Commodities Market Suppose that you are a farmer trying to decide what to plant in May. Harvest time is six months into the future. You are going to be.

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Presentation transcript:

Commodities Market Suppose that you are a farmer trying to decide what to plant in May. Harvest time is six months into the future. You are going to be more interested in the price of the crop in November ( its future price) than in May (its current price or cash or spot price). Suppose that the spot price of corn is 4 $/bushel and the November price is 6 $/bushel. Where do these prices come from? Were already familiar with the spot market. The buyers are those who want corn now and the sellers are those who have corn now.

The futures market is made up of people who want to buy corn in November and people who want to sell corn in November. If the farmer decides to plant corn and wants to lock in the price of 6 $/bushel, he would sell futures. He would be avoiding risk or hedging. A corn chip manufacturer knows that hell need corn in November and if he wants to avoid uncertainty, he would buy futures. He is hedging also.

If youre a gambler who suspects that the spot price of corn will be less than 6 $/bushel in November, you would sell futures. [You would meet your futures contract with corn bought at the lower spot price.] You are absorbing risk or speculating. If youre a gambler who suspects that the spot price of corn will be more than 6 $/bushel in November, you would buy futures. [You would take delivery of your corn and sell it for more on the spot market.] Once again, You are speculating.

November Corn

Suppose that you have special knowledge that the corn belt is going to suffer from drought next growing season. Expecting a higher spot price in November, you would buy November corn now. You and others with this knowledge would drive the price of November corn up. The higher future price would signal owners of existing corn stocks to hold their corn from the spot market (a decrease in supply as a result of the expectations of a higher price in the future) which would drive the spot price up.

The higher spot price would encourage the conservation of corn now. Cattle farmers might substitute a less expensive feed and consumers would switch from corn chips to potato chips. (Seeing higher margins on their potato chips, Frito-Lay may push their potato chips and/or raise their price on Fritos.) Though it was no part of their intention, the speculators have moved corn through time from a period of relative abundance (May) to a period of scarcity (November). This is the invisible hand that Adam Smith mentions once in his Wealth of Nations.