Unravelling the mysteries of wool futures markets

Press, 28 March 1980, Page 15

Unravelling the mysteries of wool futures markets

Wool futures must be a mystery to many woolgrowers, although they may know that it is a device by which somehow they may ensure in advance the sort of price they are going to receive for their wool. It is something over and above the Wool Board’s minimum price scheme and the Government’s supplementary minimum price scheme.

The item which follows is an attempt to spell out what is involved on the basis of information supplied by the Christchurch firm of wool buying brokers, John Marshall and-Co., Ltd. Futures markets, often called terminal markets in London, grew out of trade in . agricultural commodities. With the expansion of world trade in the nineteenth century producers, merchants, manufacturers, and consumers found, it necessary to have a method of insurance .against violent fluctuations in commodity prices which can result in heavy financial loss for buyers or sellers. A manufacturer, for example, .wants to buy supplies of the raw material that he needs at a fixed pried 1 in the foreseeable future. Similarly the grower of a crop wants, an assured market price for his produce several months ahead when his crop is harvested. Likewise the international merchant wants to protect himself against adverse price movements between the purchase of a commodity from the producer and its sale to the consumer.

By using the facilities of the futures markets growers, merchants and manufacturers can

“hedge” their purchases or sales — in other words secure themselves againstmaking a serious loss. The futures markets provide a mechanism by which risk can be transferred to others willing to bear it. It is a method by which the farmer can fix his income from wool within fairly narrow bounds.

Now how is that all done? To achieve the transfer of risk already mentioned a highly standardised system of futures contracts has been worked out. under which, for instance,. a grower undertakes to sell a specified grade and quantity of a commodity for delivery in a given month -in the future. Futures contracts can, incidentally, be sold or'’ bought according to whether a person is a seller like a grower or a purchaser like a manufacturer.

Normally in practice a futures contract is not used to make delivery of a commodity. When the grower, for instance, is no longer exposed to risk — when he has sold his wool at auction — the “hedge” or insurance against loss is lifted by him purchasing a futures contract for his wool — in other words an offsetting or opposite sale or purchase of futures contracts is made.

An important function of futures markets is the establishment of prices for raw commodities. These are determined by the free interplay of opinion of growers, merchants and manufacturers and in' the case of wool are extensively used in determining wool auction prices. ' Now let us take this a little further in an example of what can actually happen. In January farmer Brown thinks that prices then ruling for wool are attractive, being either slightly or considerably - above his expectations. But he will not be shearing for some time and is unable to sell his wool until May. He can sell futures contracts in January for delivery of his wool in May and if the market has dropped by the time his wool is auctioned he can buy back his futures contracts at a lower figure than he sold them at, which means that he has made a profit on his futures trading. In January the actual auction price is 300 c per kg greasy. He then sells one futures contract for about, each 21 bales of wool so for a 100-bale clip there would be. five contracts.

At that time the futures price for May delivery is 420 c per kg on a clean basis — all futures quotations are expressed in clean terms on the basis of the results of a core test. So if a farmers wool is worth 300 c in the grease and the yield of the wool is 80 per cent the clean price of 375 c is calculated by multiplying the greasy price by 100 and dividing by 80. By May the auction price in the grease has dropped to 260 c — a fall of 40c. As soon as farmer Brown has sold his wool in May — on the same day or as near to it as possible — he instructs his futures broker to buy back his futures contracts. The futures price is then 380 c per kg clean. Thus he has made 40c per kg on the deal less commission paid at the rate of $4O on each contract bought or sold, which spread over about 2500 kg of clean wool covered by a contract amounts to about 3Jc per kg, leaving a profit of about 361 c per kg. Therefore the drop in auction prices has been minimised to a large extent by using futures. At no time during the period of the “hedge” or insurance against loss does the grower have to put up the full value of the contract which at 420 c per kg clean could amount to about $lO,OOO. A deposit of $4OO per contract is re-

quired and this is paid back to the farmer when he buys back his contract. If, however, the futures market goes against the farmer, such as happens if he sold for delivery in May at 420 c and by that time the futures price is 450 c, he will be required to pay margins — the difference between the sold price and the actual price on the day — in this case 30c per kg. Thus if wool prices should rise after the farmer has sold his futures contracts he will lose money on his futures as he will have to buy them back at a higher price. But this loss will be offset by the increase in price that he actually receives for his wool. The initial reaction in such a situation might be to say that the farmer would have been better not to have taken futures contracts. But futures “hedging” is a means by which the farmer more or less fixes his income and while he will not enjoy the benefit of an upswing in prices neither will he suffer when they fall. . So with the help of the New Zealand crossbred greasy wool contract No. 2 the .woolgrower can himself stabilise his income.

The New Zealand crossbred fleece wool type 35F2D is used as the basis for the New Zealand crossbred greasy wool contract No. 2, being

46/50s medium crossbred B grade fleece. Although as already stated actual delivery of wool is not normally made under a futures contract, the futures market does take into account interest and storage charges for each month, so the variation between prices quoted for various months will generally increase the more distant the month. On average contracts can be sold up to about 18 months ahead. In the last 100 years growing recognition of the value of futures markets has led to their increasing use by all concerned with commodity trade.