The market for hedging services : a marketing - finance approach with special reference to rights futures contracts

Research output: Thesisinternal PhD, WU


Due to the recent and proposed reductions in price support for agricultural products, as a part of the European Union's common agricultural policy, an increase in price volatility for agricultural raw materials is perceptible. This causes an increase in price risk, both for the primary agricultural company and the affiliated agribusiness. For a risk-averse entrepreneur, the higher price volatility in the market of agricultural raw materials will increase his or her need for price risk management instruments, such as futures contracts.

Not only does an increased price volatility further the use of existing futures contracts for raw materials, it also leads to the introduction of new ones. Moreover, the introduction of production and environmental rights forms an additional impulse to the development of futures contracts as well. Recent developments in computer-guided trading systems will further enhance the attractiveness and accessibility of the futures contract as a price risk management instrument.

In addition, the introduction of a single European currency will give an extra impulse to trade in (commodity) futures contracts, since it obliterates one of the traditional difficulties in futures contract specification, standardization after currency and thus makes national futures markets more attractive for participants from other European countries. The developments mentioned above - increased price volatility in the spot market of agricultural raw materials, the introduction of negotiable production and environmental rights, the rise of computerized trading systems and the introduction of a single European currency - all add to the great interest in agricultural futures markets which exists among financial institutions. For several European futures markets, among which the Amsterdam Exchanges, the London International Financial Futures & Options Exchange and the Marché à Terme International de France, this has been the cause for the development of new agricultural futures contracts. However, futures contracts involve a substantial risk of failure. Of the 40 futures contracts launched around the world in 1995, only a few were successful in their first year. The development and introduction of futures contracts is an expensive and time-consuming process, especially when it concerns entirely new contracts. For this reason, insight into the market for hedging services is desirable.

In this doctoral thesis we will focus on those aspects of the risk reduction services provided by futures exchanges which lie in the interdisciplinary field between marketing and finance. The services offered by futures contracts will be investigated from two approaches: the finance approach and the marketing approach .

The finance approach to financial services is a normative approach: it answers the question 'which necessary conditions will have to be met to make a particular financial service successful?' Fulfilling these necessary conditions, however, does not guarantee the market success of financial services. Their success also depends on the extent to which they succeed in meeting the needs of (potential) customers at a competitive price. The latter point of view stems from the marketing tradition, which holds that customer needs occupy a central position in the development of products and services.

The marketing approach conducts qualitative and quantitative research into the need for financial services and the market potential of a particular financial service. In many cases, alternative products or services will be available to satisfy the entrepreneur's needs. For this reason, the marketing approach pays a lot of attention to the entrepreneur's decision making process. In our particular case the entrepreneur's decision making process concerning price risk management instruments. Insight into the way in which an entrepreneur reaches a decision and why he or she decides the way he or she does, provide the marketer with clues on how to market the hedging service. Given the necessary conditions imposed by the finance approach, the results from the marketing approach may serve to compose the characteristics of a particular financial service.

When creating a particular service, the marketing approach, in its preoccupation with customer needs, tends to pay only limited attention to issues of technical feasibility, whereas the finance approach tends to undervalue customer needs in favor of the technical aspects of a particular service. A combination of the marketing approach (with its stress on desirability from a customer perspective) and the finance approach (with its focus on the technical feasibility of a service) seems to offer a solution to this problem. Therefore, the development of new futures contracts would be served by a combined use of the marketing and the finance approach.

Apart from the integration of both approaches, a further deepening of each approach would be beneficial. This thesis elaborates on a number of aspects which stem from the finance approach, e.g. hedging efficiency and liquidity. The perspective has been shifted from portfolio to exchange management. Furthermore, the optimal hedge ratio and optimal "commodity product spread" have been deducted for rights futures. The marketing approach has also been elaborated upon, in that an investigation has taken place of the how and why of the choices which entrepreneurs make concerning the covering of price risk and, more particularly, concerning futures contracts.

This study consists of three parts. Part I systematically discerns the different sources of risk that emerge from transactions on the futures market. This classification has been used to develop new measures for a futures market's hedging effectiveness and liquidity, which provide both the exchange management and the hedger with insight into the risk-reducing capacity of futures contracts. Moreover, a conceptual model for over-all risk reduction has been developed, on the basis of which a measure for hedging effectiveness has been developed. Contrary to the existing measures, this one does not focus on portfolio performance, but on the hedging function of a futures contract. This measure, as opposed to others, takes into account the fact that futures contracts on the one hand realize a reduction of price risk in the spot market, and on the other hand, introduce a risk of their own, which is inherent to the futures trade. Our measure discerns basic risk and market-depth risk. Moreover, it takes into account the costs of commission. Let this measure be the distance between the hedging service offered by the futures exchange and the 'perfect hedge', an ideal situation where the hedging service eliminates risk in the spot market without introducing an additional risk of its own, then this distance can be subdivided into a systematic and a non-systematic part.

The systematic part, caused by the specifications of the futures contract and the structure of the futures exchange, can be managed by the futures exchange, whereas the non-systematic part is beyond the exchange's influence. The measure for hedging effectiveness provides the hedger with a means to compare the competitiveness of different futures contracts. It incorporates not only the characteristics of the futures contract, but also the spot market risks. The measure's futures market risk component indicates the hedging quality of the futures contract. The spot market price risk component emphasizes the need for price risk reduction. The empirical results, based on data from the Amsterdam Exchanges (Agricultural Futures Markets), show the measure's usefulness for an exchange management.

As an important determinant of the hedging effectiveness of futures contracts, liquidity, or, more accurately put, market depth has been studied more closely. Contrary to earlier investigations into market depth, we show that the price path is non-linear due to market order imbalances. The market depth measure developed consists of two dimensions, which can be related logically to the futures market's toolbox. Our findings indicate that market depth is preferably to be valued along the two dimensions that constitute its basis.

Not just motives of a financial-economic nature play a part in the entrepreneur's decision to trade on the futures market. Therefore, it is of the utmost importance to study the decision making behavior of entrepreneurs concerning price risk management instruments. To this study, Part II of this book has been devoted. In this part, a decision making model has been developed which tells us how entrepreneurs decide and why they decide the way they do, concerning price risk management instruments. In this context, risk attitude is an important concept. Methodological research was conducted into the way in which risk attitude is measured within economics (the "expected utility framework") and within marketing-psychometrics (risk attitude scales). During large-scale experiments, the risk attitude measures developed were tested for construct validity by checking for convergent validity and nomological validity. The different risk attitude measures correlate significantly, indicating convergent validity. Moreover, the value function (obtained using the rating technique) does not correlate with the risk attitude measures, indicating discriminant validity. The psychometric risk attitude scale performs well on the self-report measures, contrary to the measure obtained from the lottery technique and the intrinsic risk attitude obtained through relating the utility function (itself obtained using the lottery technique) and the value function. However, the risk attitude measure and the intrinsic risk attitude greatly outperform the psychometric scale where the relation with actual behavior is concerned.

After having gained more insight into the risk attitude construct, the decision making behavior of entrepreneurs was modeled. Important elements affecting his or her decision making behavior were: the extent to which the entrepreneur feels that the use of futures will enhance his or her entrepreneurial freedom (as compared to other price risk management instruments), his or her understanding of the functioning of futures contracts (compared to his or her understanding of other relevant price risk management instruments) and the performance of futures contracts in the field of price risk reduction (compared to that of other relevant price risk management instruments).

The decision making process of entrepreneurs appears to have a two-phase structure. During the first phase, the entrepreneur decides whether futures contracts constitute a relevant alternative and should thus be in his or her toolbox. In this phase the aforementioned elements entrepreneurship, understanding and performance are of great importance.

During the second phase of the decision making process, when futures contracts are already a part of the entrepreneurs toolbox, the difference between the entrepreneur's psychological reference price and the actual futures market price becomes an important factor in the decision for or against entering the futures market. The components entrepreneurship and performance remain of importance during this phase of the decision process, whereas understanding no longer plays a part in the second phase.

Due to the structure of futures markets, the process of disseminating information about innovative futures contracts, henceforth the information dissemination process , is of great influence on the success of a futures contract. This has been investigated for an information dissemination process in which the brokers from the exchange spread the information among the potential users of a futures contract.

Part III of this study is devoted to an investigation into the feasibility of futures contracts on rights. First, an overview and a taxonomy are presented of the different environmental and production rights in agriculture and outside of it. The prices of these rights reflect the production rent. We show that the specific characteristics of rights increase hedging effectiveness. From this point of view, rights futures seem an interesting instrument for eliminating spot market price risk. We further show that the use of rights futures may be highly effective in situations of "spreading", where production has been restricted by rights.

By integrating the marketing and finance approach, the insight into the market for hedging services is increased. On the one hand a marketing-finance approach broadens our knowledge of existing markets, on the other hand it improves the development process of hedging services. By using both approaches, potential problems, as well as opportunities, can be discovered in an early stage. Thus, our investigation into rights futures yields that, from a finance perspective, these new futures contracts have highly convenient features and are therefore efficient instruments to cover price risk. The marketing perspective, however, reveals that potential users perceive futures markets as very complex and therefore do not perceive futures contracts as alternative price risk management instruments.

The marketing-finance approach is an integral approach which contains all aspects relevant to draw conclusions about the viability of a futures market. The marketing-finance approach yields insight into the policy measures which a futures market might take to create and secure a viable futures market. In this book much attention has been paid to subjects pertaining to one of both approaches which demanded further deepening in order to reach a fruitful integration of both approaches. Further elaboration of this marketing-finance approach is of great importance to an efficient and effective futures market policy.

Original languageEnglish
QualificationDoctor of Philosophy
Awarding Institution
  • Meulenberg, M.T.G., Promotor
  • Heijman, Wim, Promotor
Award date1 May 1998
Place of PublicationWageningen
Print ISBNs9789054858379
Publication statusPublished - 1998


  • futures trading
  • options trading
  • forward trading
  • marketing
  • management
  • finance
  • public finance
  • banks
  • currencies
  • enterprises
  • risk
  • decision making
  • operations research
  • simulation
  • work flow
  • linear programming
  • legal rights
  • agriculture
  • cum laude


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