Applications and portfolio theory in the South African agricultural derivatives market

South African agriculture experienced rapid deregulation during the 1990s as the one channel marketing boards were dismantled. For the grains industry this meant the rapid development of a derivatives market (SAFEX). Derivative markets are surely the most intriguing and complex financial markets with the most misunderstood and riskiest instruments of all financial markets. Their complexity also caused its fair share of problems within the South African scenario with the inception of SAFEX in 1996/97.Not only is this type of market complex but it also creates huge fluctuations in the portfolio value of a derivatives linked portfolio. It is precisely this type of fluctuations and exposure that can be controlled and managed to the preferred level of risk by the correct and responsible application of these instruments. The successful application of these instruments depends greatly on the fact that the underlying market should be an efficient market which will then in turn allow for cost effective pricing of these instruments and ultimately lead to successful product structuring. The South African agricultural derivatives market was tested for efficiency by using a co-integration analysis which proved market efficiency. Once market efficiency was established it allowed for the structuring of marketing portfolios which ultimately resulted in a rule of thumb marketing strategy for maize producers. The strategy required the maize producer to fix a price during planting period for delivery in July the following year. In order for the producer to benefit from any potential upside during the season between price fixing and delivery the producer should buy a call option with an expiry date of the month of March following planting. This will save him at least four months worth of time value on the option premium. This study also acknowledged the fact that the derivatives market in South Africa is still in its fledgling phase and realises the vast potential for risk reduction through radical innovation by creating and mixing the basic positions of derivatives. This study illustrates by way of examples a few approaches in structured products. In an attempt to achieve successful product development the study applied portfolio theory as a means to quantify risk by using mean return and portfolio variance parameters. It addressed the more obvious price risk situation which is faced by all grain producers by developing a rule of thumb marketing strategy for farmers. The more complex situation of emerging agriculture was also considered where the objective was to enable a small scale producer to benefit from the risk reduction potential of these instruments. At the same time it would also allow them to access production credit without a traditional balance sheet while allowing the financier to be ring fenced from the risk of price fluctuation on the clients profit profile. A more adventures approach was followed for the dairy industry by creating a proxy price for milk based on the maize price of SAFEX in an attempt to encourage an increase in the volatility of the milk price which could then be managed very successfully through the use of derivatives which will then ultimately enable cash flow management. © University of Pretoria 2005 G551 AG