Forward Contracts, Futures and Options

A forward contract is a non-standardized contract between two parties to buy or sell an agricultural product at a specified future date at a price agreed today.[1] Forward contracts can be tailor-made to fit specific requirements of the underlying agricultural commodity, and they are often embedded in different forms of value chain finance (see above). As they are privately negotiated and not exchangetraded, they do not depend on well-established commodity exchanges. From the farmer's perspective, forward contracts have the advantage of protecting against price drops. This establishes a floor in the expected revenue (successful production given), which can facilitate access to finance.

Futures are agreements with highly standardized and closely specified contract terms obliging the involved parties to buy or sell a certain quantity of agricultural produce at a fixed price at a future date. They are traded on future exchange markets. Options are risk management instruments that do not lock in prices but give protection against unfavorable price movements with the possibility of profiting from favorable ones. They trade on exchanges as well as on the over-the-counter market offered by banks or traders. They are hedging instruments and do not involve the trade and exchange of agricultural products. Both futures and options are not used that often used for the benefit smallholder agricultural finance. Typically, volumes are too low here and product qualities vary too much. However, a pooling of producers, for instance via farmer cooperatives, or in organised value chains, is in principle a way to make options available for smallholders and to overcome the issue of small ticket sizes. But such arrangements would need to be set up and developed by the supply side (i.e. exchanges, traders) and brought to the market by them since small-scale farmers in developing would rather not

group together for the purposes of acquiring options.

Overall, forward contracts, futures, and options provide the farmer hedging against price volatilities but have no impact on the agricultural production risk.

  • [1] See Miller and Jones (2010), p. 85 and Winn (2009), p. 61. Miller and Jones (2010), pp. 86-87 report a successful programme in Brazil using forward contracting in the form of “rural financial notes” (cedula produto rural).
 
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