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  • QA 062
    Question:
    Does 'not hedging' one's green coffee stock amount to speculation?
    Background:
    At a recent shareholder meeting we were asked if we hedged our green coffee stocks, which we do not since we hold this stock for roasting and not for trading. One of our shareholders however suggested this in fact amounts to speculation because green coffee prices might go down. How do you feel about this?
    Asked by:
    Roaster - Poland
     
    Answer:

    Hedging is a trading operation that allows one to transform a less acceptable risk into a more acceptable one by transferring it to someone else but of course at a cost, an insurance premium… 

    Your shareholder's concern probably is that if the green bean market falls your competitors might be able to buy more cheaply, then use this price advantage to undercut you in the market place for roasted coffee, and so gain market share. Conversely, if green bean prices rise your future purchases will cost more, forcing you to raise roasted coffee prices. If your competitors had hedged this risk then the same could happen because they would have 'insured' their price risk. See chapter 9 for a full description of hedging and how it works.

    Any 'open' position, be it unsold stocks or future requirements not yet purchased, presents a price risk that can translate into damage to your business. The issue therefore is not that you hold your stocks for roasting, but rather whether you have quantified the potential for damage that not hedging the price risk may hold. 

    If the gross margins on your business are such that mainstream green coffee price movements are of no direct concern to you, as is the case for many specialty roasters, then you may judge the risk acceptable. To an extent roaster inventory is protected by the wholesale or retail sales price of the finished product. Green coffee prices rise and fall quickly but roasters' prices for finished product move much slower. In some markets roasters are much quicker to raise prices in a strong green bean market then they are to reduce prices when green bean prices decline. This suggests that the old saying that "roasters can roast their trading mistakes" is true… But if your market is sharply competitive, then your shareholder is right to be concerned… Here we would add that many banks also look at price risk when, you guessed it, they calculate the interest rate of the credit they will provide you - for larger operations banks will simply insist that price risk is hedged as a matter of course…

    Coffee growers face the same issue but of course only have stocks: either still on the tree, or already harvested. Growers too are exposed to price risk but many of them cannot access hedge instruments because they are simply too small, unless of course they organise themselves in groups, cooperatives, associations etc. But many growers are also prevented from accessing hedge instruments because of government or exchange control regulations, making it impossible for them to finance hedging operations, or to execute the quick exchange of funds price fluctuations necessitate.

    Growers who are organized in groups or who are individually large enough to be able sell direct however do have the advantage of being able to sell forward, say at least part of their crop. If they do not wish to commit immediately to a price then they can sell basis Price To Be Fixed or PTBF instead, and link this with a price hedging operation through a friendly importer. Here one should note that currently the only coffee producing country with a truly liquid domestic futures market is Brazil (see 08.07), meaning just about everyone else has to work with the London or New York exchanges instead.

    Larger roasters very often purchase green bean on PTBF basis but of course for opposed reasons. For an exact description of the PTBF process go to section 09.02 but first read section 09.01 for a review of the under-lying hedging principles. You might also find section 10.03 (Risk in relation to credit) of interest.

    Posted December 7, 2005

    Related chapter(s):
    Related Q & A:
    QA 054