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The power of hedge positions

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The same risk management tool available to farmers – trading futures – could have saved many banks in the 1980s.

We’ve all heard stories about farmers and grain elevators losing everything as a result of trading futures. Obviously, they made a mistake. But sometimes, it is a mistake not to use futures.

By definition, a hedge is a position in a market offset by an opposite position in a different market.  You are likely familiar with the phrase “I hedged my bets,” which implies no matter what happens, things will turn out okay.

In grain marketing, both offsetting hedge positions can be in the cash market. For example, many small country elevators – what few are left – usually do not have their own futures account to offset their risk in the cash market, so they “back-to-back” all their grain purchases from farmers by contracting those same bushels to a grain terminal.

By far the most common hedge in the grain business is offsetting cash grain position with an equal, but opposite position in the futures market. There are futures markets on just about everything that the quality can be standardized.

What starts out as a market risk reduction program can become a very high-stakes speculation position.  

Crash of the 1980s

By early 1982, interest rates were clearly on a long-term downtrend after the prime rate peaked at 21.5% on Dec. 17, 1980. I was a commodity futures brokerage branch manager and hungry for new business.

Bankers had issued billions of dollars of very high fixed interest rate long-term certificates of deposit. As interest rates declined, the bankers still had to pay high interest rates on the CDs. Every month the interest rates declined, they had to loan that money at rates well below what they were paying on the CDs. It was exactly like a bin full of unpriced beans as the price drifts lower month after month.

I really thought I was going to increase my business volume ten times. All I had to do was educate the bankers on how a hedge worked, and they would be hedging their interest rates like stink on a skunk.

The first problem was getting an appointment. Bankers thought futures brokers carried some disease that could destroy their bank and kill them. Eventually, I was able to present the hedge plan to three of the larger banks in Columbus, Ohio, including Huntington Bank, BancOhio and Bank One.

I presented the hedge program to high-level managers and all of them politely said, thanks, but no thanks. All three informed me that banks do not speculate in futures. I explained a hedge program was not speculation, and that they were speculating by not having their high interest rates hedged. They told me I just did not understand the banking business. I left the brokerage business in March 1984, maybe a little bit too early. 

Banks, savings, loan and mortgage companies all had a major meltdown in 1984. Heads rolled as long-established conservative financial institutions just watched their equity fade away and went belly-up.     

The Chicago Mercantile Exchange began by trading pork bellies in 1961, cattle futures in 1964 and then hogs in 1966. It was 1975 when interest rate futures began trading. By 1985, hedging interest rates had become an accepted risk management tool for the banking industry and investment firms.

There is a lot more money in the world than there is corn, wheat and beans. By 2000, trading volume of interest rate futures at the CME had become astronomical and the CME was filthy rich. By 2007, the CME had so much money, it bought the CBOT, which was founded more than one hundred years before the CME. The CME also bought the KCBOT and the New York Futures Exchange and formed what is called the CME Group – all because the CME trades interest rate futures, and banks around the world are their clients.    

Wright is an Ohio-based grain marketing consultant. Contact him at (937) 605-1061 or [email protected]. Read more insights at www.wrightonthemarket.com.

No one associated with Wright on the Market is a cash grain broker nor a futures market broker. All information presented is researched and believed to be true and correct, but nothing is 100% in this business.

The opinions of the author are not necessarily those of Farm Futures or Farm Progress. 

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