FX Markets Drive Increased Hedging Opportunities in Australian Wheat Trades

The Chicago Board of Trade (CBOT) offers a futures contract for Australian wheat, based on export prices assessed by S&P Global Platts (Platts). The international trade in wheat is in US dollars, making the CBOT contract a valuable hedging tool, but the conversion of trade revenues into local currency means there is an additional foreign exchange (FX) risk which may need to be managed.

Foreign exchange rates typically fluctuate separately from the price of agricultural commodities due to the different drivers that tend to affect FX and commodity markets. The movements in the foreign exchange rate can have a substantial positive or negative impact on incomes from international commodity trade.

Australia produces a substantial amount of wheat and supplies the international market. Australia is the world’s fifth largest exporter of wheat and major export markets are in Asia and the Middle East. The latest USDA data shows that production for the 2020-2021 marketing year were around 33 million tons and of this 22 million tons was likely to be exported. Estimates for the 2021/22 season put Australian wheat production at 28 million metric tons, with 20 million metric tons of this amount likely to be exported².

Movements in the Australian dollar (AUD) can have significant implications for the financial returns that are generated from Australian exports of wheat. For example, we can look at market prices in the period up to and including June 2021.

During this period of increased global uncertainty due to the worldwide pandemic (January to June 2020), prices for wheat in US dollars had fallen 4% in comparison to the values seen at the end of the fourth quarter of 2019 due to falling demand. At the end of September 2020, the front month futures contract was priced at 254.00 US dollars per metric ton. Over the same time period, the value of the AUD against the USD had also depreciated reflecting the strong position that Australia holds in the commodity markets. From January to June 2020, the Australian dollar vs. the US dollar fell from AUD 0.7038 per dollar to AUD 0.6900 per dollar, a decline of 2%. The fall in the AUD FX rate (vs. the US dollar) had a beneficial effect for Australian wheat exporters, as the CBOT price expressed in AUD has increased from AUD 373 to AUD 398 per metric ton, an increase of around 7%.

Such significant volatility in the FX markets highlights the uncertainty that exporters face. It is worth noting that any move in the FX rate that benefits an exporter – i.e. an appreciating USD versus AUD since the exporter is selling in USD – will conversely have a negative effect on the importers (a depreciating AUD versus USD since the importer is buying in USD) although the impact will likely be less as the importer can switch to a cheaper supplier.

CME Group offers futures and options contracts on the Australian dollar FX rate, which can be used to manage this FX exposure. These contracts are physically delivered at maturity, meaning that if held all the way to maturity, US dollars are exchanged for Australian dollars to fulfil the contractual obligation.  The contract unit of each futures contract is AUD 100,000.

Using prices at the end of September 2020, this equates to a contact value of 71,630 USD, which can be compared to the dollar value of an Australian wheat futures contract of 12,700 USD.

Below is an example of how the CME Australian Dollar futures contract can be used to hedge the FX component of an Australian wheat export transaction:

Scenario

In late March, an Australian wheat producer has an export order from a miller for 30,000 metric tons of wheat, to be delivered at the end of May. The agreed terms are for payment in US dollars at a rate equal to the Platts “APW Wheat FOB Australia” price on the delivery day, plus 10 USD per metric ton.

For the producer, this creates a two-month period of uncertainty as to the revenue that will be achieved. From a price risk management perspective, the producer is exposed to the price of Australian wheat but as they earn their income in AUD, they are also exposed to the FX rate between the US dollar and the AUD. Both price risk components can be hedged with futures.

The producer can manage their exposure to the wheat price using the CBOT Australian Wheat futures contract. The lot size of the CBOT Australian Wheat futures contract is 50 metric tons so to hedge 30,000 metric tons would require a total of 600 lots of Australian wheat for May delivery to be sold.

The price of the CBOT Australian Wheat futures May contract is 264.50 US dollars per metric ton. By selling 600 lots of futures at this price, one will hedge the exposure to wheat price fluctuations. With a price of 264.50 US dollars per metric ton established through the use of the Australian Wheat futures hedge, the producer can be confident in achieving a dollar revenue of 274.50 US dollars per metric ton on the sale of the wheat, which includes the agreed premium of 10 USD per metric ton with the miller.

The FX component of the transaction can be hedged using the CME Australian Dollar futures contract (product code AD). To determine the hedge transaction required, the producer needs to determine whether to buy or sell futures and the quantity to be transacted.

The CME Australian Dollar futures contract has a contract size of AUD 100,000, and prices are quoted in terms of the number of US dollars per Australian dollar. Buying a CME Australian Dollar futures contract is therefore equivalent to buying Australian dollars in exchange for US dollars. Selling the future is equivalent to selling Australian dollars in exchange for US dollars.

The Australian wheat producer will wish to convert the US dollar proceeds into Australian dollars upon completion and delivery of the wheat and therefore will be buying Australian dollars. The associated FX risk exposure can be hedged by buying CME Australian Dollar futures contracts. These futures should be purchased to implement the hedge and sold to close out the position once the FX hedge is no longer required. This will create a “futures pay off” on the FX portion of the hedge being the difference between the price they paid and the price they closed the trade out at. The expiration of the CME Australian Dollar futures contract occurs in the middle of the named expiry month.⁴ Therefore, for example, the June futures contract expires in mid-June. This would make June the appropriate futures contract month to hedge this transaction which has an intended completion date in late May.

The number of FX futures needed to hedge the transaction can be calculated by considering the currency exposure. With the wheat futures hedge, the producer will expect to receive US$ 8,235,000 from the sale.

The futures price, quoted in US dollars per Australian dollar, is 0.76545. At this exchange rate the sale proceeds will be AUD 10,758,377 (being $8.235 million/0.76545 for the FX rate). The contract size of the CME Australian Dollar futures contract is AUD 100,000, therefore, to hedge the FX exposure, the producer needs to buy 108 lots of futures.

We can examine what might happen to this hedged position in different outcomes. To focus on the FX component, let’s assume that the wheat price is unchanged over the one-month period.

A decrease in the value of the Australian dollar can also be viewed as an increase in the value of the US dollar, measured in Australian dollars. In this example, we assume a decrease in value from 0.76545 USD per Australian dollar to 0.73545 USD per Australian dollar, a decline of 3.9%. 

With the wheat price stable at 274.50 US dollars per metric ton, the US dollars proceeds from the sale are 8,235,000 USD, and the return from the wheat futures hedge is 0 USD. In local currency terms, the proceeds are AUD 11,197,266, which is higher than anticipated had the exchange rate not changed.  This higher outcome is offset by a loss made on the FX futures position. Overall, the cashflow has been maintained in line with expectations, which is the purpose of the hedging strategy.

An increase in the value of the Australian dollar can also be viewed as a decrease in the value of the US dollar, measured in Australian dollars. In this example, we assume a marginal increase in value from 0.76545 USD per Australian dollar to 0.79545 USD per Australian dollar.  

Again, with the wheat price stable at 274.50 US dollars per metric ton, the US dollars proceeds from the sale are 8,235,000 USD, and again the return from the wheat futures hedge is 0 USD. However, in local currency terms, the proceeds are AUD 10,352,631, which is lower than anticipated had the exchange rate not changed. To compensate, the FX futures hedge position records a gain of 324,000 USD, which equates to a gain of AUD 407,317.

Australian wheat markets⁵ remain volatile and hedging price risk remains an important consideration. In addition, the volatility in foreign exchange markets can also be an unpredictable factor that firms are looking to hedge. By hedging foreign exchange risk, companies are able to stabilize future cash flows which in turn creates greater confidence in business performance.

Salient features of the futures contracts discussed in this article.

1. Source: US Department of Agriculture’s Foreign Agricultural Service
2. Source: US Department of Agriculture’s Foreign Agricultural Service
3. Front-month CBOT Australian wheat futures settlement price; converted to AUD using CME AUD/USD futures settlement price.
4. See https://www.cmegroup.com/trading/fx/g10/australian-dollar_contract_specifications.html.
5. CME lists a number of global wheat products – details can be found here https://www.cmegroup.com/trading/agricultural/wheat-futures.html
6. https://www.cmegroup.com/markets/agriculture/grains/australian-wheat-fob-platts-futures.contractSpecs.html
7. https://www.cmegroup.com/markets/fx/g10/australian-dollar.contractSpecs.html