The Shared Hedge

The Exchange Traded Commodity Price for Arabica (The "C")has been a consistent topic within this blog. It is of such vital importance to both farmers and consumers that I've dedicated a great deal of thought and effort to articulate the factors that affect the price settlement every day. Last year in the middle of a flurry of attention following the price eclipsing $3.00, I posted some thoughts on delinking the Specialty Price from the commodity price although with somewhat sketchy details about basing it on a composite retail price.

In the past few weeks I've begun to flesh out some ideas with the goal of providing some security (hedge) and stability (certainty) within the Specialty Coffee market. This proposal is not universally suited for all and admittedly excludes parties driven solely by profit. First, I'm restricting this concept to those companies who purchase direct from farm, where interaction and negotiation with decision makers at source is possible. Second,this mechanism is intended for growers and purchasers who are both dedicated to price stability with sufficient risk/reward to satisfy normal profit motives. Last, the integrity of the proposed contracts must be unassailable as each participant is the counterparty insuring the hedge.

The proposal is the creation of a proprietary Tailored Options Contract (think of it as an insurance policy) which would be negotiated by each party under the auspices of a Third Party Registrar. This contract would be very different from normal exchange traded options contracts where the counterparties never know who is on the other side of the trade.

The basic structure can be best explained by the following: The Roaster sells a Put at the agreed strike price with an approximate 10% premium which is purchased by the Grower. The Grower Sells a Call at an agreed strike price with an approximate 10% premium which is purchased by the Roaster. Both share an expiration date at harvest the following crop year, for example Jan 1,2013
Example: Let's assume the agreed price for this years crop is $3.50 per pound farm gate. Our Roaster sells a January 2013 Put Option to the grower at $3.15 Strike Price and and receives $0.35 in proceeds. This gives the Grower the Option, but not the obligation to sell his/her coffee next year for $3.15. The Roaster who sold the Put in turn has the obligation to purchase if the Grower exercises his right. So why would the grower exercise his option to sell at $3.15? Let's say next year, the commodity price falls significantly such that similar specialty grade coffees are now selling for $2.50 per pound, by exercising his right to sell at $3.50 the grower has greatly limited his downside risk for next year.

Concurrently, the Grower sells a January 2013 Call Option to the Roaster with a $3.85 strike price and receives $0.35 in proceeds which offsets his/her cost of purchasing the Put. This gives the Roaster the Option, but not the Obligation to purchase coffee next year for $3.85. The Grower also gains the obligation to Sell at $3.85 should the Roaster exercise his right. The Roaster would choose to exercise his right to purchase at $3.85 if the price of similar grade coffees is higher than $3.85, limiting his exposure to even higher prices for a year. The effective result is that Roaster has the Option (but not the obligation) to purchase coffee next year at a 10% increase over this years price. The grower in this scenario will lose the profit potential should the price increase beyond $3.85. Should the price fall instead of rise, the grower has the Option (but not the obligation) to sell coffee to the Roaster at a price 10% below this years price.

The net result is that the exchanged options contracts keep the price within a 20% (10% up $3.85, 10% down $3.15) price range for the next year (2013). If the Commodity price moves vastly higher during 2012, the Roaster can lock in his 2013 Option and buy for $3.85. If the Commodity price moves vastly lower during 2012, the farmer and lock in their January 2013 Option and sell for $3.15. The middle ground is where both parties agreed at the beginning of the year that they wanted the price to be. By creating a specialized Options Contract, the two parties can be certain that under all circumstances that will be the case. If by chance the price remains stable for the year, the options expire and a new contract can be enacted using the same method to achieve stability for the new crop year. The beauty of this model is the spread between the prices which defines the target price for next year can be literally as wide or narrow as the parties desire, and the premiums set accordingly. The premiums can even be structured so that one party pays a lower premium than the other owing to increased risk or asymmetric strike prices on either side of the current price.
In any case the grower foregoes the upside potential beyond the strike price increase, the Roaster foregoes the savings beyond the strike price decrease. Price Stability=Shared Risk= Win/Win

Enacting the proposed structure would greatly benefit from participation of several large independent roasters/importers who are dedicated to farm support and transparency, but also with marketing programs in place to adequately articulate to customers how they are guaranteeing farm income. Alternatively I can imaging an existing Third Party Certifier adopting this type of contract model and branding it as a simple and cheap mechanism to benefit farmers and roasters alike. Remember, the Importer/Roaster benefits from price stability as much as the grower. Last, I imagine that a new legal enterprise could be established to negotiate and monitor contracts with a small net debit premium on each side from the sale of the Put/Call Options and branding the contract something descriptive of it's benefits...The Shared Hedge!

If some Roasters/Importers are currently using Private Options contracts I'd be happy to hear about them, and if anyone is interested in discussing the idea further please let me know.