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  • The fundamentals of cotton supply and demand

    Chapter 4 - Cotton trading - The former NYBOT and now ICE Futures U.S. cotton marketplace


    Unlike other basic commodities that are more land and climate specific, such as cocoa or coffee, cotton can grow nearly anywhere that has the requisite 200 frost-free days and basic water supply. While cotton is relatively easy to grow, it varies widely in terms of grade. This means that the quality of cotton grown and the availability and desirability of each grade become major pricing factors on the demand side. Cotton grading from coarse to premium is a critical economic issue for the end-user. Coarse cotton can be used for such things as denim, whereas premium cotton is necessary to make soft sheets and shirts. The market continually shifts, and favours different growths in different countries depending on growing conditions and the type of cotton suitable for the region.

    The hardy nature of the cotton plant has made it a common cash crop for many countries in both the developed and developing world. In some developing nations, over half the gross domestic product (GDP) is represented by cotton production. Like sugar, virtually every country in the world uses cotton in some form. The ease with which cotton can be grown, the seemingly endless variety of potential goods that utilize cotton, and the commodity’s vulnerability to unforeseen natural and man-made events raise the economic stakes for cotton and ensure its enduring place in the world economy. Cotton’s primary economic position and the impact of cotton pricing help to explain the significant role of a cotton futures exchange.

    Raw cotton fibre has certain qualitative and quantitative characteristics that can be standardized, making it a commodity well suited to a futures market. The success of a futures market also should involve a broad range of participants with competing price goals and be subject to uncontrollable and unforeseen events, such as drought or flood, which will create price shocks and thereby expose all levels of the industry to price risk. Cotton fulfils all these criteria, but it also presents some unique characteristics. The price history of cotton tells the story of the ever-present price risk.

    The ICE cotton futures and options markets provide risk managers with a variety of strategic choices in developing an effective hedging strategy. The successful risk manager will carefully assess business goals, market conditions and available hedging tools. Each contract and capability offers different advantages to the risk manager.

    Futures hedging provides the security of locking in a price. While margin must be posted to maintain an open futures position, futures hedging does allow hedgers to set specific price goals. Margin represents only a small percentage of the full value of a contract and stands as a ‘good faith’ deposit to guarantee that the hedger will be able to meet obligations on a daily basis if the market moves unfavourably. Hedgers may be required to add more margin to keep the account at a minimum level in the case of adverse price moves. The hedger also has daily access to any gains realized in a favourable market.

    Options on futures hedging allow the establishment of a price ceiling or floor while still allowing hedgers to take advantage of favourable cash market moves. Buyers of options must pay the full premium upon purchase of the option. Loss is limited to the full amount of the premium. Futures therefore offer greater certainty, while options provide more flexibility. The exchange supports other hedging capabilities as well.


    Other hedging transactions

    Exchange of futures for physicals

    Some hedgers will choose to enter into an exchange of futures for physicals (EFP) arrangement to help limit basis risk. An EFP is a standardized way for a buyer and seller of cotton to combine the cash market transaction with the futures hedge. The agreement allows the two parties to base the cash price on the futures price plus or minus a differential. The net cash price is set in the futures market through the use of futures contracts. EFPs allow the buyer and seller to set the price independently of each other.

    First the buyer and seller agree to use a specific futures contract price as the benchmark price plus or minus an agreed differential. Second, the buyer and seller establish a futures position and thereby effectively set the price for the deal. Third, at an agreed date, the buyer and seller register an EFP on the exchange. The brokers for the buyer and seller at that point close out their clients’ positions at the same current market price, which becomes the invoice price for physical delivery (plus or minus the differential). Finally, the cotton is delivered at that price.

    Exchange for swaps

    The exchange for swaps (EFS) allows market users to exchange futures contracts for qualifying swap agreements. A swap is a contractual agreement in which two parties agree to make periodic payments to each other. Swap contracts are customized for the parties involved. In a commodity swap, one party pays a floating price for a commodity and the other pays a fixed price for that commodity. The physical commodity is not actually exchanged. Payment flows are limited to the difference between the floating price and the fixed price. Basically one party is paying an agreed-upon rate for the second party to assume a certain level of price risk.

    Options on spreads

    Options on futures spreads (OFS) contracts are a relatively new type of option contract. Since different futures contracts trade at different prices (the outer months often reflecting ‘carrying charges’), market participants may wish to hold ‘spread’ positions, namely buy/sell contracts in two different contract months. Where a regular option contract gives the buyer the right, but not the obligation, to establish a futures position at a pre-determined price level, an OFS gives the buyer the right, but not the obligation, to establish a spread position at a predetermined spread price between the two futures contract months.

    An OFS call option contract would give the buyer the right to establish a spread position of long on the first futures contract and short on the second futures contract. The strike price of the call option is the difference between the prices of the two futures contracts. Similarly, an OFS put option would give the buyer the right to establish a spread position of short on the first futures contract and long on the second futures contract. As with the call option, the strike price of the put option is the difference between the prices of the two futures contracts.

    ICE provides a choice of trading environments and tools: traditional open outcry on ICE’s trading floor in Lower Manhattan; or electronic trading on the ICE platform. Price data are disseminated through traditional third party vendors. Direct data and analytical tools are available on the Internet through www.NYBOTLive.com – the exchange’s own real-time streaming data service. For more information on the many strategic capabilities provided by the ICE marketplace, visit www.theICE.com or contact the exchange directly.