Financial Futures: A Useful Tool for Transferring Interest Rate Risk Away From Farm Borrowers or Lenders?

Interest rate risk is more important to agriculture in the 1980s than in earlier decades. Previously, farmers and others were keenly sensitive to fluctuations in production and commodity prices, a sensitivity that led to the development of a variety of methods to alleviate these inherent risks. But agriculture was much less sensitive to movements in interest rates. Rural financial markets that were essentially isolated from national financial markets shielded farm borrowers and lenders from interest rate risk. All that has changed. Deregulation of financial markets along with technological innovations brought financial institutions serving rural areas into direct competition with those in urban areas. This greater competition for funds means that agriculture must now pay market rates as it competes for funds in money markets. Also, the decision of the Federal Reserve since 1979 to target monetary aggregates has made rates more variable. Highly stimulative fiscal policy has contributed further to fluctuations in rates through its effect on inflationary expectations. Therefore, just as deregulation more fully exposed agriculture to financial market conditions, a new macroeconomic policy mix was making interest rates more volatile. A high degree of capital intensity and a surge in debt financing during the past decade make capital formation and financial performance in the agricultural sector particularly susceptible to interest rate swings. To illustrate, in recent years, with farm sector debt exceeding $200 billion while net farm income ranged between $20 and $30 billion, a one percentage point change in interest rates would have reduced or increased net income as much as 10%. Stated another way, agriculture's debt-to-income ratio today is about ten, while it was about one in 1950. Agriculture's challenge now is to manage this interest rate risk. Financial futures can be a highly effective tool for this purpose. This paper examines how financial futures can be used by both farm borrowers and farm lenders as well as the impediments to their use; then the paper summarizes some issues that will determine whether financial futures realize