The food industry is extremely risky from the point-of-view of an owner or a supplier. Damage to crops from adverse weather, changes in customers' consumption habits, and issues with suppliers can all thwart attempts to sell the same amount of crops as the year before. Also, food is perishable so issues with the supply chain can likewise have an extremely adverse effect on sales. Common strategies to deal with risk within a supply chain include "raising prices, shutting down factories and shedding less-profitable brands" (Andrejczak 2008). However, there is a limit to the degree to which these measures can truly mitigate risk given that food products often have a very wide array of substitute goods. Also, shutting down various operations may mean that a company is ill-equipped to take advantage of the benefits of a boom the next year, if, for example, there is a bumper crop of strawberries or demand for limes spikes because of trends in cooking. Thus, yet another vital strategy to protect companies from financial damage is hedging through a more formal risk management strategy.
"Food makers use hedges to protect against sudden price moves, smoothing out some of the peaks and valleys in the commodities market by managing risk through futures and options. This gives them a better idea what costs they are likely to encounter in the months ahead, crucial to budget planning" (Andrejczak 2008). This paper will summarize how various hedging strategies can support the growth of Thomas Foods, a produce vendor that sells produce purchased from farmers to major grocery retailers across the country. "Food makers have for decades hedged their exposure to price volatility…similar to what the airline industry does with fuel. Southwest Airlines Co. is well-known for its success in holding down costs by making the right bets on oil prices, giving it a big advantage over competitors as oil prices hit record highs" (Andrejczak 2008). Making the correct hedging decisions regarding the costs of produce can be the difference between profitability and insolvency for a company like Thomas.
Hedging and forward contracts
The most common strategy for food companies include "entering into long-term forward contracts for physical delivery with…suppliers…To protect against price fluctuations, a food company will buy a futures or options contract" (Andrejczak 2008). This effectively allows the company to 'lock into' a particular price, based upon past patterns in demand and allows for a more effective and measured pricing approach. Of course, the detriment of this policy is that if prices become more advantageous, the food company may lose out on the potential for more profits. Furthermore, given that the prices of food have been in such a determinedly upward spiral, it is also possible that suppliers may be reluctant to enter into such arrangements at all, given the fact that market trends seem to be determinedly upward.
This type of hedging can be accomplished by hedging in the futures market and forward contracting. "Both types of contracts allow producers to buy or sell a specific crop at a specific time at a given price" (Contracts, 2014, Agriculture and Agri-Food Canada). In the case of hedging in the futures market, "producers protect themselves from price risk, but remain exposed to basis risk. With forward contracting, producers secure a price for their crop prior to harvest and eliminate both price and basis risk" (Contracts, 2014, Agriculture and Agri-Food Canada). Basis risk is "the risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position" (Definition of basis risk, 2014, Investopedia). Thus, with forward contracting there is the danger that risk may actually be exacerbated rather than mitigated (the risk for excess profits, of course, is also present, as well as excess losses).
Futures contracts "have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never. Futures contracts are marked to market daily, which means that daily changes are settled day-by-day until the end of the contract. Settlement can occur over a range of dates" (Contracts, 2014, Agriculture and Agri-Food Canada). In contrast, forward contracts have a single settlement…