436 Planning and Forecasting
Speculators play important roles in the derivatives markets. For one,
speculators provide liquidity. If farmers wish to short for ward contracts but
there are no bakers around who want to go long, speculators will step in and
offer to take the long side when the forward price is bid down low enough.
Similarly, they will take the short side when the forward price is bid up high
enough. Speculators also bring information to the marketplace. The existence
of derivatives contracts and the promise of speculative profits make it worth-
while for speculators to devote resources to forecasting weather conditions,
crop yields, and other factors that impact prices. Their forecasts are made
known to the public as they buy or sell futures and for wards.
Futures
Futures contracts are closely related to for ward contracts. Like for wards,
futures are contracts that spell out deferred transactions. The long party
commits to buying some underlying asset, and the short party commits to
sell. The differences between futures and for wards are mainly technical and
logistical. For ward contracts are custom-tailored, over-the-counter agree-
ments, struck between two parties via negotiation. Futures,alternatively, are
standardized contracts that are traded on exchanges, between parties who
probably do not know each other. The exact quantity, quality, and delivery
location can be negotiated in a for ward contract, but in a futures contract
the terms are dictated by the exchange. Because of their standardization and
how they are traded, futures are very liquid, and their associated transaction
costs are very low.
Another feature differentiating futures from for wards is the process of
marking-to-market. All day and every day, futures traders meet in trading pits
at the exchanges and cry out orders to buy and sell futures on behalf of clients.
The forces of supply and demand determine whether futures prices rise or fall.
Marking-to-market is the process by which at the end of each day, losers pay
winners an amount equal to the movement of the futures price that day. For ex-
ample, if the wheat futures price at Monday’s close is $4.00 per bushel, and the
price rises to $4.10 by the close on Tuesday, the short party must pay the long
party 10 cents per bushel after trading ends on Tuesday. If the price had fallen
10 cents, then long would pay short 10 cents per bushel. Both long and short
parties have trading accounts at the exchange clearinghouse, and the transfer
of funds is automatic. The purpose of marking-to-market is to reduce the
chance of default by a party who has lost substantially on a futures position.
When futures are marked-to-market, the greatest possible loss due to a default
would be an amount equal to one day’s price movement.
Futures are marked-to-market every day. When the contract expires, the
last marking-to-market is based on the spot price. For example, suppose two
days prior to expiration the futures price is $4.10 per bushel. On the second to
last day the futures price has risen to $4.30. Short pays long 20 cents per
bushel. Suppose at the end of the next day, the last day of trading, the spot