Traders with cocoa beans usually use futures contracts as a hedge against the risk of unwanted movements in the price of the beans. These merchants, who have beans in stock and others growing on plantations or being harvested for them or their suppliers, understandably hope that the price will go up. At the same time, however, they are now securing themselves in case the price of beans falls. They hedge by speculating on a drop in the price of beans. This is how they speculate using futures contracts. If the price of beans goes up, so does the price of the beans they have in stock or in the process of being harvested. And this price increase more than offsets what traders have to pay for their downside speculation. And if the price of beans goes down, they also make their stocks cheaper, while of course part of the related losses will be covered by that hedge in the form of speculation on the decline.
This method of hedging works well if the price of beans fluctuates within a certain range. But as soon as there is a sharp movement of the price, outside the band, the matter gets complicated. This is because traders have to put up collateral during their hedging speculation on a decline – that is, they have to guarantee. That’s because speculating on a fall in the price of cocoa beans – and of course other commodities – actually involves selling borrowed futures on them. The trader insures himself against a drop in the price of beans specifically by borrowing futures contracts on them, which he then sells on the stock exchange. If the price of beans really falls, they buy back the given futures contracts at a reduced price and return them to the original owner. Moreover, by buying them back at a lower price than he sold them, the trader achieves a profit, which helps him to cover part of the loss from the drop in the price of beans as part of the hedge.
The aforementioned guarantee is necessary precisely because the trader secures himself through borrowed futures contracts, not owned ones. The original owner of the futures contracts, of course, collects interest for lending the futures contracts to the trader. At the same time, he wants to be sufficiently sure that the merchant will return them to him. Coverage of 150 percent of the value of the relevant downside speculation is common. So, if a cocoa bean trader speculates on a fall in cocoa bean prices by selling 100 cocoa bean futures at a price of $10,000 each, the value of that fall speculation is $1,000,000. In total, he must bond in the amount of $1,500,000. He must deposit this money into the appropriate account and keep it there for the duration of his downward speculation.
Of course, if the price of beans goes up sharply, the trader with them is understandably happy. The value of his stock in storage or what he is currently harvesting increases. At the same time, however, there is a problem with his hedging speculation on the decline. With a significant increase in the price of beans, the amount that they have to keep as a guarantee increases significantly. For example, if the price of beans were to rise to 12,000 a piece, the value of the downside speculation rises to 1,200,000, so he has to guarantee $1,800,000. Therefore, another 300,000 dollars must be deposited into the relevant account as collateral. The owner of futures contracts with a guarantee requirement insures exactly against the increase in the price of beans. With the increase in the price of beans, the price at which the bean dealer must buy them to return them to the owner naturally increases. This increases the likelihood that the merchant might not have enough money for a buyback, which is why the owner is sure of it with a guarantee. However, if the price of beans rises really sharply, some of the bean traders will say to themselves that further increases in the guarantee are already unbearable for them and they will stop speculating on the fall – that is, they will buy futures contracts on beans back to return them to the owners. In doing so, however, they only further intensify the already dizzying growth in the price of beans. Because the fact that the trader buys back the previously sold futures contracts at significantly higher prices – sold at a much lower price – naturally drives the price of beans up further.
Lukáš Kovanda, Ph.D.
Chief Economist, Trinity Bank
TRINITY BANK
Trinity Bank has been operating on the financial market for 25 years and was created through the transformation of the Moravian Monetary Institute – a savings cooperative. It has more than 92,000 clients and its balance sheet total exceeds CZK 65 billion.
Trinity Bank specializes in private and corporate banking, for natural persons it mainly focuses on deposit and savings products that offer above-standard appreciation of savings.
More information at: www.trinitybank.cz
