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Understanding risk in cotton operation and hedging against it using commodities futures

Jameson Augustin

Summary

Farming in general is a risky endeavor and cotton production is not an exception. Weather-related threats, climate change, presence of pests and diseases and market uncertainties both in terms of input costs and output prices are some of the common factors that have potentially disastrous effects on the ultimate profit of cotton growers. The ability of a farmer to understand risk and take mitigation measures deeply relies on their knowledge of what risk is and the different types of risks there exist. The four major types of financial derivatives are swaps, forwards, futures and options. However, we focus on futures trading in this poster since it’s one of the most popular risk management tools among commodities traders. Futures contracts are a hedging instrument that cotton growers can use to shift price risk to speculators. In the case of cotton growers, they enter the cotton futures market to secure a minimum selling price for their commodity. In other words, they want to protect themselves against falling prices. Even after doing all the hard work in the fields and surviving all the lingering risks that are inherent to the farming business, nothing guarantees them a price above production costs for their commodities. As such, hedging against falling prices by securing a minimum selling price is a viable risk management tool cotton growers can use to reduce their risk. The correct use of futures trading may increase their likelihood to profit from their operations regardless of internal and external circumstances.

Details

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