Futures and options in practice in England

Broadly, FPRM tools used by farmers in England can be divided in two. Firstly, futures and options traded via a FSA regulated broker on a regulated exchange, in the farmer’s name and secondly, ‘futures’ and ‘options’, traded via the agricultural merchant trade but not in

98

the farmer’s name. The grain traders in England produce marketing products that have the features of futures and option contracts but are not actually a ‘real’ future or option contract. They are sometimes referred to as an ‘over the counter’ (OTC) contract. The two are not the same, and should not be confused, even though they are similar.

There are several uses of these FPRM tools to the market players, farmer sellers and merchants/consumer buyers. This thesis concentrates on the farmer seller, but opposite actions could be taken by a buyer6.

• The futures market enables the farmer with some physical crop to sell to fix a price for that crop. The farmer always has some crop to sell, they are always ‘long’ of physical commodity (be it undrilled but intended to be drilled that season, growing in the field or in the shed once harvested). A farmer is never knowingly ‘short’, i.e. selling more than he believes he will have (growing/in the shed), as that would be speculation. However in a low yielding year this may happen.

• Futures enable a farmer to set a price in the future for their produce at a time when it is difficult to find a buyer (normally a grain merchant) or the price offered is deemed to be too low, compared to the ‘normal’ ex-farm discount to the futures price, the basis. In the context of the English market, this could be two years ahead. Futures help the farmer in a situation when they may want to sell forward, lock into a price, and therefore a margin, but cannot find an immediate buyer.

• The futures markets are always trading on the days the exchange is open and the prices are clearly visible and readily tradable. Merchant or end-user buyers may not always be buying, or willing to price wheat, especially when looking over a year ahead.

6

These are the perceptions gained from experience in the grain trade in England and from the one to one interviews and

99 3.4.1 Exchange traded futures

Before trading can begin in exchange traded FPRM tools, an account has to be set up with a regulated broker. In England this is a broker that operates on the London exchange, NYSE LIFFE. Trades are cleared by ICE Clear Europe Ltd (NYSE Euronext, 2013). This process takes about two weeks and involves some regulatory paperwork. It covers money laundering regulations, proving identities and that all the Partners or Directors of the trading entity accept liability for the trades (Her Majesty's Treasury, 2007). The broker then sets up a client account. For the use of futures, an ‘initial margin’ must be transferred into it. At present, September 2013, for LIFFE traded feed wheat, it is £14/t. As the futures are traded in 100 tonne lots, that is £1400/ lot. The initial margin varies over time, reflecting the current volatility of the wheat market. The initial margin is designed to cover the worst daily adverse swing in the market that would still leave the account holder able to pay their ‘daily margin calls’. At the end of each trading day the farmer’s account is either credited or debited, depending on the market’s movement on that day. This continues until the future is closed or it expires, when one final payment/deposit is made. If the initial margin is depleted, then the account holder must deposit more money into the client account. If this is not possible, the broker closes the futures position automatically at the end of that trading day. Futures have unlimited upside and downside risk (New York Stock Exchange, 2013a).

3.4.2 Exchange traded options:

The same regulatory procedure is followed to set up an option account except there is no initial margin requirement. An option account has a liability limited to the premium paid, so it is only the premium that is paid initially to set up the account. There are no further liabilities to the account holder (New York Stock Exchange, 2013b).

There are two types of option contract. A wheat call option protects against a rising wheat market, following a physical wheat sale. A put option protects against a fall in the wheat market if no sale is made/cannot be made but the current wheat price of the asset is deemed acceptable. The form of call and put options traded on the LIFFE market in England are ‘American’ options. That is, the option can be decided, ‘stuck out’ on any day from inception to expiry at the buyers option (New York Stock Exchange, 2013b). There are many styles of option contract; European, Bermudan, Asian, Barrier, Binary, Exotic and

100

Vanilla, all with varying expiry times, averaging and maximising characteristics (Peskir and Uys, 2003; Linetsky, 2004; Eberlein and Papapantoleon, 2005; Glover et al., 2010; Peskir and Samee, 2011; 2013).

Hypothetical call option example: if a producer sells their wheat for £150/t for a year ahead but is concerned that the market may rise during that time they may rather pay a premium to have the right to sell their wheat again at the higher price, rather than accept the higher fixed price now. If the premium was £10, then a minimum price of £140 is created. If the market rose to £200, the farmer would resell his wheat at £200 - £10 premium and receive a new price of £190. If the price of wheat fell to £100, then the farmer would take no action, but take the £140 minimum price agreed a year ago.

Hypothetical put option example: a producer decides not to sell their wheat/cannot sell wheat for reasons of uncertain yields but thinks the forward wheat price of £150/t for a year ahead is good. However, the producer is concerned that the market may fall during that time, pays a premium to have the right to sell their wheat again at the current price. If the premium was £10, then a minimum price of £140 is created. If the market fell to £100, the farmer would sell his wheat when yield known (at harvest) at £100, gain £50 (£150 - £100) from the option and deduct the £10 premium and so receive £140, the minimum price agreed a year ago. If the price of wheat rose to £200, then the farmer would take no action with the option, but sell the physical wheat for £200 and deduct the £10 premium and so receive a new price of £190/t. This hypothetical example is shown in tables 3.1, 3.2 and 3.3.

101 Table 3.1 Call Option – set-up phase

Table 3.2 Call Option - A subsequent price rise An “at the money” basis Nov ‘14 futures Assume 100t wheat is being sold, as price/basis good Nov ‘14 futures

Nov ‘14 ex-farm price Assumes Basis = -£6 Buy call option at strike price Option Premium

Total obligation

Net price (£150.00 - £10 option)

£156.00/t £150.00/t £156.00/t £10.00/t £1000 £140.00/t min

A Call Option basis Nov ‘14 futures Nov Futures (14th June ‘14)

Action: Exercise call Option at Profit on call

(£196.00 - £156.00 = £40.00)

Gross value of physical sale Original Option Premium Net value of physical sale

(£150 sale + £40.00 profit on call - £10 Option premium)

£196.00/t £196.00/t £40.00/t £150.00/t £10.00/t £180.00/t

102 Table 3.3 Call Option - A subsequent price fall

A put option removes the risk of selling physical wheat forward, which may never be produced and reduces the effect of a price fall. A put option is a way of locking into a forward price, with yield no longer such an issue.

Option premiums, like insurance premiums, can be reduced if an ‘excess’ is applied. This is called going ‘Out of the money’ (OTM), so the buyer accepts a higher strike price in return for a lower option premium. Table 3.4 shows a hypothetical example of how the premium can be reduced from £10 to £6 by going OTM. As the option granter now has less risk of being claimed against, the premium can be reduced, as the market price movement required before a claim is possible is increased. Also, with a lower premium there is a higher guaranteed minimum price (less premium deducted from the physical wheat price). In this example the minimum price achieved being £5 OTM (strike price £105) would be £2 higher than with an ATM option with a strike price of £100. This flexibility allows almost any premium, and so minimum price of the physical wheat, to be agreed. As an extreme example, on any day an option premium could be hypothetically reduced to £1/t, but would be so far OTM that there would be little chance of any gain, but the guaranteed minimum would be high, a trade-off.

A Call Option basis Nov ‘14 futures cont... Nov ‘14 Futures (14th June ‘14)

(so ex farm £106 - £6 basis = £100)

Action: Abandon call option Profit on Call Option Gross value of physical sale Original option premium Net value of physical purchase

(£150 - £10 Option premium) £106.00/t £00.00/t £150.00/t £10.00/t £140.00/t

103

Table 3.4. Hypothetical examples of premiums with differing strike prices for a call Option.

When studying wheat, corn and soyabean options in the USA, it was found that these option markets were ‘efficient’ and that the mis-pricing claims were caused by biases in the agents’ perception of futures price distribution (Urcola, 2007).

The use of exchange traded (FSA regulated) FPRM tools has several advantages and disadvantages. These are some perceptions gained from experience in the grain trade in England and from the one to one interviews and focus groups conducted during this research and include:

Advantages

• Full backing of the FSA regulations, including the Financial Services Compensation Scheme, should the regulated broker go into receivership.

• Trades concluded directly with the Exchange traders.

• All trades time-stamped. Important in a rapidly moving market. • All trades recorded for security.

Disadvantages

• No advice from the FSA regulated broker on future and option use to farmer. • Time consuming setting up an account.

• ‘Initial margin’ or premium must be paid before trading allowed, so potential cash flow implications to the farmer;.

• Often several hours/days delay in granting an option as market often illiquid, especially when looking over one year ahead.

• Brokers fees for setting up a future, and the option premium. Premium £/t Strike price, £/t Gain point

10 100 At the Money 110

8 105 £5 out the Money 113

104 3.4.3 Merchant ‘futures’

Due to the unlimited liability nature of the futures contract, most merchants do not grant these types of contracts with their farmer clients, unless they have a close previous trading relationship. Most will include a pre-set ‘stop-loss’ built into the contract, which if reached will automatically close the farmer’s position, stopping any further losses. Some merchants insist on a physical grain contract, with no price agreed, to be placed in association with the future, as collateral.

3.4.4 Merchant ‘options’

Call options are more readily granted and form a ‘minimum priced contract’, as physical grain is sold to the same merchant at the same time. In the context of the wheat market in England, calls are felt by the grain trade in England to be within the scope of the merchant’s trading activities of buying grain and so do not cross FSA rules on trading ‘financial instruments’ (Financial Services Authority, 2013). Most merchants in England will not grant puts. A put could be construed by the FSA as speculation, not part of the merchant’s trading activities, as no grain is associated with the contract. However in reality, a merchant would only grant a put to a farmer they knew and as part of a hedging strategy.

This is very restricting from a farmer’s PRM perspective as a downward price movement is difficult to protect against if all (unless ‘simple’ futures used), or the maximum quantity that can be safely sold before harvest (as yield unknown), has been reached. In that scenario, the farmer has no alternative but to just watch the price falling and accept the loss. Additionally, if a contract can only be priced at the time of the wheat movement (like many seed contracts are) but the farmer believes the market will fall before then, a higher price cannot be locked into or guaranteed. By using only forward trades, if the physical wheat tonnage is not eventually produced, and the price has risen, a ‘buying-in’ penalty may be applied by the merchant to the farmer (Porter, 2012).

These merchant OTC contracts have advantages and disadvantages which each individual producers needs to weigh up before entering into them. These are the perceptions gained from experience in the grain trade in England and from the one to one interviews and focus groups conducted during this research and include:

105

Advantages

• Not having to go through the regulatory paperwork phase.

• Not having to pay initial margins when first setting up the futures contract or the daily requirement of margin calls associated with daily futures contract price movements.

• Not having to pay the option premium until a forward physical sale is actually moved, the premium being deducted from the proceeds of the sale.

• Trading via an organisation/person that the farmer already knows and trusts. • There is time to take advice about why these tools are being used.

• The costs of setting up an OTC future or the option premium is often cheaper as the merchant combines the FPRM tools with a physical wheat sale, which maybe is used to ‘subsidise’ the FPRM tool’s true cost.

• The FPRM tool and physical grain are often amalgamated to for a variety of ‘minimum priced contracts’, removing many of the FPRM tools’ terms.

There are however real disadvantages:

• Counterparty risk. The farmer has to make a value judgement of the advantages versus the chance of such a merchant default. Merchants are also concerned with counterparty risk, if the farmer cannot pay any losses that may occur if the market moves against them.

• Increasingly tighter FSA regulations, post MIFID (Markets in Financial Instruments Directives) in November 2007, many merchants in England believe it may be illegal to offer FPRM instruments, as none are at present FSA regulated (Financial Services Authority, 2007).

• The merchant may not be setting up the same FPRM tool as they are selling the farmer. It depends on the wider overall ‘position’ the merchant has in the wheat market.

• The FPRM tool, if in fact set up by the merchant at all, is in the name of the merchant not the farmer. This is because the merchant does have a FSA regulated account and can therefore set up a ‘real’ future/option in their own name. In the case of a merchant default, the farmer’s FPRM tool via the merchant could be worthless.

106

• No recording of conversations, important in a dispute. • No time-stamping of trade, important in a volatile market.