2
$\begingroup$

I have a multipart question about futures and production.

Lets take corn as an example. We add up the total 1 year futures of corn, call this weight $A$ kg. Next, we can get a reasonable estimate of how much the world corn production will be in 1 year call this $B$ kg.

(1) Is there a relation between $A$ and $B$?

(2) Can nonproducers of a good sell futures?

If yes, suppose noncorn farmers sell corn futures. Then $A$ may appear greater than $B$.

(3) Then how does the supply and demand work? i.e., will this cause the corn price to go down in 1 year? My confusion is, the supply and demand curves I have seen only assume $B$ and not $A$. Can the demand depend on $A$?

(4) When $A>B$, what happens if everybody who bought the futures want their corn?

PS: I am a newbie, so if this sounds dumb please explain that too. Thanks.

$\endgroup$
4
$\begingroup$

It is not a dumb question, but very confusing to me at a basic level. The Open Interest in futures (what you call A) has nothing at all to do with the total production (what you call B). The futures market is just a derivative market, where side bets are made as to what the PRICE of the crop will be. You cannot use it to infer what the PRODUCTION will be.

Of course speculators (non-producers) can both sell and buy futures.

What consumers will eat however, is physical wheat (i.e. B), not A. A is not edible. A only tells you how many people are interested in making side bets on the price of wheat (for speculative or hedging purposes). Keep in mind also that for every seller of futures there is a buyer (i.e. futures are in zero net supply, there are A futures long but also A futures short, netting out to zero).

(Added July 22, 2016)

A word about delivery. Futures are designed so that only a small percentage of contracts will be delivered. From the wheat buyer point of view delivery has 2 disadvantages: 1) it takes place at a warehouse chosen by the exchange, not necessarily one convenient to you. 2) The buyer receives wheat selected by the seller, subject only to minimum quality standards set by the exchange. When I buy oranges or bananas at a supermarket I like to carefully choose the fruits myself based on my preferences; I would not like it if the seller "assigned" fruit to me sight unseen.

Similarly, when delivery approaches wheat futures buyers will visit local warehouses and personally select the wheat they prefer, they will then buy the wheat and close out the long futures contract. Thus the futures serve only as price insurance, the actual physical wheat is purchased in the cash market.

A > B and everybody wanting delivery would break the system (like everyone pulling money out of their bank at the same time, or everyone trying to exit a stadium fire at the same time), but is very unlikely. The Futures Exchange and the CFTC watch to make sure there is "orderly liquidation" (i.e. a sharp decrease in A) in the days prior to delivery.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.