The Role of Agricultural Economists in Convergence of Cash and Futures Prices

Agricultural Economists and Futures Market Convergence

Agricultural economists have played a vital role in analyzing some issues about delivery specifications in the early years. An example includes onion futures, Maine potato futures, and wheat future contract. Futures market convergence is a process where the cash market prices and future markets prices come together. Theoretically, convergence occurs at every futures contract b because of arbitrage; if the cash price happens to remain below future prices, a market can buy in the cash market and end up selling in the future markets thus making a risk-free gain or profit. On the other hand, if the cash price happens to be above the future price, all the people who participate in then market tend to buy the items in the future market, take the goods that been delivered and also sell in the cash market thus gaining a risk-free profit.

Cash and Futures Price Convergence

Cash and futures prices have sometimes failed to converge because of many reasons. First, when we look the situation in the Chicago Board of Trade (CBOT) wheat futures market displayed poor cash-futures convergence for almost nine straight contract expirations. However, special appreciation goes to the contract changes which have been implemented by the exchange in conjunction with the people in the market. The wheat futures contract showed extraordinary convergence with its March 2010 expiration. Since we cannot detect that convergence issues in wheat futures will not recur, the Exchange is optimistic that the noticeable contract changes implemented over the past 24 months may have eased to the convergence issues.

Factors Affecting Convergence in the Wheat Futures Market

There are some major factors that came together and have caused convergence problems in the wheat futures market. First, one major issue that intricates the relationship between wheat futures and cash prices is a market structure issue. Wheat is seen as a complicated commodity which has different varieties which are known and grown in many areas in the whole world. As a result, wheat is seen as a local commodity, and there are around 20 different wheat futures contracts listed around the entire world. However, the CBOT wheat futures is the most liquid of all the contracts. Due to this nature of liquidity, the CBOT wheat future contract is used as a standard for world wheat prices. The only way to curb this problem is to ensure that the delivery system for the future contract is large enough to allow effective arbitrage between the cash and future markets. Apart from this, some groups like the CME have addressed this issue by having additional delivery territories for the CBOT wheat future market effective with the July 2009 aspiration.

The Supply and Demand Factor

Another outstanding major issue which is a threat to convergence in wheat market is the classic supply and demand factor. From 2000 to 2007, world wheat consumption went beyond wheat production in five out of eight crop years. This change put the world wheat stocks to use ratio to its lowest level in over 40 years in the first half of 2008.In this year the prices increased uncontrollably due to the scarcity of the wheat. However, the harvest of wheat has been plentiful in the year 2008/2009.It is often believed that the cure for higher prices is high prices. Therefore, the diminishing world wheat stocks led to higher prices and farmers reacted positively to those prices with record production.

The Role of Cash Prices and Warehousing

According to Tom Hieronymus who is a prominent Futures market economist, cash prices may be at a discount to futures prices during the delivery month when there is lack of warehouse space and the cash price discount to future is tied to the cost of putting the commodity into storage. Tom still argues that convergence can be problematic when a commodity is in oversupply which is relative to available storage space. The only way to address this issue is to analyze how to increase or decrease the return from storage if the cost to store commodity increases or decreases thus enabling the cost and benefits in a proper arrangement.

The Impact on the Commodity Futures Market

For many years, the success of the commodity futures market was demonstrated when the cash and futures prices matched each other on the date and location of when the grain was delivered from the seller to the customers. This is something that had not occurred in the last several years because the wheat prices at delivery points differed from the futures price when the futures contract expired. Since the year 2005, the convergence of cash and futures prices have not been the norm, and that has created economic issues for grain buyers, sellers and the merchandisers along the rivers and big lakes ports who contribute to it. The imbalance in the value of futures contracts has threated their usefulness.

Load out of Wheat Delivery

Some economists have come to realize that it is large spread between two futures contracts at the time of delivery, a person who receives the delivery will always tend to retail the contract until the next month, instead of loading out the wheat grain. As a result lack of load in the delivery points interferes with the value of the cash grain thus matching the contract

The Role of Wheat Futures Contracts

Wheat futures contracts aim at the provision of price signals to wheat traders to enable them to market a crop that b is grown once per year effectively. Their market price is widely spread, and their rapport with the cash prices provide these signals and also provide effective marketing of the crop. The relative prices also help the sellers to know whether to store or to sell it.

General Solutions to Convergence Problems

Lastly, the value that cash wheat was accepting for storage was larger than the stiff storage charge, especially in the CBOT wheat futures contract. The prices of the wheat futures should reflect higher value of storage which is also demanded cash wheat. However, this has been hindered from expansion due to financial constraints. Other general solutions to the convergence problems of grain especially the wheat are briefly discussed below.

One can decide to change the terms of futures contract to cash index rather than having a certificate market hence forcing convergence to the cash index. Besides this, one can also decide to expand the capability of delivery to accommodate much arbitrage of cash and futures prices during the process of delivery.

Thirdly, management of the influence of long-only index funds and other groups by limiting hedge exemption may make some groups sell with speculative limits. According to my opinion, this remedy emerges when you find that there are trades who have permanently forced futures prices above the fundamental value of the items in the cash market.

Works cited

Aulerich, Nicole, Linwood A. Hoffman, and Gerald E. Plato. "Issues and prospects in corn, soybeans, and wheat futures markets: new entrants, price volatility, and market performance implications." (2009).

Irwin, Scott H., et al. "Poor convergence performance of CBOT corn, soybean and wheat futures contracts: causes and solutions." (2009).

Irwin, Scott H., et al. "Recent delivery performance of CBOT corn, soybean, and wheat futures contracts." Contract 200.20 (2001): 07Z.