How Farmers Cut Costs and Reduce Risk

Here we explain how the use of futures contracts lower the cost of capital to farmers and as a result lowers prices in the marketplace. Let’s take the scenario of a farmer who needs to obtain capital to cover operating expenses.  And he goes down to his local banker and perhaps his banker is named Bob and he says “Hey Bob I have a great crop coming in this year, but I need $300,000 for my operating expenses. This will get me through the season and to harvest so that I can sell my crop.” The banker says “Well you’ve always been reliable with your crops and you’re known as a very fine producer, but how do we know that you’ll be able to sell these bushels come harvest?  We’re taking a lot of risk here,  we’ll lend you the money, but we have to charge you an interest rate of 10%.” The farmer says “Wow 10% that’s kind of high but I really need the money to get to harvest. Okay I’ll take that loan.”

Now lets look at that same scenario with a little bit of a twist. The farmer goes to the bank and says “Hey Bob I have got a great crop this year – Looks like it’s going to be 500,000 bushels. I need $300,000 to get me to my harvest.” Same scenario – the banker says “You’re a great farmer but we’re concerned about a fall in commodity prices and us getting repaid.” Well the farmer says to the banker “I have that all taken care of because I have sold futures against my crop to ensure that I can sell my crop profitably.” The banker says “Let me see your future statement.” And he sees that the farmer has indeed sold enough futures to fully hedge his production and that his price risk has been largely eliminated The banker says “Well I can see that your risk has been largely offset by these futures and we’re happy to make the loan for you and we’ll make you that loan at 6%.” So here because futures have been used to hedge the farmer’s risk the farmer was able  to borrow the money at a significantly lower rate. This lowers his cost of production.. As a result of the lower cost of capital, producers can sell their crops profitably at lower prices.

These lower costs reduce prices in the market to users of the commodity and to consumers who purchase finished products made from the commodity. The Series 3 exam requires students to understand the economic benefits of futures contracts. We hope this video and article have helped you prepare for your exam. Review our best in class series 3 study materials