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It's claimed that derivative instruments were made to allow real businesses to hedge their risks (unpredictable increase of supplies price, decrease price of the product in the future and so on, foreign exchange risks). It's a great idea, but almost everything I see in the area of derivatives right now is about trading in terms of speculation. I do know that big corporations do such risk management making deals with big banks, but what about medium sized business? Is it an often practice?

Let's imagine that I'm a farmer and I want to hedge risk of pork price decrease in a half of year. What options do I have?

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Roughly:

If you want to hedge against a drop in pork prices you would enter a futures contract to deliver y pork bellies at z price on x date in the future to lock in a better price now than where you expect the price to be in the future.

However, if you are good at predicting the future prices of pork you are generally significantly better off being a speculator in futures markets than a farmer. Thus these markets quickly attract a lot of speculators in relation to their underlying 'pure' risk management usage.

Where they can also be very useful for farmers is in being able to lock in costs for many parts of their operation. Say, for example, that to make a pig you need x amount of grain, y amount of soya and z amount of oil for heat. As these are all also available as futures you can lock in known prices for all of these critical components over the year, as well as a known price for the final article if you so wish, which can make you more confident in scaling up your operation etc as the volatility is heavily reduced and you are much closer to a guaranteed return than if you had to absorb all of these elements price risk yourself.

  • Thanks for explanation, Philip. Actually, I'm also interested in pure operational things. In other words what should I do as a farmer (let's imagine) to buy options needed to eliminate my risks. To get a credit I can go to any retail bank or use one of fancy lending platform, but what about risk hedging case? – Anthony Jan 21 at 13:07
  • I'd probably start with something like the CME group web site (cmegroup.com/trading/agricultural), click around and read up on their process etc if you want to get a feel for how it's all setup... – Philip Jan 21 at 13:37
  • cmegroup.com/education/courses/introduction-to-livestock/… this also looks a solid resource for learning more – Philip Jan 21 at 13:39
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    @Anthony - Platforms are designed for those who wish to buy or sell securities, or both. If you're a trader, you do a lot of both. If you're an investor, you don't do much of either. Same platform, different reasons for as well as different level of usage. As a farmer looking to hedge, most of the analytics are irrelevant to you. For example, although volatility affects price, your concern isn't with understanding volatility or whether it's higher or lower than usual. It's simply a determination of what the cost of hedging is and if that an acceptable cost. – Bob Baerker Jan 21 at 14:19
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    I think in any real-world example the farmer would just buy insurance and the insurance company would hedge the risks they assumed. – Daniel Jan 22 at 15:47

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