Using risk management tools
The volatility in crop prices during the last few years has made it essential to have a marketing plan. But that same volatility can knock you off your game if margin calls lead you to abandon your plan.
It's hard enough to ride the risks that are a natural part of producing a crop, but the futures exchanges have raised your risks again when you market the crop by requiring larger margin deposits on futures. It increases your costs and requires a larger capital pool – whether your own money or a lender's – to place an initial hedge. And even more when margin calls start coming.
Chicago corn futures maintenance margins have risen from 8¢ a bushel in May 2006 to 35¢ this past summer. Soybean margin calls have climbed from 15¢ a bushel in May 2006 to 65¢ during the summer. Initial margins to place a futures hedge also have risen commensurately.
Why raise margins? If you ask the industry, almost everyone will say, “To wring excessive speculation out of the market.” The decade-long rise of hedge funds and other big-money speculators has left them with a lot of cash to put to work, looking for a hot market to trade. Some of that money, which sometimes originates overseas, has made its way to the Chicago grain futures exchanges.
But the CME Group, which owns the corn and soybean exchange, denies that it is targeting any class of trader with its margin increases. In a May memo, Kim Taylor, head of the division that determines margins, said, “Margins … aren't a means to move a market one way or the other, or to encourage or discourage participation from one kind of market participant or another. As part of our overall risk-management program, margins are adjusted frequently across all our products based on market volatility,” she wrote.
How to manage margin calls
For farmers, staying in the game without getting knocked out by margin calls basically involves just two approaches: Either have a large credit line or bank account to meet margin calls, or avoid taking a futures position.
And, indeed, for years many farmers have taken advantage of grain dealers' hedge-to-arrive contracts, placing the futures risk with the elevator. A farmer agrees to deliver grain at a certain date, and the elevator hedges the deal with a short futures contract. Any margin calls come to the elevator.
Another place to transfer futures risk is to your lender. An example is Rabo AgriFinance's commodity swap, an over-the-counter derivative tied to a line of credit. The hedge is initiated by Rabo, so no margining is required by the farmer throughout the life of the transaction, essentially eliminating the farmer's margin call risk.
But Rabo's commodity swap is not the standard among farmers. Most still pay their own margin calls, often with a line of credit from their lender. “If a farmer is paying the margin calls, he has to have a banker who understands that if he has a margin call, it has to be met in order to maintain the hedge,” says Rabo AgriFinance north-central managing director Shawn Smeins. He warns that some rural bankers who don't specialize in agriculture may not grasp the importance of maintaining that hedge.