Derivatives market FAQ's

Commodity futures contracts (futures) are

• legally binding agreements,
• to provide a precisely defined service
• at a specified time in the future.

A key feature of commodity futures contracts is their mutual fungibility.
The price-setting parameters

• quantity
• quality
• Settlement period and, if applicable
• place of performance

are not negotiated individually between buyer and seller, but are precisely defined in the futures specifications (e.g. 25 tons of processing potatoes ex production site in Germany, the Netherlands, Belgium and France, loaded loose on the buyer's means of transport). This exact standardization is referred to as standardization. It does not mean that you can only participate in futures trading if the goods actually traded (e.g. the potatoes purchased on the spot market) correspond exactly to the given specifications. On the contrary, you can also participate in commodity futures trading if you trade deviating commodities on the spot market or do not want to buy or sell any commodities at all.

Commodity futures contracts are traded on commodity futures exchanges. Exchanges are highly organized market events that are precisely regulated in terms of location, time, market participants and procedure. Due to modern communication technologies, many of these are computerized exchanges. Supply and demand flow together via an electronic network and are bundled in a central computer. As a result, you can participate in trading regardless of your location.

In theory, anyone can participate in commodity futures trading. However, certain requirements must be met, which may vary from exchange to exchange. As with the opening of a securities account, the applicant's experience, objectives and financial situation play a role in the personal requirements. These aspects also determine the extent to which the respective market participant may trade. Technical requirements include an account with an affiliated clearing bank and a contractual agreement with an affiliated broker.

What all exchanges have in common is that the orders converge at a central location (trading floor or central computer). However, there are differences with regard to order entry. So-called proprietary traders (persons who trade for their own account) can enter orders directly into the electronic trading system or have a registered office at floor exchanges. For all other market participants, orders are entered via a broker, to whom the bids are transmitted verbally, by telephone, fax or computer. On exchanges with an electronic trading system, the incoming orders are stored and executed when there are sufficient orders. In the case of floor trading exchanges, the broker takes care of the execution of the order on site.

As all price-forming parameters are standardized for commodity futures contracts, order execution essentially depends on whether another market participant is prepared to buy (sell) the offered (demanded) contracts at the desired price. The type of order selected by the market participant is also relevant. Let's assume that an entry trader wants to sell 20 contracts of potatoes at the best price, then this order (usually called a market order) could be executed immediately at a uniform price if the order situation is good. However, it would also be conceivable for ten contracts to be traded at the best possible price and ten contracts at the second best possible price. If the market depth is low, there could be partial execution due to a lack of buying interest. In this case, a limit order is recommended in which, for example, 15 contracts are traded immediately and the other five remain in the system for the time being at a limited price. Such a partial execution could also be prevented with an all-or-nothing order. The most frequently used order type is the limit order. It is only executed if the market price is above (sell order) or below (buy order) the limit or reaches it.

The willingness to buy and sell is expressed by the bid and ask prices. The bid price is the price that a buyer is prepared to pay for the future and for which there is currently no offer. The ask price is the price that a seller demands for the future.
Assuming the equilibrium price for a potato contract is 20, the order book could look as follows:

• Quantity (volume)
• Bid
• Ask
• Quantity (volume)

The number columns show how many contracts are offered (ask) or demanded (bid) at the respective price. In the example, 5 contracts would be for sale at a price of 20.1. The number of contracts requested at a price of 19.9 would be 20. The difference between these best prices (the highest bid to buy and the lowest offer to sell) is referred to as the bid-ask spread - in this case 0.2. The narrower the bid-ask spread and the greater the market depth, the more efficient an exchange is. A market is described as deep if there are sufficient orders that are close to the equilibrium price and are also staggered in depth (in the example, there are 20 buy bids at 19.9. If there were only two, the market depth would be lower).

The terms are used in the above order for the opening, high, low and closing price in a session for each contract. According to the term, the opening price (closing price) is the price of the first (last) trade of a day and the highest price (lowest price) is the price of the highest (lowest) trade at the time of inspection.

The closing price of a trading day is the price of the last trade. The settlement price is the valuation price that is decisive for the daily profit and loss calculation. It can correspond to the closing price, but is also often calculated from the last transactions of a day.

When a contract is sold, it is not another exchange customer who is the contractual partner of the seller, but a clearing house is interposed between the two market participants. The offsetting position for all contract purchases and sales is taken by this clearing bank. It gives all exchange traders a performance guarantee. The contracting parties therefore have no default risks to fear. The clearing bank also ensures the anonymity of exchange trading.

If contracts are traded and corresponding futures positions are opened, commissions must be paid by the buyer and seller and collateral must be deposited. The institutions/companies involved in trading (broker, exchange, clearing house of the exchange, clearing bank and a security fund) are compensated for their services with the commissions. The amount of the initial margin depends on the current price level, the current and/or historical price fluctuations and the creditworthiness of the trader. It is usually only a fraction of the contract value and is intended to cover the loss in value that can be suffered per contract within a specified period. A loss in value occurs if the contract price changes to the disadvantage of the position holder (either a price increase after selling or a falling price after buying). The initial margins described are an essential component of a collateral system that guarantees the fulfilment of transactions on exchanges.

In commodity futures trading, the holders of long positions are referred to as long (in futures) and the positions as long positions. Similarly, holders of short positions are short (in the future). The terms can also be used for trading in physical goods. In this case, farmers who produce potatoes or already have them in stock and only want to sell them later are described as long in the commodity. In the spot market, for example, potato processors who have not yet sold produced goods are short. It is therefore advisable to buy futures contracts and hedge against the risk of rising prices because they do not yet own the goods, e.g. processing potatoes.

From the time the position is opened, a profit and loss calculation (mark-to-market method) is carried out for each buy and sell position. If a market participant has sold (bought) contracts, the increase in value (loss in value) of the positions is credited (debited) to his account if prices fall. If, on the other hand, prices rise, the buyer receives a credit, while the seller's account is debited. The recorded changes in value are called variation margins. If the price continually changes to the detriment of the position holder, his account is repeatedly debited. If there is a shortfall, the position holder receives a margin call.

By standardizing the contracts, buy or sell positions can be opened at any time if the order situation is right. At the same time, standardization also enables the reverse process, i.e. the closing of positions before a contract matures. Since contract conclusion and fulfillment in commodity futures trading - unlike spot trading on the cash market (e.g. delivery in the harvest) - are sometimes far apart in time and the contractual partner is always the exchange's settlement office, the obligations entered into can be discharged in the meantime by means of an offsetting transaction. Experience has shown that almost all market participants make use of the process known as "closing out". To do this, a seller (buyer) must buy (sell) contracts corresponding to the number of his open positions before maturity and thus liquidate his exchange positions.

Open interest is the number of open futures positions. If a contract is traded, the trading turnover is 1 and the number of open positions is also 1 (a buy and a sell position together result in the open interest of 1. If the seller closes out his position by buying and another market participant sells, the turnover increases to 2, while the open interest remains the same, because now only one other market participant holds the sell position. Since the number of open buy positions always corresponds to the number of open sell positions, either only the bought or the sold contracts are counted.

If positions are still open after the last trading day, i.e. have not yet been closed out, the holders of open short positions (buy positions) in futures with physical settlement must deliver (take delivery of and pay for) a precisely defined quantity and quality of a specific underlying commodity at the location(s) specified in the specifications. In contrast, in the case of futures with cash settlement, all positions that are still open after the last trading day are settled against a reference price (usually a price index). As the profit and loss settlement has already taken place daily up to this point, only the last day's difference to the index is credited or debited to the accounts of the participants. Physical delivery, i.e. actual delivery, is excluded in this procedure as fulfillment of the performance obligation.

On commodity futures exchanges around the world, market participants can benefit from numerous tried and tested functions. These are based on the special features of commodity futures trading described above and can be divided into individual and macroeconomic functions.
Functions from an individual company perspective:

• Information improvement (price transparency/guidance function)
• Risk reduction (price and calculation security)
• Capital procurement aid (improvement of creditworthiness)
• Investment opportunity (speculation)

Functions from a macroeconomic perspective:

• Compensation of temporal or spatial imbalances
• Promotion of competition

On exchanges, the market assessments of numerous market participants flow together in bundled form. The available information is priced into the individual orders/futures quotes. As these are published by data providers, on the Internet and in print media, commodity futures exchanges are suitable for increasing market transparency and homogenizing the level of information. In this context, one speaks of a price guidance function, as the contract prices ideally reflect future market conditions reliably, so that they are used by companies in the agricultural and food industry as a basis for their production and marketing decisions. Futures prices can also serve as a reference price for spot or forward transactions on the cash market (EFP - see point 24 below). Anyone can benefit from the advantages of improved information without having to participate in the exchange themselves. Price transparency thus makes a significant contribution to promoting competition.

Market participants on commodity futures exchanges are generally divided into four groups (hedgers, speculators, arbitrageurs and spread traders). All of their transactions can be traced back to the motives of risk management and profit realization, although their weighting varies from participant to participant.

• Hedger: Hedgers are market participants who open stock market positions in order to hedge against changes in the price of the commodity they wish to buy or sell on the spot market in the future.
  The positions entered into are usually liquidated again at the time of the flow of goods. Therefore, such a price hedge can also be regarded as a temporary substitution of the existing or expected spot transaction: Someone who wants to sell (buy) goods in the future sells (buys) them early on the stock exchange and later liquidates the fulfillment obligation he initially entered into. A hedger therefore always operates on both the spot market and the commodity futures market. Hedge transactions aim to ensure that losses caused by price changes on the spot market are largely compensated for by increases in the value of the exchange positions and that the hedger thus achieves price and calculation certainty at an early stage (compensation transaction).
• Speculators: Speculators are market participants who consciously accept the risk of price/rate changes because they expect to make a profit. Speculators sell (buy) futures when they expect prices to fall (rise) and speculate on being able to close them out later at a lower (higher) price. Accordingly, they generally have no interest in owning the commodity and are almost exclusively active on the stock exchange. Speculators belong to the group of people who assume the risk of the hedgers. With the liquidity they provide, they make an important contribution to the functionality of the market.
• Arbitrageurs: Arbitrageurs attempt to profit from temporal or spatial price differences between futures or between futures and spot commodities by simultaneously taking opposite positions on different markets.
  For example, if a potato trader arbitrages between two potato futures of different specifications, he sells processing potatoes at the higher price and buys table potatoes at the lower price. The same applies to arbitrage between a future and the spot commodity: for example, you buy the cheaper commodity and sell the more expensive future. He resolves the arbitrage by later entering into an offsetting transaction in both contracts. If the price difference has shrunk or disappeared over time, he has made a profit. Arbitrage transactions are less risky than purely speculative transactions in which one bets on rising or falling prices. Through their transactions, arbitrageurs balance out temporal and spatial imbalances and thus inevitably bring about largely uniform pricing.
• Spread traders: The aim of a spread trader is to exploit an expected change in the price difference between two futures (widening or convergence) to make a profit.
  Spread traders build up opposing positions (buying and selling either in the same future with different maturities or in similar futures) and liquidate them again at a later date. Accordingly, there are similarities between spread trading and arbitrage. However, since spread traders generally have no interest in owning the commodity and their transactions are associated with a higher risk, spread trading can also be seen as a special form of speculation.

In a price hedge, the hedger temporarily replaces an existing or expected transaction in spot commodities with a substitution transaction in futures. He is someone who wants to sell (buy) goods in the future, sells (buys) them early on the stock exchange and later liquidates his initial fulfillment obligation. With this transaction, the hedger wants to ensure that impending losses from the spot position are compensated as fully as possible by gains from the stock market position and can therefore calculate in advance with a fixed price (margin protection). In return for this gain in security, however, he also accepts that higher profits in the spot position will be eroded by the simultaneous loss in value of the forward position. A buyer therefore forgoes the opportunity to profit from falling spot market prices and a seller gives up the chance of higher proceeds from rising spot market prices. How this works is explained below for buyers (long hedgers) and sellers (short hedgers). For the sake of simplicity, it is assumed that the futures price and the spot market price in both examples are at the same level at the time of the flow of goods.
In summer, a producer of French fries wants to hedge the purchase price for the processing potatoes to be processed next spring in order to compensate for the risk of rising potato prices. To this end, it buys processing potato futures with a term of April on a commodity futures exchange in June. The price is €15 per tonne. At the time of the potato purchase on the spot market (end of March/beginning of April), the processor closes out the exchange positions entered into in June of the previous year. If the price has risen to 25 €/dt over time, the chip manufacturer must pay 25 €/dt for the potatoes purchased on the spot market: The high purchase price can be offset against the stock market profit of €10/dt, so that their purchase price ultimately amounts to the €15/dt hedged in June. The €10/dt stock market profit results from the increase in value of the positions, which can best be illustrated by comparing the opening and closing prices: The factory bought processing potato futures at €15/dt in June and sold them at €25/dt in the spring. If potato prices had fallen to 11 €/dt over time, this would not have changed the final purchase price of 15 €/t. In this case, the factory would only have to pay 11 €/t to the seller of the potatoes, but the stock market position would have lost 4 €/dt in value over time.
The example of a purchase described above can be applied analogously to the seller of the potatoes. For example, a mail-order retailer could have hedged a selling price of €15/dt in the fall by selling futures with an April maturity. In the first scenario, he would have received €25/dt from the mill for the potatoes in the spring and at the same time would have suffered a €10/dt loss in the value of his stock market position. In the second scenario, he would have been able to add a stock market gain of € 4/dt to the selling price of the potatoes (€ 11/dt).

The core benefit of price hedging is that companies have the opportunity to fix prices for future sales or purchases of goods at an early stage. Ideally, the economic result of a production or processing transaction can therefore be largely determined months in advance. The same applies to the future margin of a trading transaction. This gives companies a fixed calculation basis to which they can adjust their cash flows and leads to an overall stabilization of their business results. These positive effects are also rewarded by the banks. As the risk content of a loan has a significant impact on its structure, risk-mitigating management instruments have a reducing effect on loan conditions.
In addition, price hedging has a positive effect on a company's positioning and marketing opportunities. As trading on commodity futures exchanges is anonymous, market participants have the opportunity to conclude forward-looking transactions without their marketing partners or competitors becoming aware of them. In addition, they can liquidate the fulfillment obligation associated with the futures transaction at any time by smoothing the position. Futures trading on the futures exchange therefore has the advantage that it is much more flexible than an individual forward transaction and can therefore react to new market conditions at very short notice. Overall, the bundling of supply and demand reduces companies' search or waiting costs and at the same time increases their competitiveness. In addition to these advantages, price hedging can also be used to consolidate or expand existing marketing relationships and to establish new ones. Potato traders can issue fixed prices to producers at an early stage on the basis of price hedging and thus also provide them with planning security.

There is a close correlation between the spot market price of a commodity and the corresponding futures price: In contracts that are settled with an index, such as EUREX potato futures, the settlement price on the last trading day is the index. The price difference between the spot price and the index is called the basis.
For agricultural products, one counts

• differences in quality
• transportation costs to the place of delivery
• holding costs and
• collection and handling costs

are among the factors influencing the basis.
The basis is specific to the respective region and the respective point in time. It can fluctuate over time and assume both negative and positive values. With regard to price hedging, it is important to know your own basis. This is the only way to estimate the price that can ultimately be hedged for the company. If the potato future with the term April is quoted at 15 €/dt in January, i.e. four months before maturity, and the average basis of a mail order company is -2 €/dt, the price it can hedge is 13 €/dt. Consequently, futures quotations cannot be transferred 1:1 to your own company. The effectiveness of price hedging also depends on the value of the basis at the time the position is closed. If it corresponds to the expected basis taken into account in the hedger's calculation, the losses from the cash market transaction are fully offset by the increase in value of the exchange position and vice versa. However, if the basis changes, the result achieved deviates from the calculated result. If the potato trader in the example calculates with a basis of -2 €/dt, so that he would have to realize a price of 13 €/t, and the basis ultimately amounts to -1 €/dt, he can record a price of 14 €/dt, contrary to his expectations.
The price relationship between markets, in this case between the cash market and the futures market, is based on the possibility of arbitrage. If the futures quotation exceeds the spot market price by a higher amount than the usual basis, a trader could buy potatoes on the spot market and sell futures on the commodity futures exchange to make an almost risk-free profit. His demand on the spot market increases the price of the physical commodity, while at the same time his sales on the exchange push down the price of the futures. This brings the prices down to the usual difference.

Premium transactions combine the advantages of a forward spot transaction with the benefits of price hedging on commodity futures exchanges. They represent the optimum solution for many contractual relationships.
The supplier and buyer (e.g. a mail-order company and a potato processor) conclude a private-law purchase contract that covers all essential elements (quality, place of delivery, delivery quantity, delivery date and price). However, the price chosen is neither a fixed price nor the future spot market price, but the price of the corresponding potato futures valid at the time of delivery plus/minus a premium (bonus/penalty). The contracting parties therefore accept the futures quotation as a fair settlement price, eliminating the need for time-consuming price negotiations that could jeopardize the transaction. By concluding the contract, they generate early sales and procurement security. In addition, they obtain the price and calculation security resulting from price hedging, as a premium transaction provides for the exchange of a corresponding quantity of exchange contracts at the time of delivery of the goods. Accordingly, both buyers and sellers will build up exchange positions over time, whereby they choose a favorable point in time for this regardless of the contractual partner. This enables the buyer to realize a purchase price that is lower than the price that the seller ultimately achieves for his potatoes by offsetting the exchange transactions. The terms EFP transaction (Exchange of Futures for Physicals) and against actuals result from the described exchange of futures positions at the time of delivery. This exchange liquidates the exchange positions and thus the fulfillment obligations of both contracting parties. As the positions are settled independently of other market participants, the market depth of the exchange no longer plays a role for either contracting party once the position has been opened. The same applies to possible changes in the basis, as the basis is determined by the premium specified in the private-law contract.

In addition to futures, other products are traded on the major futures exchanges. For the agricultural sector, the next most relevant group is options, which are briefly outlined below.
The holder of an option has the right, but not the obligation, to buy (call) or sell (put) a futures contract at a fixed price within the option term. This indirectly gives rise to the right to purchase or deliver the commodity underlying the future. The advantage of options is that the option can also be allowed to expire. The buyer of a put (call) therefore still has the opportunity to profit from rising (falling) spot market prices. The risk of loss is therefore limited to the option price.