Derivatives on Agricultural Commodities. Harm or Charm for the World's Society

Term Paper (Advanced seminar), 2014

23 Pages, Grade: 1,0


Table of Contents

1. Introduction

2. Derivatives Defined

3. Types of Derivatives
3.1 Forwards
3.2 Futures

4. Conceptual Insights and Valuation
4.1 Main Mechanisms of a Futures
4.2 Valuation Concept
4.3 Relationship between Spot Markets and Futures Markets

5. Markets, Participants and their Intentions

6. Derivatives on Agricultural Markets and their Impacts
6.1 Market Characteristics
6.2 Analysis of the Link to Increased Food Prices
6.3 Conclusion

7. Result and Critical Appraisal


The following home assignment deals with the question whether derivatives harm society as a whole. The central issue is a possible impact of derivatives prices on present prices for agricultural commodities. In order to provide the necessary background knowledge, the terms derivatives, varieties, valuation, market participants and principles of operation are explained. After recognising theoretical knowledge and the results of different studies, it turns out that there is no empirical evidence for plausible harming impacts of over speculating index investors. Further studies have to be conducted in future in order to provide a reliable proof for policy makers.


Figure 1: Spot Prices on Corn in Cents per Bushel

Figure 2: Payoffs from Futures/Forwards

Figure 3: Convergence of Futures Price and Spot Price

Figure 4: Development of the Agriculture Price Index


Table 1: Overview on Prices

Table 2: The Corn Futures between A and B and its Result


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1. Introduction

The world’s society has been faced with price increases in different spheres of life in the last decade. Among other impacts, people have to pay higher rents in metropolitan areas and have to adjust their monthly budget to higher energy costs. Especially the public debate on increased food prices is very prevalent since people in third world countries are faced with undernutrition and death from starvation. According to the Food and Agriculture Organization of the United Nations (FAO) about 8,5 % of the world’s population suffered from chromatic hunger in the last years (FAO 2013a). A recent meta-study of the Institute for World Economics and International Management (IWIM) led by Hans-Heinrich Bass (Bass 2013, p. 16) heated up the debate in the last two months of 2013 because it claims that derivatives have contributed to the price development with a high probability. In Germany the Deutsche Bank and the insurance company Allianz are involved in trading with the particular derivatives. Therefore they are heavily criticised by organisations like Foodwatch and Oxfam. Furthermore even the German president Joachim Gauck, as head of state, spoke out in favour for the critics. He aims to prohibit speculation with agricultural commodities (Oxfam 2013). On the other hand scholars like Don M. Chance and Robert Brooks (2010, p.14) state about derivatives that: “Society benefits because the prices of the underlying goods more accurately reflect the good’s true economic values.“ So who is right and who is wrong and on which evidence do the schools of thought base their implications? In order to give theoretical background to this complex public debate this assignment gives answers to the following questions:

What are derivatives with respect to agricultural markets? What are market participant ’ s intentions? How derivatives work and what is their value? Central question: Are derivatives on agricultural markets a harm or a charm for society?

After giving a technical definition about derivatives, an overview about relevant types of derivatives and their connection to agricultural commodities will be given. Afterwards their principle of operation is illustrated with the help of a practical example. For the purpose of being able to discuss the potential impacts of derivatives on food prices, the theoretical foundations about valuation, types of traders and the technical relationship to prices are explained furthermore. The conclusion of chapter 6 delivers an interim result for the answer to the central question.

2. Derivatives Defined

When talking about the definition of derivatives the best way to get the actual meaning is to refer to the root word “derive”. Derivatives as financial instruments are assets whose valuation derives from the performance of an underlying asset (Chance and Brooks 2010, p. 1). Hence, the return on a derivative instrument completely depends on the value of a second variable (Hull 2012, p. 1). Concerning the definition, the scholarly literature agrees on this rather technical explanation. The main transaction (exchange of an underlying asset) has to be seen separate from the financial instrument. Derivatives were initially shaped as professional traded assets around agricultural commodity markets in Chicago in the 19th century (Andersen 2006, p. 127). The underlying assets are prevalently tradable assets, these are in agricultural markets for instance corn, soybeans, wheat, sugar or cocoa.

Whether operating in agricultural markets, stock markets or other commodities markets, etc., the buyers of derivatives can have diverse intentions by holding such a financial asset. Before going into detail with the different types of buyers in chapter 5, generally the motivation to reduce (also referred to hedging) a financial risk can be assumed (Hull 2012 p. 1-2). The risk, that is to be secured, arises out of the price volatility of any tradable asset (Chance and Brooks 2010, p. 5). A quite practically relevant example is the variation of exchange rates for foreign currency. Companies doing international business fear the risk of fluctuating currency rates in the period between input expenditures and final payment. Characterized by a value-dependence on a second variable (here the exchange rate) a derivative instrument provides protection and has therefore developed to an often-used tool among companies (Chance and Brooks 2010, p. 12). In other words, possible risks can be transferred from one party to another (Bösch 2012). That’s why derivatives have undergone phenomenal growth since the 1970s (Jarrow and Chatterjea 2013, p. 4).

3. Types of Derivatives

After clarifying the basic characteristics of derivatives in general, a deeper look into different types is needed to assess their usage on agricultural markets. A typical risk transfer on these markets could be undertaken in order to secure the risk of falling or rising prices for commodities.

For instance, a farmer wants to fix a certain price for corn that will be delivered to the buyer in six months after the next harvest. In this case suitable tools are called forward contract (also called forwards) or futures contract (futures). This chapter therefore aims to give an overview about these two relevant instruments.

3.1 Forwards

As shown in the example, a forwards is an agreement between two parties to buy or sell a certain asset at an agreed time in the future to a certain price (Hull 2012, p. 3). Unlike options (right to sell or buy an asset) the agreement reflects a binding commitment or in other words an obligation for both the delivering and the paying party. The arranged price for the transaction is called the forward price or delivery price. Just the opposite, the current price of the equivalent asset is called the spot price. The difference of both prices of the underlying asset between agreement and delivery is the value that forwards holders derive their profit or loss from (Jarrow and Chatterjea 2013, p. 212-224).

Different to stocks or options, forwards are not traded at official exchanges. Typically there are traded via a direct communication line among financial institutions such as banks in a less formal way, called over-the-counter markets or OTC-markets (Chance and Brooks 2010, p. 253).

3.2 Futures

More common for underlying agricultural commodities are futures being traded in a more organised manner on futures exchanges. Just the same as a forwards, a futures c orresponds in theory to an obligation for the seller and the buyer for an exchange of assets on a delivery day to a delivery price in an agreed quality. The quality is fixed by delivery terms and contract specifications. Having developed out of forwards, futures are more liquid contracts since holders can easily trade them and thus can be straightforwardly relieved from their obligation to sell or buy the underlying asset. The more technical term for selling that obligation is closing an open position or offsetting. What is more is that due to every day spot price fluctuations of the commodities, the agreed forward price gains or loses attractiveness for both the derivative holders. The daily wins and loses of this zero-sum game (one’s gains on the expense of the other party) are subject to a regular cash settlement (Chance and Brooks 2010, p. 3).

In essence both the forwards and the futures are comparable to a bet between two market participants. The obliged future buyer of the asset expects increasing prices and wants to fix the price (delivery price). The seller, expecting falling prices, wants to gain profit by supplying the asset on the delivery date for a lower price than the delivery price. As both have an interest on such a bet, they meet each other on derivative markets in order to agree on a buying/selling obligation.

4. Conceptual Insights and Valuation

As the mechanisms of futures and forwards might sound abstract at first glance, this chapter provides a more practical approach to their usage, underlying mechanisms and valuation based on the carry arbitrage model. Prior to the following example it can be concluded that there are significant similarities of both previous described types. Therefore a deeper view is taken into the actively traded and in agricultural sectors commonly used futures.

4.1 Main Mechanisms of a Futures

A farmer A owns several cornfields and actively trades with his harvested corn. The spot price of a so-called bushel is USD 4,282 on the 19th of December 2013 (Nasdaq 2013).

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Figure 1: Spot Prices on Corn in Cents per Bushel1

Figure 1 shows the development of the corn prices on the spot market during the last six months. As most individuals are risk averse, A also wants to transfer the risk that he is facing due to falling prices (Chance and Brooks 2010, p. 7). Hence, A is willing to step into an obligation to sell his corn in May 2014 for a fixed price, in other words a six months futures. Technically the obligation to sell or deliver is called a short position (Hull 2012, p. 102). The delivery price is for the most part determined by the costs of carry of the physical asset until delivery (explained in detail in chapter 6). Both A and B virtually meet each other at a futures exchange and arrange USD 4,382 as the delivery price per traded bushel. Besides the price, a quantity of 100.000 bushels and a certain quality standard are arranged. For further assessment of the futures, a spot price on the delivery date of USD 4,48 is assumed (see table 1). The moment where they fix the contract is referred to as to.

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Table 1: Overview on Prices2

As stated in chapter 3.2 a futures can be described as a zero-sum game. In this example B gains the difference between S t and K (S t - K) on the expense of A. In other words B is on the long position and has the obligation to buy and due to an increased price S t has the advantage to buy for the price K below market price, whereas short position seller A could have sold for S t. He therefore loses S t - K in the amount of USD 9.800 as shown in table 2. ( Chance and Brooks 2010, p. 270).

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Table 2: The Corn Futures between A and B and its Result3

In this example the prices have increased in favour for the trader B. Since the outcome of such a futures is uncertain, infinitely different win-loss combinations can occur. The following figure 2 shows how the payoffs from futures/forwards can be distributed.


1 Nasdaq 2013.

2 Own example.

3 Own example.

Excerpt out of 23 pages


Derivatives on Agricultural Commodities. Harm or Charm for the World's Society
Hamburg School of Business Administration gGmbH  (Department of Finance & Accounting of HSBA Hamburg School of Business Administration)
Specialisation Finance
Catalog Number
ISBN (eBook)
ISBN (Book)
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derivatives, agricultural, commodities, harm, charm, world, society
Quote paper
Martin Wendt (Author), 2014, Derivatives on Agricultural Commodities. Harm or Charm for the World's Society, Munich, GRIN Verlag,


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