Derivatives and Farming

Every day on my drive to the station, I listen to Farming Today on Radio 4. Most days it is a nice, calm introduction to the day, transporting me to a more romantic (more difficult) life in the countryside.

But this morning, I was struck with a story that brought me back to my actual job – “Grain Trading”

The story was about farmers learning how to trade grain like traders using “futures” and “forwards” – essentially derivatives.

Although only five minutes long, I think there were three relevant messages for pension schemes.

Derivatives started as (and continue to be) a commercial tool

Derivatives can trace their origins back to farming hundreds of years ago – when farmers would sell their produce in advance. Put another way, rather than meeting up in a room and selling their produce there and then, they would agree to sell it at a given price at some point in the future – these are known as “forwards” or “futures”.

Many people see derivatives as a risky tool for making money. However, the idea of these contracts was to give the farmer certainty, enabling them to both sleep at night and plan for the future – a commercial endeavour, not a trading activity.

Pension schemes should see derivatives as the same thing – tools that create certainty, allowing them to plan their strategy, and sleep at night,

It’s about the right price, not the best price

The whole principle of allowing this approach is not about selling at the best price. It is about selling at a price that fits in with the farmer’s strategy.

The same is true of pension schemes. A pension scheme’s investment strategy is about getting the right return, not the best return. It is impossible to get the best return. Getting the right return for your strategy is far more achievable, especially if using contractual tools.

New does not mean risky

One of the questions from the presenter was whether farmers using these tools would be taking on more risk. This is a common question we get from trustees.

As the person answering the question pointed out, these tools are there to give the farmers certainty and to manage their risk – this is the complete opposite of being risky.

Just because the tools are “new” does not mean they are riskier and that the status quo is riskless. Therefore, although derivatives are increasingly more common, there are still some schemes who are nervous to use them.

Worth understanding the basics to see whether derivatives can help

“Trading” and “derivatives” are probably as scary for farmers and Trustees as the idea of me farming! However, the exception is that for hundreds of years these tools have been used to reduce nerves and manage risk, so it is worthwhile understanding at least the basics to see whether they could help you manage the pension scheme.

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