Commodities Markets, Commodities Futures, Commodities Future Trading, Commodities Future Trading - Risks   Commodities Markets, Commodities Futures, Commodities Future Trading, Commodities Future Trading - Risks 
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Commodity Markets

Home > Commodities & Futures > Commodity Markets

Futures trading: a bit of history
Commodities Markets, Commodities Futures, Commodities Future Trading, Commodities Future Trading - Risks
Commodity Markets and Commodity Futures are a mechanism for hedging. Futures trading has a simple origin. In the 12th century, merchants from northern and southern Europe used to meet at trade fairs on the fields of Champagne. It was cumbersome and often dangerous to transport goods long distances so, after a while, merchants simply brought samples of their wares to sell, a buyer would be given a written promise that the sample he was interested in purchasing would be delivered in quantity at some future date. That written promise was called a “to arrive contract”.

Obviously, between the time the commitment to buy and sell was made and delivery took place, conditions affecting the buyer and the seller might have changed. The buyer could have suffered a decline in business that meant he would need less merchandise than he had contracted for. Or the seller might have had a difficult time producing all the merchandise he had contracted to deliver. Under the circumstances, the buyer in the above example would be forced to sell his contract to a neighboring merchant, presumably offering his neighbor the right to take the goods at a cheaper price. The seller, unable to meet rising demand, would be disposed to find a neighboring producer of the same merchandise and offer him his "to arrive contract" at a higher price. Once the "to arrive contract" became a negotiable instrument, the modern futures contract was effectively born.

Modern futures trading
Modern futures trading, Commodity Markets and Commodity Futures as we know it in North America, had its origin on the Chicago Board of Trade more than a century ago. The only difference between the 12th-century "to arrive contract" and the contemporary futures contract is that now the exact quantity and quality of goods and the exact time of delivery is specified and standardized. Where the medieval Italian silk merchant may have contracted to deliver 112 bolts of cloth sometime in the spring at Flanders, the 20th-century seller of May wheat is contracting to deliver exactly 5,000 bushels of No.1 red winter wheat to a delivery point determined by the exchange on or before the 21st day of May.

Why does the seller — let's assume a farmer — engage in futures trading? For the same reason that the 12th-century merchant did -- insurance. Imagine you are a farmer who has 1,000 acres that you know can, under normal conditions, yield 30 bushels to the acre. You know how much it will cost you to buy seed, fertilizer, and fuel for the tractor.

What you do not know is how much the price of wheat will be by the time you actually come to harvest. Why? Because the price of wheat is beyond your control. That price depends upon how much your neighbors plant, how much is planted by farmers in other countries, how much can be sold and shipped abroad, and a host of other factors you could never be fully aware of. You, after all, are a farmer who is concerned with growing your wheat on your thousand acres. But clearly you are also concerned that the price of wheat may fall between the time you plant it and the time you harvest it.

The futures exchange: A mechanism for hedging
Imagine that you are the proud owner of a large breakfast cereal company. You use a lot of wheat. You know how much it will cost you to advertise your breakfast cereal, how much to pay your employees, how much to heat and light your plant. You even know, roughly, how much you can sell your breakfast cereal for because, to a large degree, your competitors determine the wholesale price for you. However, what you don't know is how much the wheat to make the breakfast cereal will cost you when you need it. Obviously, your greatest concern is that this huge variable cost will rise.

The wheat farmer is worried that the price of wheat will fall by the time it must be sold. The cereal manufacturer is worried that the price of wheat will rise in the future when it must be bought. The futures exchange offers both of them the opportunity to pre-buy and pre-sell today what they will actually need to physically buy and sell in the future.

If the farmer plants in March, harvests in September and sees that the price of September wheat in March is such that a satisfactory profit could be realized on the crop, he can choose to sell September wheat futures in March. Come September he can deliver the harvested wheat to an elevator approved by the exchange. The cereal manufacturer who knows in January that wheat is needed in July and recognizes that the price of July wheat is cheap enough to purchase now will do so, in order to make breakfast cereal at a nice profit.

In this rather simplified example the farmer and the cereal manufacturer, respectively, contracted to make and take delivery of specified quantities of wheat at specified prices, thereby protecting themselves against any adverse price changes between the time they make their commitments to make and take delivery and the time they would actually physically do so. No matter what happens in the in future, the prices they will receive and pay for their wheat are fixed. In futures parlance, the farmer and the cereal manufacturer, because they seek price assurances, are called hedgers.

A way to provide market liquidity
If all producers and consumers could agree on a fixed price for future delivery, then obviously there wouldn’t be any need for a futures market. But they can't. Producers cannot be absolutely certain they will be able to deliver exactly the quantity they contracted to deliver. The weather could serve to reduce the farmer's yield on his wheat crop.

Nor can the consumer be definite in this commitment to take delivery of exactly what has been contracted for. Business conditions may dictate that the cereal manufacturer buy more or less wheat than contracted for originally. A liquid market is required to allow the farmer and the cereal manufacturer, the producer and consumer to fine-tune their buying and selling. That liquid market comprises the producer, the consumer and the speculator.

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