In a competitive market economy, there is general agreement among economists that a market for a product would be perfectly competitive if:
(1) Many buyers and sellers met openly, and no one individually controlled the market;
(2) The commodity was standardized so all knew the grade and quality of the product being traded; and
(3) Buyers and sellers could enter freely and participants had full knowledge of available supply and demand for their product.
While no market meets the ideal, futures markets come closer to it than most others. Because of their highly competitive nature, futures markets provide three important economic benefits:
(1) With many potential buyers and sellers competing freely, futures trading is a very efficient means of determining the price level for a commodity. This is commonly referred to as price discovery;
(2) Futures markets permit producers, processors, and users of commodities, debt instruments, and currency markets a means of passing the price risks inherent in their businesses to traders who are willing to assume these risks. In other words, commercial users of the markets can hedge, which is to enter into an equal and opposite transaction in order to reduce the risk of financial loss due to a change in price and, by doing so, lower their costs of doing business. This results in a more efficient marketing system and, ultimately, lower costs for consumers; and
(3) Since futures markets are national or worldwide in scope, they act as a focal point for the collection and dissemination of statistics and vital market information.
In the days before credit was readily accessible, some stores carried the sign, "cash and carry," meaning: pay your cash and carry away the merchandise you purchased. That, in its simplest form, is the cash market. The buyer finds the precise commodity that suits him--perhaps an orange that has ripened to the proper degree--pays his money and becomes the owner of the merchandise. It's a time-tested market system, and the one most widely used in all forms of business to transfer title to goods.
Sometimes, cash markets can be modified and improved to serve a particular purpose. For example, a person who goes to the newsstand to buy a magazine may find it is more convenient to contract with the publisher for delivery at home. This modification is called a forward contract, and such contracts are widely used in many types of business. The buyer and the seller agree today on a description of the product that will be delivered in satisfaction of the contract. The buyer makes payments as agreed, and the seller will deliver the asset at a designated site on a specified date.
The system works quite well when the cost of producing the commodity is known and the selling price is presently acceptable to a buyer. However, with commodities that compete in world or national markets, such as coffee, there are many relatively small producers scattered over a wide geographic area. These widely dispersed producers find it difficult to know what prices are available, and the opportunity for producer, processor, and merchandiser to ascertain their likely cost for coffee and develop long range plans is limited. Futures trading, used in the Midwest for grains and similar farm commodities since 1859, and adapted for coffee in 1955, provides the industry with a guide to what coffee is worth now as well as today's best estimate for the future.
In a competitive market system, buyers and sellers determine prices for commodities through their transactions in the marketplace. The prices at which sellers offer to sell their goods and buyers bid to buy them are based on their best current assessments of the supply and demand for the commodity.
Usually, no one knows the exact total supply of a commodity. For example, in the United States most commodities are produced by many firms. Storage and ownership also are fragmented. The total supply available usually is an estimate, as is new production, and inventory figures are not precise. In addition, the quality of the commodity frequently is not known. Thus contributing to the complexity of determining an appropriate price.
Even with its problems, the U.S. commodity price reporting system generally is better and reports are more available publicly than commodity reports from many other countries. Since most commodities trade internationally and are affected by incompletely reported situations in other countries, U.S. markets must cope with such unknowns.
Demand is even more difficult to measure, based as it is on what people may decide they wish to buy. Changing prices may alter consumers' intentions regarding the quantity of a close substitute commodity they want--or whether they want it at all. The availability of a substitute may change the demand picture for the original product as well as for the related one. However, prices for goods in the marketplace play a vital role in our economic system and help to efficiently allocate scarce resources.
Markets and prices play vital roles in our economy system and help to determine our standard of living. Markets are the nerve system of our decentralized economic system; prices are the impulses conveyed throughout the system, enabling us to respond stimuli and produce goods and services efficiently and changing prices force to adjust and moderate our consumption pattering. In other words, price influences production and consumption. Price is a rationer; if the price is right, the supply of a commodity should balance the demand for it--production should match use.
If the price is too high, some who may have planned to use a product may decide to use less, go without, or they may select a substitute--eat chicken instead of beef, for example. If enough users are priced out of the market, price may turn down which may encourage more use and discourage production.
If the price is too low, users will deplete existing supply and a shortage may develop. Subsequently, prices may rise, which will tend to discourage marginal buying. Should price remain relatively high this would likely promote production or attract additional supply of good.
Processors and merchandisers are guided by the prices that people are willing to pay for their goods. Their marketing decisions are made independently, based on estimates of what consumers are willing to buy and how much they are willing to pay. Once in the marketing system, goods are channeled from point of production to processor and distributor and on to the consumer. Futures trading does not enter directly into these channels; it supplies information on price which reflects buyers' and sellers' current view on a commodity's value and provides a means to transfer the price risk of holding these items in inventory for later sale.
In an active futures market, the demand for information by traders is enormous. Futures exchanges tend to become collection centers for statistics on supplies, transportation, storage, purchases, exports, imports, currency values, interest rates, and other pertinent information. These data, which are compiled and distributed throughout the exchange community on a continuous basis, are immediately reflected in the trading pits as traders digest the new information and adjust their bids and offers accordingly. As a result of active buying and selling of futures contracts, the market determines the best estimate of today and tomorrow's prices for the underlying commodity. In effect, prices are discovered at futures exchanges. Prices determined via this open and competitive process are considered to be accurate reflections of the supply and demand for a commodity, and for this reason they are widely used as today's best estimate of tomorrow's cash market prices for a standardized quantity of a commodity.
Price discovery is the process of arriving at a figure at which one person will buy and another will sell a futures contract for a specific expiration date. In an active futures market, the process of price discovery continues from the market's opening until its close.
Futures markets, because of low transaction costs and frequent trading, encourage wide participation, lessening the opportunity for control by a few buyers and sellers. Because they are freely and competitively determined, futures prices are generally considered to be superior to administered prices or prices that are determined privately.
Futures contracts are standardized as to quantity, quality, and location so buyers and sellers only bargain over price. Because of this standardization, commercial interests are better able to compute local cash prices. This contributes to local market efficiency and to consistency among markets. In many commodities, futures prices have earned a role as key reference prices for those who produce, process, and merchandise the commodity. Since cash and futures prices reflect similar price-affecting factors, their price levels tend to rise or fall together.
Commodity production and marketing involve sizable price risks, and risk represents a cost which affects the value of a commodity. While there is no way to eliminate uncertainty, futures markets provide a competitive way for commodity producers, merchandisers, processors, and others who may own the actual commodity to transfer some price risk to speculators who will willingly assume such risk in hopes of making a profit.
The process of hedging involves the concurrent use of both cash and futures markets. Since futures and cash prices tend to move together (that is, parallel to each other), and at contract expiration converge to one price, it is possible for a cotton merchant, for example, to hedge an unsold inventory of cotton with a sale of an equivalent amount of futures contracts. Since the merchant owns the commodity, he would have a loss if prices fell. To hedge, the merchant would sell futures contracts. Now if prices drop, the cash market loss will be at least partially offset by a gain on the futures contract. When the merchant sells his inventory at the lower cash market price, he will simultaneously lift his hedge by buying back his futures contracts at the lower price. The gain on his futures contracts should roughly equal the merchant's loss in the cash market.
Conversely, a cotton mill owner who wanted to sell a customer a quantity of cloth for delivery some months from now, but does not own enough cotton to produce the cloth, could hedge by buying enough futures contracts to cover the forward sale of cloth. He now has a price for raw material to which operating and production costs can be added to arrive at a base price for cloth. Quoting such a price before buying the cotton would make him vulnerable to a price rise, but having bought futures in a quantity equivalent to his needs, he has some assurance that a rise in futures prices would lessen the impact of a rise in the cost of the actual cotton.
Here are three examples of how hedging helps the cash market work better:
1. Hedging stretches the marketing period. For instance, a livestock feeder does not have to wait until his cattle are ready to market before he can sell them. The futures market permits him to sell futures contracts to establish the approximate sale price at any time between the time he buys his calves for feeding and the time the fed cattle are ready to market, some four to six months later. He can take advantage of good prices even though the cattle are not ready for market.
2. Hedging protects inventory values. A merchandiser with a large, unsold inventory can sell futures contracts that will protect the value of the inventory, even if the price of the commodity drops.
3. Hedging permits forward pricing of products. A jewelry manufacturer can determine the cost for gold, silver or platinum by buying a futures contract, translate that to a price for the finished products, and make forward sales to stores at firm prices. Having made the forward sales, the manufacturer can use its capital to acquire only as much gold, silver, or platinum as may be needed to make the products that will fill its orders.
These are just a few ways that futures markets are used by commodity owners. Adapting basic principles to individual situations tests the ingenuity of hedgers and demonstrates the management flexibility provided by futures trading. But market users should be forewarned that hedging is not an academic exercise. It requires skill and knowledge acquired only by study and experience.
Finally, while a hedge transfers price risk, it also denies the opportunity to gain from favorable price movements in the cash market. For this reason, options on the actual commodity and/or options on futures contracts are popular among people who seek price protection, but who do not wish to miss a favorable price movement. With the payment of a premium, the buyer of an option can acquire the right, but not the obligation, to buy or sell a futures contract at a specified price within a specified period of time (as stated in the option contract). In this way, for example, the holder of a put option can protect against a drop in the value of that inventory, but remain free to gain from an increase in the price of the commodity held in inventory.
There are many factors to consider in deciding whether to hedge with futures, buy or sell an option on a futures contract, or simply forward contract in the cash market. A detailed discussion of this topic goes beyond the scope of this brief publication. For more information, consult your library or contact the exchange which trades the commodity of interest.
Go to Economic Purposes of Futures Trading Page 2