Perpetuals for farmers

Imagine a crop farmer who is exposed to a number of risks that may affect the returns on the farming operation. Not only is he exposed to production risks like adverse weather, pests and diseases, but also has to worry about price and demand for his crop at time of harvest. These factors may negatively affect the balance sheet, which in turn affects his ability to grow crops in the next season and in extreme cases result in his bankruptcy. Whilst a farmer can lock in on a future price by means of a forward contract with a trader or consumer at a minimum price (marketing contract), this would not always optimize the returns. Also storing the commodities for sale in better times may be costly and affects quality over time. And what if other farmers do the same? An alternative is to buy crop revenue and/or yield insurance.

Today few farmers are hedging their risks themselves using existing futures contracts for a number of reasons:

  • Existing futures contracts do not correlate well with conditions on the ground, which produce ineffective hedges for the risks associated with the local environment (eg. weather). For example, farmers operating in Australia who hedge their price risks with futures based on the US market and fundamentals have a very high basis risk (the difference between the futures price and the spot price).
  • Futures exchanges require high initial margins of around 8-10% meaning the position is leveraged up to 10x. Considering high position values, this results in very high entry costs for a farmer who needs to deposit this amount up front.
  • Opening and managing a position on a futures exchange comes with additional brokerage, exchange and clearing costs. To trade on the exchange you need to go through a complex- and involving onboarding process.
  • Futures contracts typically come in 50-150 metric ton lots, which does not allow people to precisely hedge the exact amount exposed to a risk (eg. yield expected by the farmer).

Farmers need a stable income to fund their operations, pay for their inputs (seeds, fertilizer, herbicide, pesticide, machinery, fuel, labor) and for their land. A good price for the crops harvested or financial compensation when this price is insufficient, will contribute to an economically viable operation. This post will explain the option to effectively hedge the price risk using perpetual contracts and compare this to the alternative hedging instruments such as futures contracts.

The financial environment of a farmer

For the scenarios presented here we will assume a context where a farmer is growing 800 hectares of wheat in Australia and exporting through the port of Adelaide. On average over the past 10 years the farm has been producing 2-2.5 tonnes per hectare and the rough estimated average price observed in the past 10 years is approximately USD 6.5 per Bushel. The farmer has defined a conservative target for this year, with a break-even price of USD 6.0 per Bushel and an estimated yield of 80% of 2.25 tonnes per hectare. With 1 bushel representing 0.0272 metric tonnes, we find that the required yield for the farmer this year needs to represent the following value;

800 * (0.8 * 2.25) ÷ 0.0272 * 6.0 ≈ USD 317,647

Note: normally we should also reserve the costs for the logistics to transport the grain to the port. This is all assumed to be discounted in the price and therefore financed by the buyer.

What follows are two scenarios that the farmer could face. Scenarios that affect the yield (harvested crops) or price, and therefore impact the potential income of the farmer. For each of these scenarios we demonstrate how the farmer could employ Vosbor perpetual contracts to hedge their price risk and retain a stable, good enough, income.

Scenario 1 “Good year for Australian Wheat”

In comparison to the other Wheat producers in the World, Australia is preparing for a great year, where prices are well above the global market prices offered. At the time of planning the farmer observes a spot price for the wheat index on Vosbor of USD 6.2 per Bushel, which is identical to the future price quoted in the May contract for wheat. The farmer decides to open a USD 320,000 Vobor perpetual short position at a price of USD 6.2 per Bushel (51,613 contracts) with an investment of USD 32,000. Thus the farmer invests with a leverage of 10x.

In the example Vosbor uses a 3% maintenance margin requirement for this perpetual contract. This 3% maintenance margin requirement means that the farmer will be automatically liquidated only when his investment reaches a leverage of 33x as a result of a price hike of the index. So the Farmer needs to keep his margin account above USD 9,600, which would be the balance when the index price increases with more than 7%, this to avoid an auto-liquidation trigger. If the price is approaching USD 6.63 (close to +7%) per Bushel, the Farmer should add funds to not lose his position.

Fortunately the price first decreases to USD 6.0 per bushel and then after spiking to 6.45 in June settles at 6.3 in September at the time of harvest. Since the Vosbor Index is representative for the region of the farmer, the base is small at harvest. The farmer now sells the harvested wheat at USD 6.3 per bushel. And closes the perpetual short position with a loss at USD 6.3 per bushel.

The effect of these transactions are:

Sale:

800 * (1.0 * 2.25) ÷ 0.0272 * 6.3 ≈ USD 416,912

Note: 1.0 represents 100% harvested crops in our scenario

Performance hedge:

51,613 * (6.2 - 6.3) ≈ USD -5,161.3

The position has been open for 150 days (early May - end of September), and in this time the perpetual has been higher than the Index (wheat price traded on the platform) for 100 days.

Funding premium received:

Every 8 hours a funding fee to be paid or received by the farmer is calculated. The funding fee depends on the current funding rate, position size and current price of the asset:

Funding Fee = Position Size * Mark Price * Funding Rate

Example below presents the formula used to calculate the funding fee at a time, when for the last 8 hours perpetual contract was on average trading at a higher price than the index (in this case farmer who has a short position open receives funding):

51'613 * $6.20 * 0.0005% ≈ $1.60

As funding fee is paid or received every 8 hours, the total funding paid or received by the farmer is a sum of all fundings settled during 150 day when the farmer had the position open. Assuming an average funding rate of 0.0005% / 8hrs (0.0015% / day) we expect to receive the following roughly estimated funding premium:

51,613 * 6.2 * ((100 * 0.000015) - (50 * 0.000015)) ≈ USD 240

Note: from the 150 days that you had an open short position 100 days the perpetual was trading at a higher price than the index.

So, the total performance of the sale including the hedge is:

USD 416,912 - 5,161.3 + 240 ≈ USD 411,991

Alternatively the Farmer could have decided to hedge the price risk using futures contracts. For this the farmer is using the most liquid futures that are available on Chicago Mercantile Exchange (CME). The farmer decided to sell futures in May at a price of USD 6.2 per Bushel, and then to buy these contracts in September just before the contract was supposed to be delivered.

Note that it is more likely to find a CME future price that does not reflect the fundamentals for an Australian farmer. We would expect to find a base difference, but for the simplicity of our calculation example we reflected this to be the same as the Vosbor wheat index price that represents the price for the Australian farmer.

The contract at CME is priced 620 U.S. cents per Bushel, with a minimum contract size of 5000 Bushels. We need to sell contracts that matches:

800 * (0.8 * 2.25) ÷ 0.0272 ≈ 52,941.18 Bushels

Note: Which considering the contract size, comes down to 11 contracts.

The margin requirement (initial margin) is 10% of a 5,000 Bushel wheat contract. To sell 11 contracts, the farmer needs to fund and maintain the following margin level:

10% * 11 * 5,000 * 6.2 = USD 34,100

With a maintenance margin set to 9.1%. Which means that whenever the future price falls below 9.1%, you receive a margin call and need to add funds to move your margin balance to at least USD 34’100 (the initial margin level). In September the farmer buy’s 11 contracts for USD 6.3 per Bushel. And sells his harvest for USD 6.3 per Bushel. These transactions result in the following proceeds:

Sale:

800 * (1.0 * 2.25) ÷ 0.0272 * 6.3 ≈ USD 416,912

Note: 1.0 represents 100% harvested crops in our scenario

Performance hedge:

11 * 5,000 * (6.2 - 6.3) ≈ USD -5,500

There are further costs associated with the futures option. You also need to pay brokerage fees. But ignoring that for now, the overall result is:

Overall result:

USD 416,912 - 5,500 ≈ 411,412

Scenario 2 “Long, warm and dry summer”

This year the summer has been a long dry one. There was not enough water to irrigate and grasshoppers were destroying the crops. Historically these situations have resulted in 20% crop loss despite pesticides treatment. You with your current state of crops could expect not more than USD 5.2 per Bushel.

At the time of planning (well before disaster strikes) the farmer observes a spot price for the wheat index on Vosbor of USD 6.2 per Bushel, which is identical to the future price quoted in the May contract for wheat. The farmer decides to open a USD 320,000 Vobor perpetual short position at a price of USD 6.2 per Bushel (51,613 contracts) with an investment of USD 32,000. Thus the farmer invests with a leverage of 10x. Since the Vosbor Index is representative for the regions of the farmer, the base is small at harvest. The farmer now sells the harvested wheat at USD 5.2 per bushel. And closed the perpetual short position with a profit at USD 5.2 per bushel. The effect of these transactions are:

Sale:

800 * (0.8 * 2.25) ÷ 0.0272 * 5.2 ≈ USD 275,294

Note: 0.8 represent a loss of 20% on the harvested crops in our scenario

Performance hedge:

51,613 * (6.2 - 5.2) = USD 51,613

The position has been open for 150 days (early May - end of September), and in this time the perpetual has been lower than the Index (wheat price traded on the platform) for 50 days. Assuming an average funding rate of 0.0005% / 8hrs (0.0015% / day) we also receive the following funding premium:

Funding premium received:

51,613 * 6.2 * ((50 * 0.000015) - (100 * 0.000015)) ≈ USD -240

So the total performance of the sale including the hedge in this example is:

USD 275,294 + 51,613 - 240 ≈ USD 326,667

Would this trader have used futures to hedge its position then we would have found the following.

Sale:

800 * (0.8 * 2.25) ÷ 0.0272 * 5.2 ≈ USD 275,294

Note: 0.8 represent a loss of 20% on the harvested crops in our scenario

Performance hedge:

11 * 5,000 * (6.2 - 6.3) = USD -5,500

Note: since this was a local disaster. Futures at CME traded at 6.3 (not 5.2)

As the markets represented by the futures were not exposed to this scenario like the one that the farmer was facing, the futures hedge ended up introducing a further loss. At harvest it represented USD -5,500 value. Because of the base price difference the farmer could not make the required USD 317,647. He now actually has to incur a total loss of 42,353 + 5,500 = USD 47,853.

Conclusion

Perpetual contracts offer an interesting new way to hedge price risk. Perpetuals can be based on a price index that closely resembles the fundamentals for the farmer, therefore reducing the basis risk. In other words, correlation is significantly improved. Margin requirements are reduced and additional brokerage, exchange and clearing costs can be much lower than in traditional futures market environments. Plus, the onboarding process is more efficient, because of the reduced involvement of third-parties.

The farmer will however need to monitor the perpetual position more actively and there is a risk of auto liquidation, but only at well defined ratios of margin and taking into account the size of the position. No wipe out after a missed margin call however!

The index follows the spot price of the selected index and synchronizes every X hours (funding cycle). All the time that a perpetual moves against the contract (e.g. the perpetual is developing a loss) an additional premium (funding rate) is received, as per funding cycle every X hours. Effectively, ensuring that perpetuals trade much closer to the physical spot index price. This gives farmers the opportunity to sell their crop when they want to sell and food manufacturers the option to buy ingredients when they need them (ultimately exchanging the perpetuals for physical contracts).

One more step in our mission to build the infrastructure for the future of food security!