The futures markets provide a vital economic function.
Futures markets have their existence in relation to an underlying cash market. The cash market is a physical commodity such as wheat, cattle, gold, T-bills, etc. that is bought and sold between parties. Due to cash market price volatility, the futures markets emerged in part as a way to help ensure price stability at a later delivery date.
A futures contract is an agreement between two parties that a specified quantity of a commodity at a specified price will be delivered at a specified future date. In actuality, few futures contracts are settled through delivery as the majority of market participants liquidate their contracts before delivery is scheduled to be made.
There are two primary participants in the futures markets: the hedger and the speculator. The hedger seeks to protect a cash position against adverse price movements while the speculator provides market liquidity by providing risk capital in the hopes of making a profit through prediction of price movements.
A hedger can be the owner of a commodity who will want to sell at the highest possible price, or a buyer that will want to buy the commodity at the lowest possible price. For example, let’s assume that the price of corn has increased over a dollar a bushel in two months time due to high demand and supply shortages. A cereal maker could have purchased a futures contract at the lower price two months ago in anticipation of his future cash purchase.
One or more speculators in the above example could have sold their previously bought futures positions to the cereal maker at his asking price, thus offsetting the speculative position and exiting them from the market.
Speculators are in the markets to make a profit. They play a vital economic role by providing the capital needed and assuming the financial risks involved in moving world commodities around the globe. The interplay between speculators and hedgers is what makes the markets work.
ABOUT THE AUTHOR
Brett Krkosska provides how-to advice on small business and home-based work issues. He is the founder of HomeBizTools and the publisher of Straight Talk, a syndicated column that offers a unique perspective on today’s business issues.