Chicago became a major hub of commercial activities in the early 1840s when Midwest farmers went to Chicago to sell their wheat produce to dealers who in turn shipped them all over the country. There were very few storage facilities in the city and no established procedures for weighing or grading wheat grains during the early trading period. Farmers were therefore at the mercy of dealers who offered to pay low prices for wheat grains. The late 1840s saw the opening of a central place where farmers and dealers met to deal in ‘spot’ grain and with time, farmers and dealers began to enter forward contracts in the wheat market.
A forward contract is an agreement between two parties to exchange some item in the future at a prearranged price. The prearranged price is referred to as the forward price. It is the price at which two parties in a forward contract will exchange some item in a future date, regardless of what the prevailing spot price will be at that point of time.
Forward contracts enables western farmers to hedge their exposure to market price fluctuations for their merchandise. Besides wheat, several other commodities and products such as corn, sugar, soybean, cattle among others were brought to Chicago by farmers to be offered for sale.
How Forward Contracts are made
Suppose a farmer has planted his fields with corn and he is expecting to harvest them in a month’s time. If this farmer finds the current market price of corn to be more favorable and is reasonably certain of the quantity of his produce, he may want to eliminate the risk of uncertainty associated with the future price of corn, essentially because his wealth is tied to the corn.
A retail corn dealer who buys and sells corn in different markets who knows that he will need to buy corn in a month’s time may also be faced with uncertainty about the future price of corn. For him to reduce his price risk he can decide to buy corn now for future delivery. In such a situation, the retail corn dealer becomes a good match for the farmer and the two parties will enter a forward contract of corn at a forward price which will be paid to the farmer by the retail corn dealer on the day of delivery. The forward price of this forward contract is valid regardless of the future spot price of corn a month later.
This has enabled both the farmer and the dealer to hedge their risk against price volatilities in the commodity markets. When you hedge, you eliminate the risk of loss by giving up the potential for a gain. For example, assuming a farmer and a dealer entered into a forward contract to exchange corn at a forward price of $5 per bushel in a month time. If the spot price of corn rises to $7 per bushel in a month time, the dealer will still pay $5 per bushel to the farmer. On the other hand, if the price of corn is to fall to $3 per bushel one month later, the farmer will still offer it to the dealer at $5 per bushel due to the forward contract. Both the farmer and the dealer can be said to have eliminated their future price risk by foregoing the potential of a gain in the future.
Forward contracts are essential because commodity prices are highly unstable. In Ghana and all over the world, the prices of food items fluctuate throughout the year. In some periods, GHS1 can secure you as much as ten units of tomatoes while in other periods that same amount of money may secure you only about three units of tomatoes. An individual who enters into a forward contract with a tomato seller may have the units of his tomato fixed for the same amount of cash throughout the year, irrespective of fluctuations in the price of tomatoes. Most forward contracts in Ghana are done in much of an informal manner.
The major problem farmers and retail dealers encountered with this system of trading is that it was difficult to find a party who was willing to buy or sell a commodity at the time and place that is most convenient for all parties to the contract.
It is for this reason that the futures exchanges were established to operate as an intermediary by matching buyers and sellers. On the exchange market a buyer of corn futures contract never knows the identity of the seller, in that, the contract is officially between the buyer and the futures exchange. In like manner a seller on the futures exchange never knows the identity of whoever buys from him.
On the futures exchange, both the farmer and the retail corn dealer will be able to trade regardless of their location and timing differentials. Futures contracts traded on the exchange are standardized forward contracts that enables buyers and sellers to trade without time and locational limitations.
Instead of searching for a buyer and entering into a forward contract at a forward price of $5 per bushel for say 100,000 bushel of corn, to be delivered one month later at a great distance. The farmer and the retail dealer can enter a corn futures contract with the futures exchange at a future price of $5 per bushel. The farmer takes a short position whiles the retail corn dealer takes a long position and the exchange matches them. A month later, the farmer sells his corn at his local market at whatever spot price prevailing at that point of time and the retailer also buys his corn at whatever spot price prevailing in his local market.
They then settle their futures contract by paying to or receiving from the futures exchange the difference between the $5 per bushel futures price and the spot price multiplied by the quantity specified in the contract. The futures exchange then transfers the payment from one party to the other.
To better illustrate this with numbers, assuming the price at which the corn farmer and the retail corn dealer are willing to trade is $5 per bushel for 100,000 bushels of corn.
To hedge his exposure to price fluctuations the famer takes a short position in a one month corn futures contract for 100,000 bushels at a futures price of $5 per bushel with the futures exchange. To illustrate what happens at different spot prices on the delivery date – if the spot price of corn turns out to be $3 per bushel a month later, the farmer’s proceeds from the sale of corn will total $300,000 but he will gain $200,000 more from his short position on his futures contract. Earning him a total of $500,000.
However, if the spot price turns out to be $5 per bushel on the market, the proceeds from his sale will total $500,000 and he will have no gain or loss on his short position with the futures exchange. Again if the spot price turns out to be $7 per bushel of corn, he will aggregate $700,000 from the sale of corn on the market but will also lose $200,000 on his short position in the futures contract. His total receipts becomes $500,000.
Thus, no matter what the spot price turns out to be on the delivery date, the farmer winds up a total receipts of $500,000 from both selling on the market and his short position of corn in the futures contract.
The retail corn dealer acts the opposite way to hedge his exposure to price risk by going long in corn futures. If the spot price turns out to be $3per bushel, he pays only $300,000 for the 100,000 bushels of corn but he loses $200,000 on his long position in the futures contract and his total cost sums up to $500,000. A spot price of $5 per bushel leaves the retailer paying $500,000 for his bargain and he neither loses nor gain a dime on his futures contract. However, if the spot price happens to be above the futures price of $5 per bushel, say $7 per bushel the retail corn dealer pays $700,000 for his corn on the market but gains $200,000 on his long position in the futures contract – making his total outlay equal $500,000.
Both parties know for sure what they will get and what they will pay out. The futures contract therefore eliminate the risk posed by price uncertainty and also eliminate the problem of double coincidence between farmers and retail dealers.
Both the farmer and the retail corn dealer are said to be hedging their exposure to price risk.
The Role of Speculators
Speculators, otherwise known as traders from all over the world either in person, via computers or through brokers meet on the futures exchange floor. Big money and little money, smart money and dumb money, private money and institutional money all bet on the future spot prices of commodities. Speculators do not deal in physical commodities of corn. They take the opposite side of a hedger’s trade when other hedges cannot be readily found to do so and profit by correctly forecasting the future spot price of corn using either fundamental of technical analysis.
The activities of speculators makes futures markets more liquid than they would otherwise be. If only hedges bought and sold futures contracts, there might not be enough trading to support organized futures exchange. The presence of speculators is therefore a necessary condition for the very existence of futures markets.
Private speculators usually come to the market after a successful career in business or in the professions. An average private futures trader in the United States is a fifty year old, married, college-educated man. Many futures traders own their own businesses and many have post-graduate degrees. Nevertheless, farmers and engineers make up the two largest occupational groups among futures traders.
Economic significance of a futures exchange to Ghana’s development
Futures exchanges and for that matter futures contracts have enormous significance to the social and economic development of emerging economies.
As a Nation, agriculture continues to remain a major pillar in Ghana’s economic development and over the years there has been several efforts from past governments to make this sector more lucrative to the point of attracting the youthful population. Nevertheless, this sector continues to suffer major challenges that emanates from poor systems and structures.
Farmers continue to face post-harvest loses in season and out of season, poor pricing systems continue to hinder the prosperity of farmers, poor road networks hinders timely delivery of produced commodities to the markets. Essentially, cultivators in our society today are faced with the same devise challenges that Midwest farmers in the 1840s faced, and even worse of it. Thank goodness, they have found their solutions, but we are yet to.
Here are a few reasons why an efficient futures market can promote Ghana’s economic development to a wider extent:
- Competitive Pricing: this is facilitated by futures markets because the large pool of transactions that takes place on a daily basis makes prices more stable. Price stability ensures that the real value of producer’s wealth are preserved. This creates an avenue where producers can produce and sell their merchandise at any time of the year favorable to them, without having to hoard goods produced. Favorable market pricing will boost morale and enhance productivity among Ghanaian farmers.
- In addition to this, futures contracts will also help farmers to properly forecast the future prices of their merchandise and adjust their supply accordingly. This will help in minimizing the annual post-harvest loses Ghanaian farmers face during harvest seasons.
- Liquidity: futures contracts are borderless. They bring together producers, consumers, manufacturers and speculative investors all over the world to transact exchanges. Contracts can always be completed without physical delivery of goods and this provides a system of global trading.
- In the final analysis, futures markets will enable buyers and sellers in Ghanaian communities and other market participants to effectively hedge their price risk, as it offers protection from higher prices to buyers and an equal protection from lower prices to sellers.
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By E.O. ESSIEN
E.O Essien is an Associate Financial Economists, currency trader, trainer and private trading coach. You can reach him via email at email@example.com or on +233240080104/+233203656160.