On Futures Markets Convergence to Spot Prices

This is a bit wonkish.  It also contains a lot of preliminary thinking on my part, so caveat emptor.  If I'm wrong about any of this, I'll owe up to it sooner or later, and hopefully sooner.

Futures markets are super useful things.  They allow a farmer to lock in a selling price for his grain before incurring all his production expenses, thereby limiting his risk.  And they allow an ethanol plant manager to lock in her buying price for grain before scheduling a delivery of fuel, thereby limiting the ethanol plant's risk. Thus, futures markets are generally wonderful things, allowing people to coordinate and plan production and consumption a little better over time, and thereby improving the efficiency of markets.

In recent years there has been a big inflow of money from Wall Street into commodity futures.  Basically, there is a ton of money out there looking for someplace to hide in the crazy, fearful world of international financial markets.  Commodities have been a pretty good bet of late, so agriculture and other areas are receiving more than their share of the giant pool of money.  As that influx occurred there has been some peculiar behavior in some futures markets, particularly in grains.  Futures markets, which trade on gains to be delivered at some future date, have not been converging to spot prices--the price one has to pay for grain at a particular moment in time.

To economists, this is a strange phenomenon.  Non-convergence looks like an arbitrage opportunity--like money lying on the table that no one is picking up.  If the futures price is above the spot price just before before delivery, then sellers should sell on the futures market and buyers should buy on the spot market, driving the prices toward each other.   If the futures price is below the spot price, the opposite should occur.  So spot prices and futures prices should always converge on the delivery date of the futures contract.

But they haven't always.

A very nice new paper by Philip Garcia, Scott Irwin and Aaron Smith seeks to explain why futures prices have not been converging to spot prices, especially of late, and especially in grain markets.  (NB:  Scott Irwin recently sent me a copy--I haven't been paying much attention to this until now.)

I'm just starting to get my head wrapped around this paper.  While I think they nail the jist of things, it seems to me they may be making the situation a bit more complicated than it needs to be.

There are a few key issues here.

First, there isn't a futures market for every day and minute of the year.  Futures contracts are usually only written for certain months of the year (in grains, usually 4 to 6 of the 12 months of the year).  And formal trading usually stops a few days to a couple weeks before [the last day] delivery is promised.

Second, in grain markets, a futures delivery isn't for grain, but for a ticket that the buyer can redeem for grain from a certified and registered "regular" trader, usually a big conglomerate like Cargill or ADM, that has the proven facility to store grain and honor deliveries.  The buyer isn't required to take delivery, but if s/he doesn't, then s/he must pay a storage fee to the regular.  So buying a future isn't really buying grain for delivery; it's buying an option to take delivery for some grain. [The fact that there is flexibility in the timing of delivery is key.]

Now suppose you're bullish on grains--you think prices are going to be going up over time.   There are two ways you can bet on this premonition: (1) you can buy grain and store it; (2) you can buy futures.  If you're Cargill you might choose option (1), since you have a comparative advantage in storage facilities.  If you're a Wall Street trader you'll choose option (2)--you've got no direct use for grain or any place to feasibly store it.

Okay, so suppose you're a Wall Street trader and you've bought grain on the future's market.  But spot prices turn out less than the price of your futures contract on delivery.  Still, you're fairly bullish on commodity prices going forward: you think prices will go up eventually.  You've got two options: (A) take delivery and immediately sell your grain at the spot price, absorb your loss, and buy another futures contract for the next delivery date;  (B) keep your futures contract and pay a storage fee to the regular associated with your ticket.  For (B), you basically let the regular store your grain for you.

In this situation it's not so surprising (to me, anyway) that option (B) might make a lot of sense to outside investors. Perhaps the outside investor thinks prices could spike soon, well before the next delivery date.  Perhaps the futures price for the next contract is considerably higher than the current spot price.

If enough outside investors feel this way, and taken together are more inclined to store grain than regulars like Cargill or ADM, we can have futures prices that don't converge to spot prices--the prices at which Cargill and ADM are willing to sell grain at the moment.  After all, outside investors are looking to grains to spread their risk to something less aligned to their predominant position--stocks, bonds, etc.  They are going to be much less concerned about risk in agricultural markets than major agricultural players, and thus more comfortable taking long positions (ie., buying futures/storing grains).

The more I think about this the more it seems strange to me that futures markets converge as closely as they do to spot markets.  Convergence, it seems, requires that only the regulars (Cargill, ADM, etc.) are indifferent to selling short and storing or buying long.  When they're not the marginal traders, we can have non-convergence.

None of this implies markets are irrational or imperfect, except that there isn't a separate futures contract for every moment. (But I do not mean to suggest that markets can be irrational and/or imperfect in other situations...)

The punchline is that, by raising the storage fee associated with not taking delivery on the futures contract, outside investors will be less inclined to let regulars do their storing for them. They will instead absorb their losses and reinvest in the next futures contract.  Regulars will once again be the marginal traders in both futures and spot market, and we'll have convergence of futures prices to spot prices.

It's not perfectly clear to me that higher storage fees are in broader social interest.  But they might be.  And the regulars certainly won't mind.


  1. Interesting hypothesis. I always wonder when pondering human behaviour in markets if it would be possible to survey people who are buying and see what their attitudes are and if their rational is in-fact what you suggest.

    The issue you didn't discuss in your post - maybe a topic for another day - is the extent to which pure speculation contributes in a positive way to market efficiency. Is there an optimal level of participation by speculators in a market beyond which increasing speculation is in-fact harmful to the people that rely on the market to facilitate actual production?

  2. Tristan,

    Individuals are often irrational and often do really silly things. There's little in economics to refute this.

    But it's different to say market's are irrational, especially when the markets punish people in obvious ways that any individual actor might exploit for profit. That's how some have interpreted non-convergence, and that just doesn't make much sense. If there is a lot of obvious, risk-free money lying on the table, someone will pick it up.

    The trick here is paying close attention to the way the contract is written. The contract indicates that a futures contract on delivery is simply worth more than the grain, since it also includes an option to store grain and sell it at a later time. Grain plus option value > grain.

  3. Those of us in the farming industry having to live with high grains prices have been saying this for some time.

    I heard a figure of 70%, i.e. 70% of the transactions in the CBOT is fund money.

    Another stat: by June last year the equivilant amount of the world crop of maize was traded each month in those 6 months.

    That would seem to support point one.



Post a Comment

Popular posts from this blog

Nonlinear Temperature Effects Indicate Severe Damages to U.S. Crop Yields Under Climate Change

Commodity Prices and the Fed