COFFEE DIVISION OF ED&F MAN

December 2011

INSIGHT SPECIAL: Coffee Futures 101

CBS&A Coffee Business Ser vices & Academy, a Volcafe Initiative

Highlights
All commodity markets tend to be volatile. Agricultural commodity markets, with their
vulnerability to weather shocks, are particularly volatile.

The coffee market especially has the well-deserved reputation of boom and bust in
relation to price levels. The act of bringing coffee from seedling to cup is a journey
set against a background of high price uncertainty, which could paralyse market
participants and prevent them extending business beyond just the near horizon.

This is where a risk management tool, developed over many years, steps in; the
exchange-traded coffee future contract.

Kirsty MacGregor is Volcafe’s THE BASICS

Head of Research. She is an A coffee future is a standardised contract that trades on a commodity exchange,
industry leader in the field which prices coffee for many months in advance, and can be settled by physical
of research, insights and delivery of a specified type of coffee at a certain time. When you buy or sell a coffee
forecasting, plus a key part future, you are agreeing to the obligation to buy or sell the physical underlying
coffee at a certain price at a certain point in the future. However, coffee futures are
of the CBS&A team of coffee
usually not settled with physical delivery, unless market conditions recommend it.
experts. In this Insight Special
we explain the basics of coffee The majority of coffee futures users are hedgers. Hedging is the practice of reducing
futures. the price risk of a position in physical coffee, by taking the opposite position in the
futures market. Physical market losses would result in future market gains, and
physical market gains would result in futures markets losses.

INSIGHT SPECIAL: COFFEE FUTURES 101 1

 A hedger’s futures market position is normally liquidated on the futures market
itself, once the physical position (for which the futures hedge was done) has passed.

Mapping the coffee futures markets

There are three main futures exchanges for coffee, with three different futures
contracts which go some way to covering the diversity of global coffees:

• the ICE exchange in New York trades the ‘C’ contract where the underlying
coffee is washed arabica
• the Liffe exchange in London trades a contract with robusta as the underlying
• the BM&F exchange in Sao Paulo trades a natural Brazilian arabica futures
contract.

Along with having different physical coffee as the underlying, these three futures
contracts have different standardised pricing units, lot sizes, trading hours, delivery
months, etc.

Three main futures exchanges

for coffee at a glance
ICE ‘C’ contract LIFFE robusta contract BM&F arabica contract
Where New York London Sao Paulo
Trading Hours (GMT) 08.30 - 19.00 09.00 - 17.30 11.00 - 18.45 & 19.30 - 20.00
Size of one lot 37,500 lbs / 17 tonnes 10 tonnes 100 bags of 60 kg / 6 tonnes
Price Quotation / Unit US cts/lb USD/tonne USD/60kg
Delivery Months Mar, May, July, Sep, Dec Jan, Mar, May, July, Sep, Nov Mar, May, July, Sep, Dec
Physical Settlement Certain quality of washed Certain quality of robusta Certain quality of Brazilian
arabica coffee from 19 specified coffee from any country arabica natural coffee
countries, Brazil will only be
included from 2013

Why futures?
Of course, any coffee market participants can enter into forward contracts directly
with each other, not through the terminal market / exchange. However the
coffee futures contract has the benefit that the exchange is always the financial
counterparty to the futures market participants when a bid and offer (coming from
market participants) are matched / filled. This reduces counterparty risk. Coffee
future trading also has the advantage of mass access and plenty of participants
willing to take the opposite side of a trade. The three main coffee futures contracts
which are traded in New York, London and Sao Paulo, can be bought and sold by
anyone with an account. The coffee futures markets allow mass participation,
liquidity, and thus, in theory, efficient price discovery.

2 INSIGHT SPECIAL: COFFEE FUTURES 101

WHO USES FUTURES MARKETS:
The hedgers – those who grow, buy, sell and process
physical coffee
Sometimes it is preferable for a farmer and a roaster to plan a price (or ‘lock in’
a price) at which they will sell or buy their raw product in the future.
Producers – the natural ‘longs’ of the coffee world
Farmers know that, barring natural disasters, they will have coffee to sell once the harvest comes in. While they may not
want to, or be able to, sell to their normal buyers today, they can sell to the futures market. This means they can avoid the
risk of the market falling by the time the harvest is in and they are ready to sell the actual crop.

December 2011

Sells one lot coffee future at

230cts/lb
for March 2012 delivery

er
th
Ei
Or

by March 2012 In this example, the farmer liquidates

Market Falls to 200cts/lb Market Rises to 260cts/lb his short futures position by buying
• Buys back Future at 200cts/lb • Buys back Future at 260cts/lb back his futures on the exchange and
• (pockets 30cts/lb) • (loses 30cts/lb) selling his physical coffee locally to
• Sells to trade buyer at 200cts/lb • Sells to trade buyer at 260cts/lb the trader. In theory, he could equally
• (loses 30cts/lb) • (pockets 30cts/lb) well deliver the coffee to a warehouse
NET Price received = 230cts/lb NET Price received = 230cts/lb approved by the exchange, but in
practice this rarely happens.

Roasters – the natural ‘shorts’ of the coffee world

The roaster has a different concern. He is worried that the market will rise by the time he is able to buy the coffee, so he buys
from the futures market instead to hedge this risk.

be-fixed’ basis. When physical coffee

December 2011 is traded price-to-be-fixed, a coffee
roaster agrees to purchase coffee at a
Buys one lot coffee future at differential to the futures market, and
only later do they decide to ‘fix’ the
230cts/lb final price against the price of a future
for March 2012 delivery
that the trader has to purchase at the
moment/in the manner the roaster
chooses. The ‘fixation desk’ at a
er
th tradehouse is a busy place indeed. This
Ei
Or

by March 2012 means that the roaster’s involvement

in the futures market can be limited
Market Falls to 200cts/lb Market Rises to 260cts/lb
to telling the coffee tradehouse at
• Sells back Future at 200cts/lb • Sells back Future at 260cts/lb
• (loses 30cts/lb) • (gains 30cts/lb) which time to fix the final price, with
• Buys from trade at 200cts/lb • Buys from trade at 260cts/lb the futures only being traded in the
• (gains 30cts/lb) • (loses 30cts/lb) tradehouse’s account. Of course,
NET Price paid = 230cts/lb NET Price paid = 230cts/lb larger roasters with futures accounts
will be opting for ‘price coverage’ in
addition to this, and those futures
This is the theory, but in practice not producers prefer to sell outright on they do own, will be transferred to the
many producers, and a surprising the day of sale with no futures trade tradehouse at the time of fixing the
amount of roasters, do not operate previously, and many roasters buy physical contract, in a trade called ‘AA’
their own futures accounts. Many coffee differentially on a ‘price-to- – or against actuals.

INSIGHT SPECIAL: COFFEE FUTURES 101 3

Tradehouses To summarise
Tradehouses like Volcafe are the key link between the usually geographically - The trader sold futures at
distanced producers and roasters (for example the producer in Guatemala and the
270 cts/lb, and bought futures
roaster in Japan). Our operational capabilities in key origins allow us to procure,
sort and prepare green coffee according to the specific requirements of our at 230 = gain of 40 cts/lb
customers. Expertise in coffee qualities and sustainability know-how help us to - The trader bought physical
meet and even exceed the expectations of our most discerning customers; and our coffee at 273 cts/lb, and sold at
reputation for reliability and service is extremely important to us. The nature of 235 = loss of 38 cts/lb.
coffee production and consumption however generates vast price risks for a coffee
trader; we use the coffee futures market to reduce this risk to manageable levels.
- Trader makes 2 cts/lb.

Usually, a coffee tradehouse will: In the trader’s eyes, he has made

• buy from the producer on a outright basis. a “differential” gain of 2 cts/lb,
• sell to the roaster on a “price-to-be-fixed” basis.
since he bought at +3 and sold
For example: at +5. The futures transactions
• March 2011 – a tradehouse sells 17 tonnes of coffee to a roaster at +5 cts/lb were just a mechanism to allow
over the ICE ‘C’ contract, price to be fixed, buyers call, November shipment.
• August 2011 – the tradehouse can now buy the coffee from the producer,
him to manage his risk between
at 273 cts/lb outright. The tradehouse hedges this outright purchase around purchase and final fixation of sale
this time with the sale of 1 lot of Sep 11 future, at 270 cts/lb. Thus the buying price. The outright price is much
differential is established at +3 cts/lb over the ‘C’. more volatile than the differential.
• October 2011 – the roaster phones up the tradehouse to fix the price of their
The futures market helps to
purchase. The tradehouse buys 1 lot of Dec 11 future at 230 cts/lb. This closes
the trader’s futures trade with a gain of 40 cts/lb (the Sep/Dec futures ‘spread reduce the risk, and with more
is managed elsewhere in their ‘book’). The physical coffee sale is now fixed at willing participants, allows for
a price of 235 cts/lb. This closes the physical trade with a loss of 38 cts/lb. more efficient price discovery.

WHO USES FUTURES MARKETS:

The funds and speculators
It is not just commercial hedgers who trade coffee futures (those who need to
reduce the price risk of physical coffee positions). In recent years, more and more
financial investors (a nice way of saying speculators) have sought exposure to
commodities as an asset class. In the ICE ‘C’ contract at least, those classed as
commercial hedgers account for around two-thirds of the open interest, while
financial investors account for the rest. These non-commercial participants
include index funds, macro funds and system funds, a fund’s inclusion in one of
these groups being marked out by its usual strategy and style of trading.

4 INSIGHT SPECIAL: COFFEE FUTURES 101 Disclaimer: Any comments or opinions in this report are not intended to be an offer to buy or sell commodities or futures
and options thereon as they merely state our views and carry no guarantee as to their accuracy. ©2011 VOLCAFE LTD.
Terminal Terminology: Coffee Differential: Hedging results
in a ‘differential’ or ‘basis’ position. The

the basics
difference in price of the physical coffee
versus the futures price. It is always
calculated physical coffee price less
COFFEE FUTURE CONTRACT: month, when any trader with an open position futures price. The price volatility of coffee
A standardised contract that trades on an be notified or can notify that the futures he differentials is the main price risk left after
exchange, which prices coffee for many is long or short will be settled with physical a physical coffee position has been hedged
specified months in advance, and can be delivery. through the coffee futures market.
settled by physical delivery of a specified type
of coffee at a certain time. Expiry: When the delivery month contract Order: An instruction to buy or sell a certain
ceases to trade. volume of a certain contract of a certain
FUTURES MARKET / COMMODITY delivery month at a certain price. Nowadays
EXCHANGE / TERMINAL MARKET: Spot: Used to indicate immediacy. Employed normally entered through electronic trading
All these terms mean the same thing; to describe physical coffee that is available at systems.
a market where futures contracts are traded. once (already shipped). Also used in the futures
market to refer to a futures delivery month Bid: An order to buy.
DERIVATIVE: An umbrella term for any most commonly during its notice period.
contract (standardised and non-standardised) Offer: An order to sell.
that is traded in or outside of exchanges, 1st month / Spot month / Nearby
which prices an underlying asset through month / Front month: Various terms Limit order: An order to sell / buy down or
trading the right or obligations to trade that to describe the delivery month closest to up to a certain price limit.
underlying asset at a point generally in the expiration.
future. Derivatives are for the most part used Market order: An order to sell / buy at the
to hedge risk. A coffee future comes under 2nd or 3rd month etc / Forward nearest bid / offer.
this umbrella term. month: Terms to describe the delivery
months coming after the front delivery Stop order: An order to buy or sell only
GOING LONG COFFEE FUTURES: Buying month. once the market reaches a certain level,
coffee futures, which basically means you usually in order to liquidate a losing trade.
are agreeing to buy a certain volume of the Liquidate / Close a position / Square:
underlying physical coffee at a certain price The act of cancelling a futures position by GTC: An order that is Good Til Cancelled – ie
at a specified point in the future. carrying out the opposite futures trade to the it stays in the market for any number of days
one already done. A trader who has bought until it trades or is cancelled.
GOING SHORT COFFEE FUTURES: Selling futures can just sell the same number of lots
coffee futures, which basically means you of futures in the same delivery month, before Day order: An order that automatically
are agreeing to sell a certain volume of the expiry of this delivery month (and most cancels if it is not traded / filled.
underlying physical coffee at a certain price straightforwardly before the notice period),
at a specified point in the future. to cancel all obligations. Fills: Orders which are successfully
matched to a corresponding bid or offer,
PHYSICAL UNDERLYING: The actual type of Delivering / tendering / issuing: ie they are traded / executed.
coffee which the futures contract claims to Providing (selling) the physical underlying
be pricing. The physical delivery settlement coffee, in the notice period of the delivery Minimum Price Movement:
of a coffee futures market is key; the price of month, in order to settle a short futures The smallest increment of price movement
the future at the time of delivery must reflect position. allowed per futures contract. In ICE, it is 0.05
the underlying price of the coffee it claims to US cts/lb, in Liffe 1 USD, in BMF 0.05 USD /
represent. Otherwise the market participants Stopping / receiving / taking delivery: 60kg.
who use coffee futures as a hedge (see Accepting (buying) the physical underlying
below) for physical business are increasing coffee, in the notice period of the delivery Points: In the ICE ‘C’ contract, 0.01 US
their risk rather than reducing it. However, month, in order to settle a long futures cts/lb is referred to as points. When the ‘C’
coffee futures are usually not settled with position. contract moves by 5 cts/lb, one can say it has
physical delivery, unless market conditions moved by 500 points.
recommend it. Lot: The unit of one future. The size of one
lot varies per exchange. NB futures prices FND: First Notice Day, the first day of the
Delivery months: A coffee future always are usually quoted in smaller units than the notice period.
has a delivery month (also called contract price of one full lot. Even though the Liffe
month), by the end of which the trade must robusta contract is traded in lots of 10 tonnes, Initial margin: A ‘deposit’ posted by a
be (and is most commonly) liquidated either the price is always quoted in US dollars per trader/tradehouse to the exchange when a
through the opposite futures trade (see 1 tonne. trade is opened.
below), or through physical delivery of
coffee in exchange-licensed warehouses. Hedge: The practice of reducing the price Variation margin: The value of the position
These delivery months have codes, for risk of a position in the physical market by marked at current prices.
example U12 refers to September 2012, taking the opposition position in the futures
or H13 refers to March 2013. These months market. Someone who has bought physical Margin Call: A back-and-forth between
are the same calendar months every year, coffee would sell futures, and someone who the exchange and the trader to increase
for each specific exchange. has sold physical coffee would buy futures. or decrease their margin deposit with the
Physical market losses would result in future clearing house, either due to a market
Notice period: The multi-day period of market gains, and physical market gains move, a change in position or exchange
time at the end of the trading life of a delivery would result in futures markets losses. rules.

5 INSIGHT SPECIAL: COFFEE FUTURES 101

Clearing: The process to accept and record and offer is one lot traded) in a specified Moreover the physical coffee can be priced
trades and settle margins on a daily basis. time period, while open interest is the total for sale against the more expensive front
number of unsettled (not liquidated or month.
Clearing member: All traders must trade expired) lots at a particular point in time.
through a clearing member of an exchange, Exchange-certified stocks: Coffee
usually a bank or a brokerage firm. AAs: An abbreviation of against actuals, stocks that are certified by the exchange
a simple exchange between two hedgers as suitable for delivery to settle a futures
Bullish: A market outlook where you think who want to exchange futures in reference contract.
the price will go up. to a physical trade. The futures are traded
through the exchange, but flagged to be Tenderable parity: the price level of
Bearish: A market outlook where you think only traded by the agreed two hedgers. physical coffee offered in a producing
the price will go down. country which corresponds to a break-even
Futures pit / floor: The (now non- for a trader who would buy that coffee,
Outright position: Generally refers to a existent) places where coffee futures were and then tender it to the exchange as
stand-alone position either in the futures or traded between floor brokers in the open physical settlement of a short futures
physical market, that is not offset by another outcry system. Market participants would position taken as an immediate hedge
trade. have to phone their floor broker to place when buying the physical coffee. A coffee
an order. Only coffee options in New York differential has reached tenderable parity
Book: A summary of all the trades and are still traded in the pit. Coffee futures are when the (minus) differential is the same
offsetting trades that a trader or a company now traded electronically through various as the total cost of transport, finance,
takes. software platforms, directly by hedgers and insurance and certification of that coffee to
speculators. the exchange.
Spread/switch: Terms which can describe
the price difference between delivery months Market Structure / Forward Curve: Delivery ports: The ports specified in the
of the same futures contract. Spread can Both terms describe the various price levels coffee futures contract, where exchange-
also refer to the price difference between of delivery months in relation to each other. licensed warehouses are located. It is in
two similar markets, like arbitrage. these warehouses that the exchange-certified
Contango (carry) market structure: coffee stocks are stored, and where these
Rolling: If a trader (for example a hedger or When the 1st delivery month is a lower price coffee stocks can be delivered or received
a speculator with a long-term trade outlook) than the 2nd delivery month. This implies as settlement of an expiring coffee futures
wants to maintain his futures positions past sufficient spot or nearby supply. It is also contract.
the expiry date of the delivery month in which called a carry market, because this market
he has a position, he can ‘roll’ it to the next structure supports the carry trade. That is, Technical / Chart Analysis: Used by
delivery month. For example, if a trader has if a trader owns fully hedged physical coffee, traders to try to predict price direction, based
bought January 2012 futures, he rolls this the short hedge (short futures) in the front on past volume and price action.
position to March 2012 by simply selling month can be bought back, then this futures
the January contract and buying the March is ‘rolled’ or sold again higher in the next Candlesticks: Appearing on the chart
contract. This particular ‘roll’ trade of a long month, thus creating a ‘profit’ that covers looking like candles, these show the open
position can be called ‘selling the spread’. the cost of carrying that coffee in the next /high / low / close of the daily / weekly /
couple of months: ie financing, insurance monthly etc price moves of coffee, with
Arbitrage: The price difference between and storage rent. different shades whether the close was
two similar markets. In coffee futures, below or above the opening price.
the New York / London ‘arb’ is classically Backwardated (inverse) market
quoted New York less London, most of the structure: The opposite of a contango Position Limit: The number of lots a trader
time creating a positive number, while the market, where the front month is more can be long or short in a certain delivery
New York / BMF arb is classically quoted expensive than the next month, implying month or all months, regulated and enforced
BMF less New York, mostly creating a a lack of spot or nearby supply in a well- by the exchange. The ICE ‘C’ contract and the
negative number, as an easy comparison to regulated market. A backwardated or inverse BMF arabica contract have position limits,
the physical differential of Brazilian coffee market will give the incentive for a coffee the Liffe robusta contract does not.
against the New York market. owner to sell that coffee, as it causes a ‘loss’
now to roll the hedge (the trader has to buy Liquid market: A market with enough
Volume vs Open Interest: Volume is the 1st month at a more expensive price participants and a large enough volume of
the number of lots traded (ie a matched bid than the sale of a future of the 2nd month). bids and offers to allow for large transactions
to be filled without a price spike or steep
price drop. Opposite of thin market.

CFTC: A regulatory body created by the US

congress in 1974, the Commodity Futures
Trading Commission regulates commodity
futures and options markets in the US.

Commitment of Traders: This report is

published weekly by the CFTC. It classifies
traders into separate commercial and non-
commerical categories, and publishes the
net position per category, allowing for some
market transparency for the New York ICE ‘C’
contract.

INSIGHT SPECIAL: COFFEE FUTURES 101 6