The Social Function of Futures Markets
In a previous article, I described the "social function" of stock speculators. In the present piece, we'll explore the role of healthy futures and forward markets in a modern economy. Of course, both parties to any voluntary exchange expect to benefit, at least ex ante — otherwise the exchange wouldn't be voluntary. But beyond this truism, it is at first unclear how anything is added when intelligent workers are sucked out of other occupations and devote their careers to trading "futures contracts." After all, these intangible financial instruments can't be eaten or used to build a house, so what good are they? The present article seeks to answer just this question.
Futures and Forward Contracts
The first task is to define exactly what these contracts are. A forward contract is an agreement entered into today, in which one party agrees to buy a specified number of items for a predetermined price, called the forward price, at a specific time in the future, the delivery date. On the other hand, the party who sells the forward contract agrees to supply the items on the delivery date in return for the forward price. In essence, buyers and sellers who work through a forward contract merely delay their underlying transaction.
A futures contract is a special type of forward contract. There are a few differences that are significant for a real world trader, but for the present article these complications will be ignored. (For example, a futures contract is standardized and trades on an organized exchange, whereas a forward is custom made for the two parties. Another difference is that with a futures contract, as the price of the underlying commodity moves and thus changes the market value of the futures contract, the losing party may be required to kick in additional cash to the exchange. In contrast, with a generic forward contract there are no cash flows until the delivery date.)
Because of the easier solution, we will discuss the pricing of forward contracts, but the general principles would carry over to futures prices.
Determining the Forward Price
Austrian economists know only too well the difference in subjective valuation between a present and a future good. As Ludwig von Mises argued, the very nature of action implies a higher valuation (other things equal) of a present satisfaction over the same satisfaction to be enjoyed at a future date. In short, people have positive time preference.
Unfortunately, the convention in financial markets doesn't translate so easily into this framework. One might think that the spot price of iron ought to be higher than the forward or futures price of iron, since "present iron" is more subjectively valuable than "future iron." However, we must remember that a forward contract involves no exchange of money when it is entered into. The agreed upon forward price isn't paid until the delivery date. Thus, the forward price itself is quoted in "future dollars," and hence the influence of positive time preference on forward markets is subtler than one might at first think.
If one turns to a mathematical finance textbook, he will see that the equilibrium or arbitrage-free forward price must satisfy a certain condition. Namely, for an underlying asset that has no storage costs or dividend payments, the forward price must be exactly equal to the spot price when allowed to grow exponentially at interest until the delivery date. For example, if a share of Microsoft is currently selling at $30, and the one-year interest rate is 5 percent, then the 12-month forward price on Microsoft stock must be $31.50.
If it were higher than this, say $32, then a speculator could make a sure profit by borrowing $30 from the bank to buy a share of Microsoft today, while selling a 12-month forward contract on the stock. On the delivery date, he would exchange his share of Microsoft for the contractually specified $32, and pay off his loan to the bank with $31.50. Except for the risk of default by the counterparty to the forward contract, this is a riskless operation that would net him a sure 50 cents.
Hence, if the spot and forward price ever were in this relation, speculators would buy Microsoft shares on the spot market (driving up its price) and sell on the forward market, driving down the forward price, until the textbook no-arbitrage condition became satisfied.
Going the other way, if the forward price were too low, say $30, then a speculator could short sell Microsoft in the spot market, lend the $30 out at 5 percent interest,1 and at the same time buy a forward contract. After 12 months, he would have $31.50 from his loan, out of which he would use $30 and his forward contract to acquire a share of Microsoft, which he would then return to satisfy his short sale. When all was said and done, he would have a sure profit of $1.50. Again, this arbitrage opportunity would quickly disappear, as short selling Microsoft would push down its spot price, and buying forward contracts would push up its forward price.
The important thing to remember about forward contracts is that their initial market value is zero; that is why both parties enter into the contract costlessly. What happens is that the forward price is chosen such that the present value of the contract is zero. Now over time, as the forward price for a given delivery date changes, the market value of older forward contracts may indeed become positive or negative (for the buyer or seller).
To return to the Microsoft example: Suppose that on January 1, 2007 the spot price of Microsoft is $30, the annual interest rate is 5 percent, and thus the 12-month forward price is $31.50. Smith buys a forward contract from Jones, agreeing to buy (say) 1,000 shares of Microsoft, at $31.50 each, from Jones on January 1, 2008. No money changes hands initially, and the financial wealth of neither Smith nor Jones changes because of this new contractual obligation.
Further suppose that six months later, on July 1, 2007, the spot price of Microsoft stock has risen to $40, while the interest rate is still 5 percent. In this case, the six-month forward price on Microsoft — i.e., the price built into a newly signed forward contract with delivery date of January 1, 2008 — will be just under $41. Now this new forward price, by construction, will render forward contracts struck on July 1 to have a market value of zero, but it will nonetheless affect the wealth of Smith and Jones. Recall that Smith owns a contract that entitles him to purchase 1,000 shares at $31.50 each, while (now on July 1) the prevailing January 1, 2008 forward price has risen to $41. Thus the market value of Smith's forward contract itself will have risen from zero (when he first signed it with Jones) to about $9,270.2 On the other hand, Jones is "short" that very same contract, and so he is $9,270 poorer than he would be had he never signed the contract six months previously.
A Zero-Sum Game?
Because any given forward contract has one party "long" and the other party "short," a change in the relevant forward price will necessarily benefit one party and penalize — dollar for dollar — the other. Viewed in this light, it might seem that forward and futures markets are nothing but gambling, where the wagers concern pork bellies rather than roulette wheels.
As the libertarian economist might expect, such a conclusion would be premature. In fact, forward and futures markets perform a vital service in coordinating production and consumption decisions over various horizons. Just as varying interregional prices serve to efficiently allocate goods and services over space, so too do varying intertemporal prices allocate them over time.
Although it's true that a particular forward contract can only have positive market value for one party if it has a corresponding negative market value for another, this doesn't at all mean that the "losing" party should regret the transaction. This is because one of the primary uses of forward (and futures) contracts is to hedge away risk. In this type of case, the contract is chosen so that its positive or negative market value (under various scenarios) will offset losses or gains from other sources in those same circumstances.
For example, an airline's profitability is closely tied to the price of crude oil, because their jets use so much fuel. If the price of oil shoots up, operating costs rise and profit margins shrink. (Even if the airline can raise ticket prices, consumers will fly less.) On the other hand, if oil prices fall then the airline benefits.
Yet the price of oil isn't something related to someone's expertise in running an airline. The owners of the airline might prefer to avoid this additional "gamble" by purchasing large quantities of oil futures. If the spot price of oil suddenly rises, the airline is hurt because of the higher operating costs, but this hit is (at least partially) offset by the growing value of its futures contracts.
On the other hand, if the price of oil collapses, then yes the market value of those same futures contracts becomes negative. Yet the airline is fine with this, because the lower fuel prices are good for business and allow them to cope with the loss.
We see that forward and futures contracts can act as a type of insurance policy, where traders can reduce their exposure to fluctuations in critical spot prices by buying or selling the appropriate instrument. To continue the analogy, consider that when assessing the damage in a given car wreck (say), the auto insurer and motorist have diametrically opposed interests. Yet it would be wrong to conclude that the institution of insurance is a zero-sum game.
A World With No Futures
To fully appreciate the benefits of liquid futures (and forward) markets, it's easiest to first imagine an economy without them. For example, suppose that the owner of an oil field is trying to decide how many barrels to produce this year. Being a good capitalist, he wants to maximize the present discounted value of his operation throughout its lifetime. If he sells more barrels this year, he naturally earns more revenues now, but at the cost of fewer barrels that he can sell in the future. In order to rationally approach this problem, therefore, the oil tycoon needs to compare the spot price of oil today with the expected price he can fetch in the future.
Even at this stage we can see the fallacy in typical environmentalist condemnations of "shortsighted" big business. It would be sheer lunacy for the Big Oil companies to exhaust their reserves in a few years. Better than anyone else (for it's their money on the line), the people running the oil companies would have expert forecasts of available supplies and world prices at various points in the future.
If the alarmists really were correct, and humans really were using up a particular resource (such as oil) too quickly, then the impending scarcity (and hence high prices) would signal the owners to restrict current output in order to sell at the higher prices in the future. The reduction in present supply would raise spot prices today, causing consumers of oil to ration their usage. In short, the market would voluntarily do just what the conservationists want.
Unfortunately, there is a snag in this benign process. The people who are experts in pumping, storing, and distributing oil might not be exactly the same people who have the best forecasts concerning the future price of oil. Thus the owner of an oil field might think that next year's spot price could be $50 or $60 or even $70 a barrel, and not be sure how many barrels to produce this year accordingly.
On the other hand, an analyst armed with excellent data sources and supercomputers might be quite certain that next year's spot price of oil will be at least 18 percent higher than today's, yet he might be reluctant to buy thousands of barrels of oil and store them for a year.
An organized futures market in crude oil eliminates these types of problems. The oil producer needn't speculate (literally) on what the price of oil may or may not be in twelve or eighteen months' time; he can simply sell oil futures at a guaranteed futures price. On the other hand, the speculator who believes "the market" is improperly pricing oil futures can stake out a position accordingly, by buying futures if he thinks they are underpriced or selling them if he thinks the futures price is too high.
The speculator needn't know the slightest thing about actually handling physical barrels of oil; as the delivery date nears, he can unload his futures contracts to another party at their market price. If his predictions were accurate, then his contracts will have appreciated in value from the time he acquired them.
Forward and futures markets are yet another refinement in the growing complexity of a modern financial economy. By distilling the purely speculative aspect out of intertemporal transactions and placing this risk on those who want to bear it, forward and futures contracts foster a greater specialization in the division of labor. Even though the vast majority will never own such contracts, all consumers benefit from the more efficient allocation of resources and production decisions over time.
- 1. In the real world, it is not necessarily true that someone who short sells a stock can earn interest on the cash generated. In any event, actual owners of Microsoft stock (who otherwise wanted to retain their shares) could sell it and then buy it back in twelve months for a sure gain.
- 2. To see this, note that on July 1 Smith can sell a six-month forward contract (for 1,000 shares of Microsoft) for a delivery price of $41. On January 1, 2008, his two forward contracts will allow him to (a) buy 1,000 shares of Microsoft at $31.50 and (b) sell 1,000 shares of Microsoft at $41. Assuming neither party defaults on the forward contract, then, Smith can lock in a guaranteed $9,500 on January 1, 2008. At a 5 percent annual interest rate, this prospect is worth about $9,270 on July 1, 2007. Finally, since the market value of the six-month forward contract (we know) is zero, the value of the earlier contract must account for this advantage.