Farmer Jim Kreutz uses derivatives to soften the blow should the price of feed corn drop before harvest. His brother-in-law, feedlot owner Jon Reeson, turns to them to hedge the price of his steer. The local farmers’ co-op uses derivatives to finance fixed-price diesel for truckers who carry cattle to slaughter. And the packing plant employs derivatives to stabilize costs from natural gas to foreign currencies.
Far from Wall Street, President Barack Obama’s financial regulatory overhaul, which may pass Congress as early as Thursday, will leave tracks across the wide-open landscape of American industry.
Designed to fix problems that helped cause the financial crisis, the bill will touch storefront check cashiers, city governments, small manufacturers, home buyers and credit bureaus, attesting to the sweeping nature of the legislation, the broadest revamp of finance rules since the 1930s.
I don’t want to be overly blunt, but the folks in this article aren’t all that sharp. He could have bought an option on the same crop, and it might have cost him 10 or (at worst) 15 cents a bushel. Price goes down — your option is “in the money” and you either sell it on to a speculator, or you get to the expiry date and you “exercise” the option and somebody has to buy your grain at the “strike price” for which you purchased the option.
Price goes up — crumple up the option and send it to File 13. Sell your grain on the spot market and you’re only out the cost of the option. The only folks more clueless than farmers who purchase bare futures are those who sell commodity grain on the spot market all year long.
Smart farmers will option about a third of their crop on a good “weather rally” (the price jumps because folks are afraid of a drought or a flood or frost or heat or whatever) in the spring. There’s usually a pullback, and then later another mid-summer rally about one thing or another. You option another third of your crop at that price. Finally, if there’s a big autumn bump (and you’ve got a really good idea about your yield) you might option a [i]quarter[/i] of your crop, leaving the last 1/12 as cushion for harvest problems, mis-estimation, and so on.
Now, I’ll try to explain “derivatives” in a separate post, lest this become too long to read.
The term “derivatives” is completely understandable to anyone with at least a bit of calculus under their belt. This construct actually helps you make sense of financial derivatives.
Consider that you car is located at a particular point. Let’s say you’re moving at 40 mph. Speed is a derivative of location.
You’re also at that moment pressing your foot onto the accelerator. Let’s say you’re speed is increasing by 5 mph each minute. After one minute you’re going 45, after two minutes 50, and so on. Acceleration is a derivative of speed.
However, at the same moment you’re pressing the pedal deeper towards the floor, so after one minute your acceleration isn’t 5 mph, but 10, and after two minutes it’s 15. In this case, after one minute you’ll be going about 48 and after two minutes about 62. That’s the third derivative.
You could also be changing the rate at which you’re stomping on the accelerator — for example, if you’re trying to outrun one of our Kansas tornadoes — that’s the fourth derivative.
Here’s the key point: the deeper you get into the derivative structure, the harder it is to predict what will happen to the original underlying factor, in this case “position” of the car.
What caused many of the problems in the financial world was that people were buried deep in the derivative structure, but not related to something as straight-forward as #2 yellow corn. The combination of goof-ball mortgages issued (for political reasons) to folks who probably couldn’t pay them back, sliced and diced six different ways and then buried four or five derivatives deep … was never going to end well.
The problem with current legislation is that few, if any, Congress Critters even understand a basic derivative, let alone have written one to hedge cattle or diesel or corn or copper. That fundamental disconnect has led them to regulate [i]all[/i] derivatives in the same way.
Deep derivatives on goofball underlying ‘assets’ need to be regulated and transparent. They should not be treating my propane vendor’s attempts to secure a predicable price in the same way.
[b]The core problem is a political class completely disconnected from how the real America thinks, works, and does business.[/b]
Somehow it doesn’t surprise me that the Wall Street Journal should not object to financial institutions having a carte blanche to offer the kind of fraudulent financial instruments that brought this economy to its knees. But when it comes to business the WSJ is as uncritical and unperceptive as the HY TImes is to all its liberal obsessions.
Bart,
Nice description of things, and you are right that the folks in the political class know next to nothing about how derivatives work in the real world; well, except for Hillary Clinton’s brief, and very profitable, foray into futures :).
One minor point on your derivatives. Isn’t the first derivative of location (dx/dt) the velocity, not the speed? Also, your farmer may be using futures because of the favorable tax treatment (Sec. 1256 contracts) afforded futures relative to options. All non-LEAPS options income is treated as ordinary income, while 60% of Sec. 1256 contract income is treated as a long term capital gain without regard to the holding period.
And “velocity” is different than “speed” in what way other that 4 syllables as opposed to one?
An additional point I neglected to include — the value of speculators is that they provide “liquidity” to the market, meaning they make it vastly easier for me as a farmer to buy or sell options and the like. Roughly 90% of the non-spot grains market is speculation, which is not a bad thing. Were we limited to about 10% of current volume our derivatives markets would be vastly more volatile, unstable, and difficult to use.
1256 is primarily oriented towards the speculators, with the intent of enough favorable treatment to ensure that those of us who actually need the things — and can take or make delivery as needed — have a liquid enough market to work with. If 1256 goes away we’re screwed, but it’s not generally a factor in our marketing decisions because we have a “cash position,” meaning we’ve actually got the commodity to deliver.
Velocity is a vector function (magnitude and direction), Speed is a scalar function (magnitude). For example 60MPH is your speed, but foreward, reverse, curved or straight is your velocity. Sort of.
Bart,
Sorry for the velocity vs. speed issue. I had that one beat into my head in classical mechanics course at university.
I have a futures question for you. If you sell a corn contract against your crop, what happens if your farm gets hit by a massive hail storm that knocks all the corn stalks over before the ears are mature enough to harvest? Do most farmers put on a hedge for this? If you are short a corn contract, would it be worthwhile to buy a corn put option to limit any potential loss from destruction of your crop, or would you just buy back your future contract in the event of a crop failure?
The linked article confuses commodities futures (which were legitimately traded for well over 100 years with no problems) with derivatives (abstractions based on futures, but without any connection to the actual goods). Futures were traded by farmers and purchasers of agricultural products to protect themselves against price swings and worked well to do that. Recently, derivatives based on futures were created by the Wall Street geniuses as a vehicle for speculation. This led to the the sudden explosion of food prices in 2008 which was not due any actual shortage of food, but was purely due to speculation. As a result, millions starved.
See here:
http://blogs.howstuffworks.com/2010/06/17/how-investment-banks-starved-a-lot-of-people-but-made-a-tidy-profit/
Nos. 5, 6, and 7:
While it is true that velocity is a vector and speed is a scalar, in a problem such as Bart was discussing, in which motion is only considered along one axis, they are effectively identical.
The distinction reminds me of an old joke that used to circulate at Caltech:
Q: What do you get if you cross a mosquito with a mountain climber?
A: Nothing. You can’t cross a vector with a scalar.
(I didn’t say it was a good joke.)
A futures contract is exactly that, a contract. If your crop is wiped out you have to purchase corn (for example) to make good on your promise to deliver the goods. You can get crop insurance, but it rarely covers anything like full value. It is especially not-fun because you probably were not the only one in your area to have a problem, so local prices will be higher. Buying 10,000 bushels of corn at $5 to sell it at $3 really sucks.
That’s why options are a much better way to go. Options give you the right, but not the obligation to deliver (or take delivery, as the case may be) on a particular commodity on a specific date at an agreed price. Your total downside risk is the cost of the option, typically about a dime per bushel. In the current example you’ll be out a thousand bucks … instead of twenty thousand.
And since we’ve now started bad physics jokes … two very similar cats begin sliding down the same tin roof at the same time from the same spot. Which one falls off the edge first?
The one with the smaller mew.
Dorp —
You’re wrong about the 2008 food price surge. Rice nearly tripled, and it is cash market only. There was no market speculation whatever on rice, because there do not exist the instruments to allow it. It actually rose more than many other cereals, so you can at least make the case that the options and futures markets restrained the worst swings in the other grains by assuring buyers on the “call” end of the trade that they actually had grain lined up.