Wheat Futures as a Tool of Stabilization of Raw Material Costs in Bakery Sector. Sławomir Juszczyk. Rafał Balina

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1 Overcoming the Crisis: Economic and Financial Developments in Asia and Europe Edited by Štefan Bojnec, Josef C. Brada, and Masaaki Kuboniwa Wheat Futures as a Tool of Stabilization of Raw Material Costs in Bakery Sector Sławomir Juszczyk Warsaw University of Life Sciences SGGW, Faculty of Economic Sciences Rafał Balina Warsaw University of Life Sciences SGGW, Faculty of Economic Sciences Abstract: The article presents the example of using relations between the price of wheat flour sold by the milling companies and the price of wheat futures listed on the FOREX market to protect the companies from bakery sector against adverse price movements of raw material wheat flour. The paper aims to present a method which can help to reduce risk of changes wheat flour price in the market by using wheat futures traded at FOREX market. JEL Classification: G14, G13 Keywords: futures contracts, cost advantage, market risk Introduction The risk is considered as one of the biggest challenges in the theory and practice of finance of the XXI century (Bennett, 2000). It is a global issue which is very important for the Polish economy which is undergoing extensive structural changes. The basis for economic decisions is the economic calculation that takes into account analysis of the cost of alternative activities and is taking into account the impact of internal and external business environment (Baranoff, 2004). As is known, we are not able to accurately predict and control the future. Both practitioners of economic life, as well as its theorists are aware of the insufficient knowledge of economics, why there is a continuing need to improve the methods of reducing the risks associated with doing business (Rejda, 2010). This is because of the need of taking decisions that should only stem from information which should use various methods of research. Also the decision-making process in the company will need to continuously look for new instruments and should adapt existing instruments for changing the breathtaking speed reality (Miciuła, 2012). From the selection of appropriate methods of risk reduction in a company it depends on its success (Dragos, Beju, Dragos, 2009) Given the above reasons companies increasingly tend to manage risk. The concepts of risk management policies that include risk associated with the company (Harrington, Hiehaus, 2004). Its primary object is to improve the company's financial results and provide such conditions that the institution did not incur losses greater than originally intended (Dziawgo, 2010). In practice, the idea is that the maximum limit and how best to protect themselves against it (Adamski, 2004). In the case of companies in the baking industry risk management of commodity price changes seems to be necessary today because lower harvest wheat in Poland and East Central Europe, in 2010 contributed to a considerable increase price of wheat grain on the domestic market. Limited supply of raw material and its high price on the Polish market has forced milling companies to increase import of wheat grain. Price increase of raw 99

2 material resulted in higher prices of wheat flour which is the basis of bakery production. Cause of higher wheat flour price was increase share of flour cost in the net selling price of bread which has doubled in the second and third quarter of 2010 and the estimated increase the price of bread sales by producers reached 20-30% (Mielczarski 2010). In addition, the increased level of economic uncertainty in the current crisis has changed the way of functioning of many businesses from the bakery sector. When the increased volatility of exchange rates, interest rates and commodity prices on commodity markets, bakery company discovered that their growth was not only contributes of the risk specific to the type of their business, but also of the risk of price changes in the financial markets (Gryglik, 2001). In order to avoid significant changes in the prices of flour, bakery companies may use futures contracts that allow reducing the risks associated with fluctuations in commodity prices (Reilly, Brown, 2001). Hedge against adverse movements in prices of raw material which is wheat flour, can afford to attain the cost advantage against other market participants because it gives a chance to keep the cost of raw materials at the current level and thus will not need to raise prices of bread. Futures contracts are known for more than four centuries - the first mention of the futures contracts become from the seventeenth century from Japan where feudal lords needing money for a lavish life, often selling their future harvest (Zalewski 2006). Despite a long history of using in practice futures contracts are considered to be extremely complicated. Consequently, the futures contracts are not popular in Poland (Reilly, Brown 2001) which explains their rare use as a tool to protect against market risk caused by changes in commodity prices. However studies show that they are a good tool with high efficiency to protect against adverse price changes for livestock farmers, consumers and producers of feed and other agricultural products (Bliźniak, Gontarski 1996). Going forward it can be concluded that the futures contracts can also be used in the bakery industry to protect against uncontrolled changes prices of flour. Furthermore the use of futures contracts on wheat consumption as a tool for reducing the risk of adverse fluctuations in raw material prices may affect the stabilization of the entire production process (Gore, Haapasalo, Kess, 2011). Purpose and methods The paper aims to present a method which can help to reduce the risk of changes wheat flour price in the market by using wheat futures traded at over the counter market (OTC). Authors used statistical analysis tool for determining the strength of the relationship between the price of wheat flour and the wheat price on the domestic market and the wheat futures price. In addition, the study used a comparative analysis which helped to select the most favorable strategy. For the analysis authors used weekly data since January 2006 until October 2010 about wheat flour price [PLN/t], the wheat grain price [PLN/t], wheat futures prices [PLN/bushel], quotes a currency pair USD/PLN [PLN/$]. Wheat flour prices came from studies of the Department of Agricultural Markets, Ministry of Agriculture and Rural Development in Poland and represented the average sales price of wheat flour by milling companies. Information about wheat futures and quotes a currency pair USD/PLN reflect the actual trading of the FOREX market. The study assumed one unit for the articles comparison - PLN/t as a result of this authors had converting the wheat futures using the fact that a bushel of wheat has a mass of 27.2 kg. In addition to determining the value of the wheat futures was used its specification - the price of a wheat futures is based on the market value of 100 wheat bushels, with delivery term within 2 or 3 months multiplied by a $

3 Results of research The results of analysis showed that the selling price 1 ton wheat flour by Polish companies leading grain milling [PLN/t] are quite strongly correlated with the price of wheat futures [PLN/t] listed on the FOREX market. The correlation coefficient between them was Therefore, the change in trading wheat futures contracts at the world market results in a change of the net sales of wheat flour on the Polish market. For the enterprises of bakery a fairly strong correlation between these changes is a good start to use futures contracts to secure their wheat flour purchases on the Polish market as rising prices of wheat flour in the domestic market - which translates to the company on higher costs purchase of raw materials, may well be offset by the purchase of wheat futures where the wheat grain price increase could generate additional revenues that could cover the increased costs resulting from higher flour prices. Weekly changes in the wheat flour price and wheat futures price are presented in Figure 1. Figure 1. Evolution of the price 1 ton wheat flour [PLN/t], and the price of futures contract price for 1 ton of feed wheat [PLN/t] Price of 1 ton wheat flour [PLN/t] Price of 1 ton futures contracts for wheat [PLN/t] As can be seen the price of 1 ton wheat flour has a similar trend as the price fluctuations of 1 ton wheat futures. Therefore it could be concluded that it is reasonable to use wheat futures to protect against the risk of wheat flour price changes. In order to recognize the effectiveness of futures contracts to mitigate the impact of adverse changes on wheat flour prices in the domestic market, in further consideration authors have take following assumptions: The company buys every seven days a tone of wheat flour, which is consumed entirety until the next delivery. The price paid for the delivery by bakery company is accounted by price applicable on the day of delivery, delivery shall be implemented without delay. For further test authors used seven options that can help to use future contracts to reduce fluctuations in the flour price which can be used in bakery businesses. The first variant assumes that the bakery company buys a wheat futures contract for 1 ton on the day of delivery, and then after seven days, on the next delivery closes bought seven days ago future contract and in the same time buys another to protect against fluctuations flour price, and so progressing through the whole period from January 2006 to October 2010 (Strategy I). Second scenario assumes that the company in each day of the flour delivery buys a wheat future and held the position until final delivery at the end of the month, whereupon company is repeated this procedure throughout (Strategy II). Third option is assumed that the 101

4 company buy in each week wheat futures and is keeping them to the end of the calendar year. In the last day of delivery in a given year the company close all positions (Strategy III). In another variant the company secures, at the beginning of the month in the first day of delivery, planned volume of supplies for one month, and then on the day of last delivery in the month company realized profits or losses from transactions (Strategy IV). Fifth option envisages securing the quarterly consumption in the first day of the delivery of the quarter, and then taking profit on the day of last delivery of the quarter (Strategy V). In the sixth option it s assumed that the company will secure the purchase of flour by buying a wheat futures contract for half a year, which means that the first day of delivery in the first half of year company is secure the entire planned volume of supplies for a given period, and then in the day of last delivery in half of year is taking profits or losses from the transaction, and so proceed throughout (Strategy VI). Last option proposed by the authors is strategy that involves securing the annual consumption of wheat flour by buying the corresponding wheat futures contract which secure the estimated annual consumption of wheat flour by company (Strategy VII). Using the above assumptions and the collected data authors calculated annual performance which are results of using above options by bakery company. Calculated results of using propose strategies are the sum of profits and losses of using wheat futures contracts and profit or losses from flour price changes on the market. Adopted by the fact that the loss of the wheat futures contract should be covered by a drop in wheat flour prices in the market. Profit from the wheat future contract should compensate increase cost of wheat flour. Table 1. Result of market risk protection simulation [PLN] Total Strategy I Strategy II Strategy III Strategy IV Strategy V Strategy VI Strategy VII Lack of strategy As is apparent from the above calculations all presented strategies had higher overall results than the wheat flour purchase without securing wheat flour price changes by using wheat futures contracts. Analyzing table 1 it can be concluded that if we take into account only sum of the results of the survey period the most effective strategy is strategy VII which has generated the best result. But when we look at the results in individual years it turns out that they were of considerable volatility. For example in 2007 the amounted profit was almost 14.7 thousand PLN but a year later there was a loss - over 10 thousand PLN. Using Strategy VII to obtain the cost advantage in the bakery business was not satisfactory because in one year this strategy can cause significant cover wheat flour prices changes on the market while in others years not. Discrepancies between the results obtained in each year covered by the survey are shown in Figure

5 Figure 2. The assumed result of investment strategies Strategy I Strategy II Strategy III Strategy IV Strategy V Strategy VI Strategy VII Lack of strategy Figure 2 shows that the effectiveness of each strategy was conditioned by changes in prices of feed wheat on the world markets. In , presented strategy was characterized by negative results in those years because in this time was decline price of wheat flour and wheat futures contracts for wheat. In order to find the optimal strategy, which was effective in the period when the price of flour rising and when the prices falling must be sought such a strategy in which the discrepancies between the results obtained in different years were the smallest. Strategies to meet this assumption is the Strategy I and Strategy III. In both cases the results obtained from use of these strategies give suitable results for the bakery companies. The result were higher than the results in case of refusal of securing the purchase of flour. Figure 3 presents the results obtained from the Strategy I and Strategy III. They don t provide throughout favorable results, an example of the negative effect of the application of the protection strategy is the year 2008 in the case strategy III where the outcome of its application has brought a much worse outcome than the situation without any protection. The same situation we have with strategy I. In 2009 the results of applying strategy I. have been worse than if we didn t use any protective strategies. Figure 3. The result obtained by the use of seven investment strategies in PLN Strategy I Strategy II Lack of strategy Despite appearing in some years adverse results from using selected strategies the results obtained by the bakery business in the whole period can be considered beneficial. In most of 103

6 the value obtained from using selected strategies have generated results well above the value which reached bakery company without using any protection against adverse movements in prices of wheat flour. Conclusions This article showed that someone can effectively use wheat futures contracts listed on the FOREX market to protect the bakery business against adverse movements wheat flour prices. Application in practice strategy I and strategy III can allowed bakery companies to achieve cost advantages by reducing the adverse changes in the wheat flour prices. As we can see from the studies the strategies are more efficient if the prices of flour in the domestic market are rising. Evidence of this are the results obtained in and 2010 where the prices of flour increased significantly. If prices dropped down which took place in , the effectiveness of using wheat futures contracts was lower. It should be noted that wheat futures contracts are a good tool to achieve cost advantages in the bakery industry, especially when the wheat flour prices are increased on the domestic market. References Adamski A Rola i zadania dyrektora finansowego, Oficyna Ekonomiczna, Kraków : 26. Baranoff, E Risk Management and Insurance, Wiley: Bennett, D Ryzyko walutowe, Dom Wydawniczy ABC, Warszawa: 45. Bliźniak D., Gontarski L., Giełda towarowa, Wydawnictwo Fundacja na Rzecz Giełdy Zbożowo-Paszowej, Warszawa Dragos C., Beju D., Dragos S Public and Financial Institutions in Transition Economies: An Overview and Recent Evidences from Central and Eastern Europe, Managing Global Transitions International Research Journal, Vol. 7, No. 2, Summer: Dziawgo D Ryzyko na rynku finansowym. Wydawnictwo PWN, Warszawa: 89. Gore A., Haapasalo H., Kess P Production Planning through Customized ERP at a Nordic Manufacturing Company, Management, Vol. 6, No. 3, Fall: Gryglik M Zarządzanie ryzykiem walutowym, Wrocław: 103. Harrington S., Niehaus G Risk Management and Insurance, McGraw-Hill/Irwin International Edition: 8. Miciuła I Klasyfikacja strategii i instrumentów zarządzania ryzykiem walutowym w przedsiębiorstwie, Zeszyty Naukowe Uniwersytetu Szczecińskiego Nr 690, Finanse, Rynki Finansowe, Ubezpieczenia, Nr 51, Szczecin: 59 Mielczarski M., Przegląd piekarski i cukierniczy, Wydawnictwo SIGMA NOT, Warszawa: 11. Reilly F. K., Brown K. C., Analiza inwestycji i zarządzanie portfelem, Wydawnictwo PWE Warszawa: 458. Rejda, G. E Principles of Risk Management and Insurance, Addison Wesley, Eleventh Edition: 45. Zalewski G., Kontrakty terminowe w praktyce, Wydawnictwo WIG PRESS, Warszawa: