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The commodity futures industry affects the lives of many people, although they may not be aware of its existence. It touches the food they eat, the clothes they wear, the energy they consume, and the materials that provides they shelter.
Prior to the creation of futures trading in the United States, most citizens were farmers or made a living by providing products or services to them. However, the industrial revolution brought a new technology and ability to produce more machinery and, consequently, more food, economic output no only began to keep pace with the phenomenal growth in population, but also greatly raised all levels of living. The new productivity called for more agricultural storage, transportation, and more efficient distribution.
At first, cash markets, in which purchasers tender cash and receive goods upon payment, sufficed to meet the growing demand. However, this became an enormous chore. For end users who did not need goods immediately after harvest, storage and price fluctuation became important factors. They either had to purchased the goods in anticipation of later needs, or acquire them later, hoping that prices would then be lower. This actually made end users speculators. It forced them to speculate that prices would move favorable between the time the goods became available and the time they were needed.
The commodity futures markets, i.e., markets for the future delivery of commodities, answer this need with the following features:
Forward Pricing
Efficiency
Liquidity
Easy Access
Storability in not required
The central theme of commodity futures markets is standardization. Futures contracts are standardized with regard to commodity, quantity, quality (grade) and point of delivery.
Delivery dates are standardized within each delivery month; i.e., there is a range of days during which all contracts must be performed.
Bu standardizing contracts terms, futures markets make it easier to transfer the risk of loss caused by price fluctuations form those who do no which to bear this risk (hedgers) to those who are willing to accept the risk (speculators)
The transfer of risk is aided further by the fact that cash prices and futures prices then to move in tandem. The deferred futures prices normally are higher than cash and near-month futures prices for non-financial contracts (normal market). The normal market configuration results from the costs associated with holding a commodity until the contract goes into the delivery period. These costs are also known as carrying charges, or the “cost of carry.”
An inverted market is caused by current shortages in supply, high current demand, or an expected surplus. These circumstances cause current prices to be higher that deferred prices. The cash and futures prices usually move in the same directions by approximately the same amounts, making it possible to hedge a position in the cash market by taking an opposite position in the futures market. What is lost on one position may approximately be regained on the other position
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