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Economic significance of futures markets

Introduction

There is not much debate amongst scholars of futures markets regarding the economic functions of these markets, although the functions are described in different ways. The economic functions are as follows:

• Price discovery.

• Market liquidity.

• Market efficiency.

• Resource allocation.

• Capital formation.

• Output.

• Public welfare.

• Competition.

• New product development.

Although these functions are described separately below, they should not be seen in isolation but as interdependent.

Price discovery

Futures markets have developed from the desire of participants in the financial and commodities markets to hedge against the risk of adverse price changes in these markets in the future. Thus, there was a need for an instrument to allow participants to hedge against unexpected cash market prices in the future.

As noted earlier, the theoretical futures price (fair value price) is made up of the cash market price plus the net carry cost. It is also known that futures prices do not always equate to the theoretical price. Futures prices can be substantially above the theoretical price (i.e. at a premium), at a discount to the theoretical price and even at a discount to the cash market price. Clearly then, futures prices are not only influenced by the cash market price plus net carry costs, but are also heavily influenced by expectations of price changes in the underlying market.

Thus, the futures price is the outcome of the cash market price, the net carry cost and the perceptions of the many participants in the futures market regarding the course of the cash market price in the future (i.e. the futures price reflects all available information and the participants' interpretation of this information). It can thus be said that the futures market, at any point in time, "discovers" the cash market price in the future.

The question that arises now is to what extent the futures price can be regarded as rational and correct. This question is more pertinent the further away the expiry date of the futures contract. As shown, the futures price converges with the cash market price and becomes zero at expiry date. Thus, the closer to expiry, the more rational and correct the futures price is in terms of "discovering" the cash market price on expiry.

Controversy in the above regard abounds. The debate revolves mainly around:

• The determinants of price variability

• The causality of price movements between the futures market and the cash market

• The general economic consequences of price volatility.

Some scholars of the futures market believe that price volatility is an inherent characteristic of the futures market and attracts speculators to the market. These speculators enhance liquidity, which is necessary for the efficient functioning of the market; they thus contribute to rational and correct pricing. Critics, however, believe that price volatility results from speculative activity and obstructs the process of price discovery.

As regards the causality of price movements, certain commentators believe that because futures prices are based on perceptions of price changes in the cash market in the future, the causality is from the cash market to the futures market. Critics, however, contend that futures market activities result in the causality being reversed, i.e. prices in the futures market dictate price movements in the cash market.

Concerning the economic consequences of price volatility, some critics state that volatile futures prices are transmitted to the underlying markets and cause distortions in the spot prices of these commodities. This could have consequences for production.

However, as we saw above, there are commodity markets where the spot price is derived from the near futures price. Thus it can be said that the futures market is essential for price discovery in the spot market.

 
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