Speculation and Futures Markets

Question 1

Role of Futures Markets

Answer 1

Futures offer the benefits of forwards without the constraints due to:

Centralisation of the market

Standardisation of Contracts

So they arose from copying and improving forwards rather than out of a need to provide a delivery channel. As such they play two roles:

Question 2

Price Insurance

Answer 2

Essentially FMs are forward markets but are more fungible and highly liquid

Arises out of centralisation and standardisation as:

Interested parties who couldn’t trade forwards can trade without credit constraint
Greater liquidity generated
Allowed more traders into the market

Question 3

Key Outcomes of a Futures Market

Answer 3

Risk is spread more widely across more people

Is done so more cheaply than in forward markets

Question 4

Price Discovery

Answer 4

Efficiency is a central part of market analysis. Key to this is the way information is used:

This is their price discovery function. Futures markets are seen as an efficient collector, processor and disseminator of information

Question 5

How can Futures Markets predict price

Answer 5

Markets are collectors of expectations:
Prices reflect beliefs about supply and demand now an din the future. By trading on the futures market, expectations are made public thus aiding resource allocation.

Markets are ‘paper-based’
Allows quick/instant response to price changes (i.e. expectation changes.

Question 6

Current price

Answer 6

If spot price is not equal to nearest futures then buy in spot and sell in FM
Such arbitrage draws prices together
Geographical Equality

Question 7

Expected spot

Answer 7

Fp is an expectation of Sp at time t so will affect consumption, production and storage now and improve allocation.

Question 8

Speculators and Risk Premia

Answer 8

Key element is that speculators cut risk premia.

If there were no speculators then there would be no FM as premia too great

Speculators are less risk averse unlike hedgers

Question 9

Too Much Speculation ?

Answer 9

Recall Financialisation of commodity markets
Key question is this activity distorting markets?
Seminal work by Working (1950s) explored speculation that followed hedging activity
Speculation only excessive in relation to hedging
Adequacy index - speculation balanced hedging activity and indeed concerns expressed there wasn’t enough speculation.