An introduction to forward contracts and commodity futures for South African farmers

The agriculture sector is notoriously volatile, but producers can find stability using financial derivative tools. This article clearly defines and differentiates between two key instruments: forward contracts and futures contracts.

- Petri de Beer

Agriculture has always been notorious for its volatility with commodity prices swinging wildly between seasons.

In such an environment, risk management has become key to ensuring sustainability. This is where financial tools such as forward contracts and commodity futures can assist.

Though often associated with speculators and investors, these instruments are in fact powerful tools for producers themselves, offering ways to shift and manage risk.

There has long been a tendency to lump together forward contracts and future contracts. This confusion is largely driven by a lack of understanding about the mechanics of these derivative products.

There are fundamental differences between these, and both offer distinct advantages and risks to farmers. Understanding these differences is essential for producers who want to use them effectively.

FORWARD CONTRACTS

A forward contract is perhaps the more straightforward of the two and traditionally the one farmers were most exposed to. It is a private, customised agreement between two parties to buy or sell an agricultural commodity at a set price on a future date.

Because it is a private agreement, its terms are flexible and can be negotiated between the buyer and the seller. By entering a forward contract, farmers secure a guaranteed price for their harvest, insulating themselves from the risk of falling market prices. Buyers, such as food processors or millers, benefit by ensuring steady supply at predictable costs.