The Potential Value of Agricultural Trade Options

By Frechette, Darren L. | Agricultural and Resource Economics Review, October 2003 | Go to article overview
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The Potential Value of Agricultural Trade Options

Frechette, Darren L., Agricultural and Resource Economics Review

Hedgers located far from organized commodity exchanges suffer a mismatch between their local prices and exchange prices. Futures and options traded on the exchange may still be valuable to distant hedgers, but only to the extent that basis risk is small. Forward contracting allows hedgers to manage risk using a local delivery price, but the Commodity Futures Trading Commission has long banned the sale of off-exchange options, limiting the opportunities available to hedgers. Recently, agricultural trade options (ATOs) have been introduced as over-the-counter option products designed specifically for hedgers. To date, ATOs have found little interest from potential sellers, but the potential demand for these options may be substantial. This study develops a methodology for measuring the potential value of ATOs. It describes and quantifies the demand for corn ATOs by dairy farms in Pennsylvania and estimates the value these farms might place on ATO contracts offered locally.

Key Words: agricultural trade options, dairy farms, futures, hedging, options, risk management

Futures, options, and forward contracts are traditional risk management tools for controlling price risk in agriculture. Futures eliminate upside and downside risk simultaneously, while options eliminate downside risk without eliminating upside potential, in exchange for a premium paid in advance. Futures and options are highly liquid but are traded only on organized exchanges, resulting in basis risk. Distant hedgers face especially significant basis risk that dissuades them from using futures and options to hedge. Forward contracts can be tailored to local conditions, but their liquidity is typically low or nonexistent. Hedgers must choose among these three risk management instruments or "goods" with different combinations of attributes: liquidity, upside potential, and basis risk.

If it were possible to provide hedgers with another alternative, their welfare might be increased. One such alternative is agricultural trade options (ATOs). ATOs are a risk management tool with the upside potential of exchange-traded options but with little or no basis risk. The result is to combine the positive aspects of options and forward contracts into a new product for hedgers.

For many years, the Commodity Futures Trading Commission (CFTC) has banned off-exchange contracts that involve option-like payoffs. The potential for fraud and misuse has seemed too great to allow option-like contracts to be traded outside of the heavily regulated exchanges. Only recently has serious pressure been mounting to deregulate and allow agricultural trade options contracts to be sold to agricultural producers and agribusinesses. Their notable proponents have included U.S. Senator Pat Roberts of Kansas (Associated Press, 1998), U.S. Senator Richard Lugar of Indiana, then-Treasury Secretary Lawrence Summers, and Federal Reserve Bank Chairman Alan Greenspan (Associated Press, 2000).

ATOs are option contracts sold by licensed merchants, such as banks and grain elevators, to hedgers who negotiate terms directly with the merchant. ATOs provide the upside potential of options contracts without significant basis risk. Another advantage of ATOs is that they do not mandate fixed contract sizes, so small farms and businesses can tailor ATOs to their individual needs.

ATOs have been available (in theory) since the CFTC began a three-year pilot program in June 1998, but the number of merchants licensed to trade them has been negligible. One possible reason for the dearth of merchants is that ATOs are still highly regulated. Capitalization requirements and other regulatory requirements have been dropped or substantially reduced in recent months to help promote the use of ATOs. Pressure to deregulate ATOs further has resulted in a continuing series of revisions to the program since its inception.

It is not yet clear what the eventual response will be to deregulating ATOs, but the tools exist for a serious analysis of the potential benefits from doing so.

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