“They are financial weapons of mass destruction,” Warren Buffett wrote in his popular annual “Berkshire Hathaway Letter from the Chairman,” in 2003. Mr. Buffett was referring to financial derivatives.
Michael Phillips has noted that, “Derivatives are financial instruments whose value ‘derives’ from something else, such as interest rates or heating oil prices. The fi rst derivatives were crop futures, which appeared in the United States at the end of the Civil War and became a standard facet of business for companies across America.”
So derivatives did not start out in the domain of the financial “rocket scientists,” Wall Street parlance for the mathematicians and physicists hired by financial firms to develop newer forms of derivatives. They began as simple hedges—a means for the farmer to gain some protection for the price of his crop—sold on the Chicago Board of Trade. They were called futures contracts.
The farmer or rancher has always had to live with the possibility of the ravages of nature. Hailstorms could destroy a crop, as could a seasonal drought or a torrential downpour if it occurred at harvest time.
A heavy snowstorm could prevent a rancher from reaching his cattle with feed and the cattle could perish, or a tornado could wipe out the family homestead, livestock, and equipment in seconds. These “acts of nature” are risks to be expected, feared, and tolerated in this sector of agribusiness. Little can be done to prevent them.
However, this is not the case for the price of the farmer’s crop. He can exert some control over this aspect of his agribusiness. The successful and savvy farmer or rancher can use the Chicago Board of Trade futures market. Using the mechanism provided by this “securities market” a farmer can sell a futures contract on his crop. This “locks in” a price at a future date—harvest time. The futures contracts were sold in units that were already familiar to the farmer (bushels) and also at a relevant time (he knew when his crop would be harvested).
If the futures price goes down before harvest, the farmer can sell the crop for that price, buy a futures contract (to close out his position) at that price, and after settling with the broker realize a “profit” from the futures transaction. The “profit” gained and the price of the crop approximate the price he wanted in the first place. Similarly, if the price of the crop increases, he would have to pay a “margin” call to the broker, sell his crop for the higher price, and again realize the price he wanted initially, although he would miss out on the gains. The result of this venture is a price for his crop that the farmer feels is equitable.
The farmer/rancher engaged in this business does so to “lock in” a price and take control or deliver a crop. Another participant in this activity at the Chicago Board of Trade is the speculative investor. This individual attempts to “guess” the direction of prices, then buys and sells contracts accordingly. In times of heavy fi nancial strain these individuals (traders) are often vilified for the speculative ventures; however, they serve a purpose. These traders provide “liquidity” because, if there are more individuals and companies willing to buy and sell futures contracts, it insures that any trader can fi nd a “counter party” to his or her trade.
This is the reason Jim Kreutz, Giltner, NE, uses derivatives to soften the effect of a decline in price of feed corn (5,000 bushels/contract, Chicago Board of Trade) used to feed cattle, not people; and his brotherin-law, Jon Reeson, hedges the price of his feed lot steers (40,000 pounds/contract, Chicago Mercantile Exchange). Similarly, their local “farmers co-op” (a company owned “cooperatively” by farmers who invest and share the profits of the cooperative together) hedges the price of diesel fuel.
Futures contracts as sold on the Chicago Board of Trade have a distinct and valid purpose in agribusiness:
They help mitigate environmental risks. These financial instruments are used by small independent farmers/ranchers and huge multi-national agribusinesses, such as Archer-Daniels Midland Company and Cargill, as an everyday part of their agribusiness ventures. Hedging activities through derivatives has created
a $300 trillion ($300,000,000,000,000) U.S. derivatives market.
Risk management is an essential feature in any business; it is vital to the viability of an agribusiness.
Thus, it is unfortunate that the newer, distant cousins of these financial instruments—the ones developed by Wall Street’s “rocket scientists”—are tainting a risk-management tool vital to agribusiness to function successfully in its risky environment. Cargill, as an everyday part of their agribusiness ventures. Hedging activities through derivatives has created a $300 trillion ($300,000,000,000,000) U.S. derivatives market.
Risk management is an essential feature in any business; it is vital to the viability of an agribusiness.
Thus, it is unfortunate that the newer, distant cousins of these financial instruments—the ones developed by Wall Street’s “rocket scientists”—are tainting a risk-management tool vital to agribusiness to function successfully in its risky environment. Cargill, as an everyday part of their agribusiness ventures. Hedging activities through derivatives has created a $300 trillion ($300,000,000,000,000) U.S. derivatives market.
Risk management is an essential feature in any business; it is vital to the viability of an agribusiness.
Thus, it is unfortunate that the newer, distant cousins of these financial instruments—the ones developed by Wall Street’s “rocket scientists”—are tainting a risk-management tool vital to agribusiness to function successfully in its risky environment.

Questions

1. Why does Warren Buffett say that Wall Street’s “rocket scientists” give financial derivatives a bad name?

2. Explain how futures contracts are risk-management tools?

3. What career choices and company choices are available to someone who wants to work with futures contracts? What types of courses would be appropriate to develop the knowledge and skills needed in these jobs?