Farmers are no strangers to the unpredictability of the markets every year. The prices for agricultural products vary each season due to the ever-changing levels of demand and supply, and periods of high supplies often result in decreased prices. To minimize the associated risk and help ease the strain and difficulty that comes with it, farmers should consider using a hedging strategy to lock in prices in higher-priced periods.
What is Hedging
Hedging is simply a strategy that seeks to limit risks in financial assets. A hedge is an investment position that intends to offset potential losses or gains that may be incurred. While this might seem like a complicated concept, it is an efficient strategy for turning a profit even during a difficult period.
Benefits of Having a Hedging strategy
It Safeguards Against an Abundant Yield
Depending on whichever strategy you use, hedging can make profits more consistent by initiating a floor or ceiling for prices. For example, in predicting an abundant harvest, farmers might want to brace up for lower profits due to the expected surplus by locking in profitable prices for the future. Suppose a farmer can profit on a particular farm produce by selling at the current market price; in anticipation of a reduction in profits, they will want to lock in a future price above that current market price to lower risk. This will allow them to profit even when the market is in a downtrend.
It Protects Against a Poor Yield
In the same way, an abundant yield can reduce prices, but a poor yield can also be just as detrimental to the profits of a farm. An appropriate hedging strategy can balance costs irrespective of which way the market moves. An excessive change in a dry or wet season can significantly affect the yield of a harvest, reducing supply and profits. Hostile weather can make managing and controlling pests more difficult, which can further reduce the yield. With so many uncertainties potentially endangering profits, it becomes more apparent that developing a solid hedging strategy is essential to the health and sustenance of the farm.
It Provides Opportunities for Farms That Do Not Grow Their Crops
The cattle industry, for example, can suffer the effects of a strong or weak growing season. In a season with poor yield, the cost of raising cattle automatically increases as the price of the farm produce required for feeding may increase as well. If cattle futures trade at a particular ceiling price per pound, and the rancher can turn a profit at a specific floor price per pound, they can lock in the price at the ceiling price to secure profit.
While the possibility of fluctuations in price is there, the benefit of hedging is to increase the chances of turning a profit at the end of the season to remain open for the next.
How Hedging Works
The best way to understand hedging is to imagine it as a form of insurance. When farmers decide to hedge, they insure themselves against a negative market impact on their business.
A farmer who expects an abundant yield of corn during harvest season can establish a price for it and enter into a futures contract to protect against a potential change in prices. A futures contract is a hedging method that allows the farmer to buy corn at a specific price at a set date in the future. Now, he can go about his business without being concerned about a change in the price of corn.
In this example, let us assume that the price for corn during the planting season is $5 per bushel. The farmer then short-hedges his crop by selling the equivalent of his expected yield in a futures contract at that price.
Suppose that six months pass, and the farmer is ready to harvest and sell off at the prevailing market price, but unfortunately, the price has indeed fallen to just $4.2 per bushel. He can then sell his harvest to local dealers at the current price of $4.2 while he buys back his short futures contract for $4.2, generating a net $0.8 profit. He, therefore, has sold his corn at $4.2 + $0.8 hedging profit = $5. He locked in the $5 price when he planted his crop.
Assuming now that the price of corn skyrockets above the price specified in the futures contract to $5.4 per bushel, this hedging strategy would have paid off because the farmer would sell his corn at that market price and repurchase his short futures for a $0.4 loss. His net proceeds are, therefore, $5.4 – $0.4 = $5.
Regardless of whether the price skyrockets or goes below the estimate, hedging helps to ensure that farmers are protected from unexpected fluctuations in prices.
Due to the ever-changing prices of commodities, farmers should frequently analyze their risk exposure and adjust their hedging strategies. Before deciding to use hedging, you should determine whether the potential benefits justify the expense. Remember that the goal of hedging isn’t to make money; it’s to protect from losses.
Whether a farm produces or consumes agricultural produce, hedging can help to minimize risk. However, it is essential to note that every hedging strategy has an associated cost. To engage in one or more hedging strategies, farmers would need to have enough financial backing. This could mean that they would need to take a loan to cover whichever strategy they deploy. While securing a loan can be intimidating and overwhelming, United Farm Mortgage offers you seamless coverage and a hassle-free process.
United Farm Mortgage can get you agricultural loans that best suit you. Our services are structured in your favor to cater to your financial needs, allowing you to scale up your business easily. Our experts have a deep understanding of the agricultural loan process, and with over 35 years of experience, we are equipped with the knowledge to satisfy our customer’s needs.