Coffee as a commodity: analysis of its financial markets and contracts

Originally born in today's Ethiopia, coffee is the third most consumed beverage in the world, after water and tea, and the second most traded commodity, after crude oil. It is produced in 70 countries, with Brazil as the world's largest grower and seller, followed by Viet Nam, Colombia and Indonesia. The aim of this thesis is to deepen the coffee industry analysis, focusing in particular on the process of acquisition of coffee by companies, which can happen through international trade houses who take the responsibility for making everything which is necessary so that coffee is delivered directly to the roaster or through the financial markets and the derivatives contracts. However, there are some roasters, especially the largest ones, such as Lavazza or Nestlé, which also maintain their own in-house buying companies, which deal directly with the origin country. When talking about coffee (and other commodities in general), it is important to distinguish between two types of markets: the spot market and the financial market. The first one is where the physical product, coffee, is traded at the spot price, which is the price determined by the supply of and demand for coffee, so it is influenced by the factors affecting them. In particular, the supply of coffee, which is composed of production and stocks, is first of all affected by producing countries' weather shocks. Indeed, by being coffee a product of the nature, it is subject to the effects of climate, which cause prices to be volatile as any weather shock is expected to cause damages to the crop and so to the supply. On the other hand, the demand for coffee is affected by consumers' income but also by the competition from other beverages, especially soft drinks. The financial market, instead, is where the physical commodity is traded too but it especially is where the vast majority of the contracts exchanged are used for hedging. In particular, coffee contracts are traded over organized markets, the New York Board of Trade and the London International Financial Futures and Options Exchange, where contracts are standardized and defined by the competent authorities of the market in which they are traded. The coffee contracts I am referring to are the derivatives contracts, which are instruments whose payoffs are linked to previously issued securities or assets, known as underlying. In this case the underlying is coffee. Among the derivatives coffee contracts there are futures and options. Futures are derivatives financial contracts in which two parties, the buyer and the seller, agree to buy or sell a determined quantity of an underlying asset, at a predetermined price and defined time in the future. They have been created to protect investments from future price changes. In this sense, those expecting prices to increase (decrease) can go long (short), which means that they will buy (sell) the futures contract. On the other hand, options are derivatives contracts which give the right, but not the obligation, to buy and sell the underlying asset at a predetermined price (called strike price or exercise price) on (or before) a given date in the future. Another way to exchange coffee as a commodity is through coffee exchange traded funds (ETFS) and coffee exchange traded notes (ETNs), which are both debt obligations. Their main difference is that ETNs track the price of the underlying other than commodities, while ETFS track commodities indices.