Minimizing Risks for Produce Buyers

Thomas Foods -- Hedging Strategies

If Thomas Foods expects to protect itself against suddenly rising prices that farmers charge for their produce -- due to crop failures, inclement weather, or other unexpected events -- then Thomas Foods needs to engage in some form of a hedging strategy. There are a number of ways to do this, and this paper will point to several strategies and models that might work for Thomas Foods. At a minimum, the comptroller at Thomas Foods should be knowledgeable about ways to protect his company from suddenly skyrocketing produce prices

What are "futures"? The available literature on ways to protect a company like Thomas Foods from suddenly being stuck with prices from farmers that are well above what was understood at the outset of the contract -- is to buy futures. A future is a financial deal signed as a contract that obligates the "…buyer to purchase an asset (or the seller to sell an asset)" such as produce from farmers at a "predetermined future date and price," according to investopedia.com. For example, say a farmer is producing corn; that farmer could use futures to "lock in a certain price" for his corn, and hence reduce the risk, or hedge the risk against falling prices when the harvest is ready (investopedia.com). Thomas Foods could also buy futures to lock in the price it pays the farmer for corn.

What are "options"? In many cases, options pertain to the stock market; an investor engages in a securities contract, a "call" or a "put" that gives the investor the right to either buy ("call") or sell ("put") an asset (or an equity) at a "predetermined price" (called the "strike price") at a predetermined window of time (with an understood "expiration date") (investorplace.com). The "calls" offer the buyer (in this case, Thomas Foods) the right, "but not the obligation," to buy a product or asset at a specified price in a certain window of time (investorplace.com). On the other hand, the "puts" offer the purchaser the right (but again, not the obligation) to sell a product or asset. The "put" would be on the farmer's end; the "call" would be done by Thomas Foods.

What is a "forward contract"? This is a private contract between say, Thomas Foods and a farmer; Thomas Foods agrees to buy and the farmer agrees to sell a "specific quantity" of produce at a price indicated in the contract (finweb.com). For example, before planting his strawberries, the farmer signs a deal with Thomas Foods, locking in a price for 7,000 pounds of strawberries at $2.50 a pound. Thomas Foods has thus pre-purchased those strawberries at a fixed price, assuring that even though the cost of strawberries may go up for others, Thomas Foods knows how much it will pay. Both parties "sacrifice the possibility of getting a better price"; but then "eliminated the risk of getting a worse price" (finweb.com).

Advantages of forward contracts: a) offers a "complete hedge"; b) can be written "for any amount and term"; disadvantages of forward contracts: a) "requires tying up capital; b) "difficult to find a counterparty (no liquidity)" (UAH). Advantages of futures contracts: a) plenty of liquidity; b) easy to reverse position; and c) doesn't tie up a lot of capital; disadvantages of futures contracts: a) is only a "partial hedge"; and b) subject to risk, as bond issuer can default (UAH). Advantages of options: a) limits possibly losses but doesn't limit possible gains; b) does not tie up large amounts of capital; and c) positions can be reversed; disadvantages of options: a) very little liquidity; b) written for fixed amounts; c) subject to "basis risk"; and d) is only a "partial hedge" (UAH).