Hedging, otherwise known as the art of transferring risk, looks to minimize the effects of volatility in the markets. Coffee buyers around the world deal with volatility day in and day out. What is volatility? While there may be many definitions for what volatility is, the basic premise is that it measures change in the underlying price of a product in reference to time. We call it the “Headache Factor.”
One of the main concerns a roaster has is the uncertainty of the price in green coffee on the day he/she runs out of it. It is clear that the most expensive inventory in the world is the one we do not have available at the precise time we need to roast and deliver to our willing buyers. Having little or no inventories puts a roaster at a major disadvantage in the market and increases the headache in finding said coffee – clearly not a good thing. In this very active world we live in, our raw material has a historical, yearly volatility, alias headache factor, of 35%.
That said, we are reminded of the old adage that states, “One man’s garbage is another man’s treasure.” In the roaster’s daily life, garbage is volatility; in a speculator’s world, volatility is a major treasure. Hedging, in the mind of a roaster, should be interpreted as taking out the garbage, because hedging transfers volatility to those who seek it – speculators.
So how do we hedge? Many years ago, at least one hundred, a group of commercial commodity traders got together to establish centralized markets, or exchanges. At these exchanges, commercial hedgers were able to buy and sell standardized units of a particular commodity – in our case, coffee. The standardized units leveled the field and set a standard for quality, size, and time of delivery in the form of a contract. The contracts were then traded in the exchanges, making the exchanges nothing more than a venue where the industry comes together to discover price. Every trade is made up of two sides; a buy and sell. Commercial traders went out looking for someone to take the other side of their trade. Thus, the speculator was born.
The speculator is the guy looking for his new treasure, volatility. The hedger, on the other hand, is taking out the garbage, a marriage made in heaven. The exchanges provided that venue to exchange positions. A roaster worried about price going higher could now buy from a speculator who was looking for price to go lower, thus transferring his risk. This mechanism allows the roaster to put in place a financial instrument that represents his coffee in the future. While he may not be able to find physical coffee at the correct price on the spot market today, he mitigates his risk by buying it in the futures markets. Hedging allows the commercial participant to do something today to protect the price of something that he will inevitably do in the future.
With that said, if I have to buy coffee in December and I am nervous today about price, the exchange allows me to buy a December futures contract of coffee today, in May, to be delivered in December. If Tylenol or Advil cannot take away the “Headache Factor,” a speculator will.