Commodity Markets: Cash Markets and Forward Contracting | Market to Market Classroom

Farming is full of risk. In any given year,
growers face numerous weather perils ranging from droughts and floods to hail storms, wind
storms, tornadoes and the occasional hurricane. Even when producers escape those extremes,
growing conditions must be favorable at critical periods in the growing cycle, like planting,
germination, pollination and so on. And even after the crops are grown and harvested
producers still encounter risk. But the greatest risk of all may not be associated with producing
commodities, but in marketing or selling them. Two methods that are commonly used to sell
commodities are cash marketing and forward contracting. They look like this. Farmer Smith
has always marketed his crop according to his father’s old adage, don’t sell something
you don’t own. So he has built plenty of storage bins to hold all that he produces each year.
And he usually sells his grain several months after harvest on price rallies. Smith’s practice
of storing his entire crop assures he won’t be forced to take the harvest price, which
typically is among the lowest of the year. He can store the crop until the price reaches
the point where he wants to sell it for cash, usually at a local elevator. By storing his
grain he hopes for a favorable price sometime in the future. He has not entered into any
kind of contract to deliver the grain at a certain time or at a certain price and his
primary risk is that prices could move lower while he is holding his grain.
Farmer Jones also stores most of his crops on the farm. But for some of his crops he
establishes what is known as a forward contract with his local elevator. A forward contract
is an agreement to deliver a certain amount of a certain commodity at a certain time in
the future. Because no one really knows whether prices will go up or down, a forward contract
locks in a price that is higher than the current cash price. Jones’ strategy of forward contracting
with his local elevator guarantees him a known price for some of his crop. But the agreement
restricts his flexibility to change his mind and sell directly into the cash market. His
primary risk is if prices are higher at the delivery date. He is still obligated to deliver
the contracted grain at the lower price he agreed to earlier.

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