David R. Henderson  

Futures Market Exposition

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When I teach why futures markets are so neat--they help people hedge against risk--I lay out numerical examples with oil or corn. Some of the students always wonder a little about how the actual transactions are made and I tell them. But I'd never found a clear piece laying out the mechanics that I could refer them to.

Until now. In today's Wall Street Journal, there's a front-page article on why people in Nebraska are worried about the financial bill's new regulation of futures markets. In it, the author, Michael M. Phillips, has a nice few paragraphs laying out the mechanics. Here are three key ones:

Here's how Mr. Kreutz does it: Say in early summer he sees that the price for a Chicago Board of Trade futures contract on corn for delivery later in the year is $3.56 a bushel. If he likes the price, and wants to lock it in, he calls AgWest and sells a futures contract for 5,000 bushels. The futures contract is a derivative in which the price for corn is set now for exchange in the future, though no kernels will change hands. Instead, when the contract nears expiration, Mr. Kreutz and the buyer of his contract will settle--in effect--by check.
By fall, when Mr. Kreutz is ready to deliver his crop to the local co-op, the market price might have fallen by 50 cents. He'll sell his actual corn for that lower amount. But he'll make up the difference through his financial hedge. (Mr. Kreutz buys a new futures contract at the lower price to make good on his earlier promise, making up the 50 cents.) In all, he'll have hit the price target he locked in earlier in the year, minus brokerage fees.
If the price rises during the summer, as it did during the food crisis two years ago, Mr. Kreutz has to pony up extra cash for his broker--a margin call--to maintain his positions. He recoups that by selling his actual corn at a higher price, but has to take a loss to meet the futures contract he signed earlier in the year, missing out on a windfall but ultimately meeting his target price.

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COMMENTS (4 to date)
Charley Hooper writes:

Markets have long ago figured out this complicated process which benefits all parties. Do we really believe that politicians are going to understand this process deeply enough to retain the good aspects and mitigate the bad? Most likely, they will prevent some transactions outright and raise the costs enough to prevent some other marginal transactions. Given that everyone benefits when there is a transaction, each transaction prevented will reduce total wealth.

SpotCash writes:

The seller-farmer does not settle with his buyer. Through the miracle of the clearing house, all today's contracts are subject to a type of novation and the clearing house becomes the buyer to every seller and the seller to every buyer. Thus the seller can now cover his position by buying from anyone. That long position cancels his short position.

The essentials are correct: his futures losses should approximate his cash market gains and vice versa.

very time the Congress gets involved in this, they manage to create a little more of a problem and the costs of hedging go up. The increased costs, of course, lessen the value of the hedge. Uh... whoops.

There was a great book, which was written by an professor at one of the major midwestern universities, on the economics of hedging. I recall that the author's first name was Thomas and that the book probably was published in the late 60s or early 70s. It had a great explanation of how the hedge worked.

David R. Henderson writes:

Thanks SpotCash. So that means that the Journal reporter got it wrong, right? Good to know because then I'll check for that Thomas guy's book. But is it really the case that this clearing house method has been going on for 40 years? It would have to be so for Thomas to get the mechanics right even then. I know that there are many good readings on hedging and why it works; that's not what I'm after. I want a reading that's up to date on the mechanics.

Kevin writes:

The reporter says Kreutz and his buyer will settle "in effect." I'm confident that this device was chosen on purpose in hopes of sidestepping the logistics of settlement. That said, as a technical matter, Kreutz' buyer *is* the exchange, so even if one wanted to read "in effect" as modifying only the "by check" portion of the sentence, the reporter's still correct.

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