Hedging commodity exposure in international markets

Hedging has always been a popular way to manage commodity price risk, particularly in more developed agricultural markets and among the processors and manufacturers that form the middle of the agricultural value chain. However, the popularity of this form of risk management has also spread to other parts of the market in recent years. Producers are becoming increasingly sophisticated in their use of hedging tools to manage risk, for instance, as are end-users of all types. We are also seeing an uptick in interest in agricultural risk management in new countries and regions around the world. In line with this increased activity, agricultural organisations continue to become more astute at managing risk through the use of futures and options products such as those offered by CME Group. And access to a diverse set of risk management tools is crucial for businesses that wish to hedge against fluctuations in agricultural commodity prices efficiently and effectively.

As interest in this area of risk management continues to grow, exchanges must maintain a constant dialogue with their users, keeping abreast of market trends to ensure contracts provide the necessary coverage. CME Group, for example, worked with the market to tweak the specifications of its live cattle contract, which celebrates its 50th anniversary this year, to ensure it remains consistent with current commercial terms. Improvements in feeding productivity in the livestock market in recent years have resulted in larger cattle. Since the contract is physically delivered, we want to ensure delivery of cattle is consistent with the physical marketplace. As such, it is very important for us to stay close to our customers and ensure our products are appropriately designed to reflect their needs.

Customer feedback has also enabled the continued development of CME Group’s agricultural options complex. In the past, we found that while many of our customers were interested in using options to manage price risk, they were often deterred by high premiums in times of market volatility. With this in mind, CME Group developed a range of options that carry lower premiums but still provide solid protection against price fluctuations. A corn producer, for example, might want to hedge against a drop in prices when planting corn for the upcoming season in January or February.

Traditionally, the producer would buy an option that expires in November on the following December’s futures price. However, CME Group’s short-dated new crop options contracts allow producers to buy a contract covering a shorter period of time at a reduced premium. A contract covering the planting season, for instance, would expire in May, rather than in November, and would therefore cost less. Such products have been created as a direct result of interaction with customers who have expressed interest in using options in a more targeted way.

As a result of this focus on customer feedback, CME Group’s non-standard options products – such as options on calendar spreads or short-dated contracts – have been gaining traction in the agricultural market. CME Group’s weekly agriculture options traded more than 110,000 contracts in October 2014 – the second-highest volume since inception and a 245% increase in average daily volume year-on-year. By November 2014, open interest in 2015 short-dated new crop options had already reached more than 45,000 contracts. More than 26,000 contracts traded during November 2014, a 158% increase compared to November 2013.

Historically, the over-the-counter market fulfilled a lot of the demand for non-standard options. However, regulations put in place after the onset of the financial crisis in 2008 have squeezed OTC market activity, driving demand for non-standard options products offered by exchanges instead. As these new options products have gathered pace in the market in recent years, CME Group’s customers tell us they have begun to replace the traditional tailored OTC offerings in this area. Indeed, it is difficult for OTC products to compete with exchange-traded futures and options in markets with slim margins, such as the agricultural sector. Our bid-ask spreads are extremely tight and the market is very deep and has a lot of liquidity. As such, CME Group has been very successful in designing products to help customers manage commodity price risk.

In line with increased interest in hedging commodity price fluctuations throughout the world’s agricultural markets, CME Group will also continue to expand the global distribution of its risk management products on Globex, CME Group’s global electronic trading platform. For example, since 2010, traders have had access to Bursa Malaysia’s benchmark palm oil futures contract on Globex. This means Globex offers hedgers and traders access to the two most popular vegetable oil contracts in the market – soybean and palm oil. Such partnerships provide CME Group’s customers with a great deal of flexibility when it comes to managing commodity price risk, and we look to continue building partnerships throughout the global agricultural markets to ensure that continues to be the case for our customers.

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