Land O’ Lakes is an iconic American brand — most consumers have seen the company’s products on the shelves at grocery stores across America.
But what you also might not know is that the company is a participant in the capital markets, using sophisticated trading vehicles to hedge costs and risks. Derivatives are one of those trading vehicles.
You’ve probably heard of financial derivatives, but may not be entirely clear on what they are. At the most basic level, derivatives represent a contract between two parties based on, or “derived” from, the value of an underlying asset. It’s a tool for hedging risk and to protect against unexpected events.
How does that work in practice? Consider how a company like Land O’ Lakes, Inc. uses a type of derivative known as futures to manage risk and uncertainty in the prices of agricultural commodities.
In Land O’ Lakes’ 2013 Annual Report, the company indicates they purchase commodities like milk, butter, soybean oil, corn, wheat and other agricultural products through “derivative commodity instruments.” These derivatives include “futures contracts offered through regulated commodity exchanges” that the company purchases to reduce their exposure to sudden changes in price.
Let’s look at an example using simple numbers. A company using agricultural inputs, like Land O’Lakes, knows that it needs a certain amount of corn in six months, but is concerned that the price might rise before then and it would like to set the price it will pay for corn now. That company could enter into a futures contract for, say, 1,000 pounds of corn at an agreed upon price of $1 per pound, for delivery in six months.
Sure enough, six months later it turns out that bad weather caused and resulted in a smaller than expected corn crop, and the price of corn shot up to $2 per pound.
Since the company locked in the lower price six months ago through a futures contract, they’re protected against the increase in cost. Consumers benefit also, as it means the company is less likely to need to raise prices at the checkout counter. (To be sure, a futures contract can go the other way, too — if the price had fallen over six months to 75 cents per pound crop, the company would still have paid the higher price agreed upon in the contract).
It’s not just agricultural commodities that can be hedged using derivatives. To take another example, airlines frequently enter into futures contracts based on the price of fuel, to hedge against future changes in price. This is another case where consumers may directly benefit; since airlines can manage the risk of fluctuations in one of their greatest costs — fuel — so they can offer lower prices for airline tickets.
Other common types of derivatives include swaps and options, as we have outlined.
Derivatives are simply a tool for connecting buyers and sellers in a free exchange of value and helping to guard against the unexpected.