Handbook of agricultural economics
Editors: Bruce L. Gardner Gordon C. Rausser
HANDBOOK OF AGRICULTURAL ECONOMICS
To economists, futures markets, along with the options markets associated with them, present many interesting features.
First is the nature of organized exchanges, traditionally run as not-for-profit cooperatives by their members, whose individual purpose is profits pure and simple. Second is the range of participants and their motives for trading.
Alongside commercial firms focused on storing, transporting, or processing a commodity are traders who hold their positions for a matter of minutes and traders who seem to enjoy the speculation itself.
No law of nature compels either giant grain-exporting firms or amateur speculators – proverbially, dentists from Des Moines – to participate in futures markets, but they do.
Third, are the patterns in the prices that emerge from the trading. In the most active futures and options markets, prices move second by second, and moreover, tend to lead the price changes in related markets: Futures markets are said to “discover” prices.
Yet these very attributes raise many issues about how futures and options markets incorporate information about, say, planting prospects. Somehow, option prices reflect the cycle of uncertainty through a crop year and the year-to-year risks of, say, a freeze.
Somehow, the futures prices for various periods into the future prevailing at any one moment have a sensible structure, which is closely associated with inventories held not just in exchange-approved warehouses but worldwide.
Fourth are the inherent complexities of any economic analysis of futures markets and commodity markets more generally.
Economists must consider what heterogeneous price-taking firms do, yet place as central in their analysis the industry-level interactions. Economists must abstract from the particulars of a single commodity during a short stretch of time, yet must recognize that those particulars determine individual traders’ strategies.
Futures markets are interesting for a fifth reason, although one that does not concern the markets themselves as much as the approach to models and evidence as practised among economists. For at least sixty years, two perspectives on futures markets have existed in parallel.
One of these perspectives, which might be styled the risk-management perspective, posits that some market participants, called “hedgers”, use futures markets out of risk aversion while other participants in the market earn a “risk premium”.
The other perspective, which might be styled either the transaction-cost or the arbitrage perspective, posits that commercial firms, cognizant of transaction costs, involve themselves in arbitrage-like trades in which they temporarily hold futures positions, while the other participants contribute to the market’s liquidity or forecasting ability.
Judged by the large number of papers published on the theory of “optimal hedging”, the more commonly held perspective among economists is the risk-management one. The empirical evidence, however, supports this perspective poorly.
Commercial firms do not use futures contracts in the proportions or timing suggested by the theories of optimal hedging; and speculators, far from earning a risk premium on average, usually break even at best. Moreover, these basic facts have been reconfirmed over the years.
Yet the business of writing theoretical papers goes on, with no mention of the evidence.
The transaction costs perspective, for its part, has pointed to the general seasonal movement in the use of futures markets for empirical support. But it has not offered evidence of