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Suppose I am a farmer who entered into a futures contract to deliver crops in 6 months. Suppose that a natural disaster destroyed all my crops just before the delivery date. As a result, it will be impossible for me to deliver. What happens to me, the other party, and the futures contract? Do I default on my obligations? Will the other party be compensated?

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    $\begingroup$ if the contract is still open, then the farmers best course of action is to close the position. Depending upon the price this might be a gain or loss but since the exchange has not automatically closed the position there is at least enough margin in the futures account to cover the current level. This will mitigate any further downside risk. Non-delivery is met with fines/legal action which will be more costly than simply closing the position. A farmer whose risk management permits the possibility of complete crop failure with no time to close futures contracts is destined to failure.. $\endgroup$ – Attack68 Apr 12 at 7:02
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    $\begingroup$ the futures contract eliminates price risk (the risk connected with the nationwide price of the crop). It does not protect against quantity risk, the inability to grow the planned quantity of the crop (if anything it complicates it as Attack68 explained), or basis risk (the risk that the price in your local area is different than the exchange price due to special circumstances). These are known limitations of futures as a hedging tool. $\endgroup$ – noob2 Apr 12 at 8:40
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To answer your questions in turn:

What happens to me, the other party, and the futures contract?

Nothing happens to you initially. The other party is the exchange - nothing happens to exchange initially. Nothing happens to the contract - it's still valid.

Do I default on my obligations?

If the contract is has final settlement via physical delivery and you don't deliver, then yes you have defaulted. The exchange can then take legal proceedings against you.

Will the other party be compensated?

The other party of your initial futures contract trade will get their crops delivered as their contract is with the exchange, and the exchange will (almost certainly) not default. They will do this by buying the crops in the spot market and pass it on to the holder of the long contract.

If for some reason the exchange never gets compensation from you, the cost will be borne either by the exchange (it is a corporation like any other), or distributed amongst its members, depending on its member rules.

However, all this can be avoided if you simply buy the offsetting amount of the futures contract so as to make your open interest on the specified contract zero, before the final trade date. Then you don't have to deliver anything, but you might have lost (or made!) some money on your futures contract in the process. However, you still lost youur crops, so likely you will have lost money. Did you buy weather insurance? :-)

EDIT:

There is another way you can avoid default with the exchange. On the delivery date, you can buy the crops in the spot market and then deliver them.

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  • $\begingroup$ The futures market is the Chicago Mercantile Exchange. Where is the spot market? $\endgroup$ – Flux Apr 24 at 5:47
  • $\begingroup$ Depends on the contract $\endgroup$ – ThatDataGuy Apr 25 at 10:37

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