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How futures and options are making rich farmers poor.
April 22, 2008 1:31 AM

For those interested in the nuanced and hazy world of how futures and options work, in particular in relation to soft commodities like soybeans, wheat, corn, and cotton, the NY Times has a very interesting article out detailing how these markets are ailing:

Prices of broad commodity indexes have climbed as much as 40 percent in the last year and grain prices have gained even more -- about 65 percent for corn, 91 percent for soybeans and more than 100 percent for some types of wheat. This price boom has attracted a torrent of new investment from Wall Street, estimated to be as much as $300 billion.

Whether new investors are causing the market's problems or keeping them from getting worse is in dispute. But there is no question that the grain markets are now experiencing levels of volatility that are running well above the average levels over the last quarter-century.

Until recently, that system had worked well for generations. Since 1959, grain producers have been able to hedge the price of their wheat, corn and soybean crops on the Chicago Board of Trade through the use of futures contracts, which are agreements to buy or sell a specific amount of a commodity for a fixed price on some future date.

More recently, the exchange has offered another tool: options on those futures contracts, which allow option holders to carry out the futures trade, but do not require that they do so. Trading in options is not as effective a hedge, farmers say, but it does not require them to put up as much cash as is required to trade futures.

What's essentially happening is that a larger portion of Wall Street's money from hedge funds, pensions funds, etc., is pouring into these commodities because they feel that they can't get the same returns in the stock market and other financial instruments, thus artificially inflating the prices of each. Other commodities that are experiencing this same phenomenon include oil, gold, coffee, sugar, silver, etc.

Because there is too much money out there chasing (or paying for) too few goods, you get this inflation bubble which becomes a self-fulfilling prophecy. That is, if all that speculative money pumps up the price of wheat "artificially," and the price never retreats, then the actual user of the commodity (grain purchaser for food, cotton merchant for t-shirts, oil refinery for gas) is forced to pay that inflated amount.

To be more specific, if you are a corn farmer and have 1,000 bushels of corn that you're growing but won't be able to sell it until it's harvested, you "hedge" your crop by selling a future - or a contract that locks in a set price in the future. But since it might take 6 months to harvest your crop, the price of that future might go up considerably and since you sold it, you're "losing" a lot of money. You're not really losing the money since you will eventually exchange your crop for that set price. The problem arises when that set price might have risen so much that you are required to put up extra money to cover the temporary loss (up to the duration of the futures contract; in this example, 6 months) . If you can't borrow the money from your bank - which is certainly more common these days due to the credit crises - you're screwed:

"If you've got 50,000 bushels hedged and the market moves up 20 cents, that would be a $10,000 day," said Fred Greider, a farmer for 30 years in Illinois. "If you only had $10,000 in your margin account, you'd have to sit down and write a check. You can see $10,000 disappear overnight."

On an unusual day, he said, he might get four phone calls a day from his broker seeking additional margin. "But usually, the margin calls come in the mail, in a little blue envelope," he said. "You don't have to open it to know what it is."

It's that little blue envelope that's potentially killing the farmer and leading to higher prices for food, gas, and clothing. All in this new world of hedge funds and higher prices, which is certainly making many farmers wealthy...as long as they're not selling futures to hedge their crop...

Read the entire article
to understand this fascinating story...

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