller, and Tunaru point out that there is a 30-year history of trying to create financial contracts based on housing prices. What are some of the issues that come up?