Grain Futures Contracts: An Economic Appraisal

195 Pages·1993·19.6 MB·English

by  S. Craig Pirrong

GRAIN
FUTURES
CONTRACTS:
AN ECONOMIC APPRAISAL
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GRAIN
FUTURES
CONTRACTS:
AN ECONOMIC APPRAISAL
by
S. Craig Pirrong
David Haddock
Roger Kormendi
with
Michael Brennan
Merton Miller
Richard Roll
Hans Stoll
Lester Telser
A MIDAMERICA Institute Research Project
Library of Congress Cataloging·in·Publication Data
Grain futures contracts : an economic appraisal / by S. Craig Pirrong,
David Haddock, Roger Kormendi with Michael Brennan ... [et al.].
p. cm.
"A MIDAMERICA Institute Research Project."
Includes bibliographical references and index.
ISBN 978-1-4613-6423-8 ISBN 978-1-4615-3238-5 (eBook)
DOI 10.1007/978-1-4615-3238-5
1. Commodity futures--United States. 2. Grain trade·-United
States. 3. Chicago Board of Trade. 1. Pirrong, Stephen Craig,
1959· . II. Haddock, David D., 1944- . III. Kormendi, Roger C.
HG6047.G8G7 1993
332.63'28--dc20 92-44334
CIP
Copyright © 1993 by Springer Science+Business Media New York
Originally published by Kluwer Academic Publishers in 1993
Softcover reprint ofthe hardcover Ist edition 1993
AII rights reserved. No part of this publication may be reproduced, stored in a retrieval
system or transmitted in any form or by any means, mechanical, photo-copying, record ing,
or otherwise, without the prior written permission of the publisher, Springer Science+
Business Media, LLC.
Printed an acid-free paper.
Contents
Foreword IX
The Grain Futures Delivery Process: An Overview xi
CHAPTER 1
The Economic Function of Futures Trading 1
CHAPTER 2
The Role of the Futures Delivery Process 9
CHAPTER 3
Futures Contracts as a Merchandising Tool:
The Role of Delivery as a Means of Ownership Transfer 51
CHAPTER 4
Maintaining the Integrity of Grain Futures Contracts:
The Economics of Manipulation and Its Prevention 63
CHAPTER 5
The Economic Effect of Potential Grain Futures
Contract Redesign 107
CHAPTER 6
Summary and Conclusions 139
References 147
Index 183
v
vi
Tables • Graphs • Figures
TABLE 2-1: Corn
Range of Futures Price in Relation
to Cheapest-to-Deliver Cash Price Showing Extent
of Arbitrage Violations Between Cash and Futures Prices 152
TABLE 2-2: Soybeans
Range of Futures Price in Relation
to Cheapest-to-Deliver Cash Price Showing Extent
of Arbitrage Violations Between Cash and Future Prices 154
TABLE 2-3: Wheat
Range of Futures Price in Relation
to Cheapest-to-Deliver Cash Price Showing Extent
of Arbitrage Violations Between Cash and Future Prices 156
TABLE 2-4
Summary Statistics by Contract for Basis
During the Delivery Month 158
TABLE 2-5
Receipts at Primary Markets as a Fraction of U.S. Output 160
TABLE 2-6
Receipts at Chicago as a Fraction of U.S. Output 161
TABLE 2-7
Chicago, Toledo, and St. Louis Receipts as a Fraction of
Receipts at all Terminal Markets 162
TABLE 3-1
Deliveries as a Fraction of Open Positions 1980·1989 163
TABLE 3-2
Deliveries as a Fraction of EFPs + Deliveries 1983·1989 164
TABLE 3-3
Total Soybean Delivery Regression Results 165
TABLE 3-4
Total Corn Delivery Regression Results 166
TABLE 5-0
Delivery Option Regression Results 167
vii
TABLE 5-1
Soybean Hedging Effectiveness
Under Alternative Delivery Specifications 168
TABLE 5-2
Corn Hedging Effectiveness
Under Alternative Delivery Specifications 170
TABLE 5-3
Soybean Percentage Price Change Correlations 172
TABLE 5-4
Corn Percentage Price Change Correlations 173
GRAPH 1
Soybeans Basis: Contracts for March Delivery by Year 174
GRAPH 2
Soybeans Basis: Contracts
for September Delivery by Year 175
GRAPH 3
Corn Basis: Contracts for March Delivery by Year 176
GRAPH 4
Corn Basis: Contracts for September Delivery by Year 177
GRAPH 5
Wheat Basis: Contracts for March Delivery by Year 178
GRAPH 6
Wheat Basis: Contracts for July Delivery by Year 179
FIGURE 1
Competitive Equilibrium in a Futures Market 180
FIGURE 2
Non-Unique Competitive Futures Market Equilibirum 181
FIGURE 3
Futures Contract Manipulation by a Large Trader 182
Foreword
This study is an independent scholarly analysis of the economics
of the grain futures contracts of the Chicago Board of Trade. The
study was made possible by a research grant to the MidAmerica
Institute from the Chicago Board of Trade, and we gratefully
acknowledge this financial support, as well as the information and
vast body of experience made available to us by the Division of
Economic Analysis and members of the Exchange.
Several other organizations also provided invaluable help from
the inception of this study through the full process, either in the form
of information, or through discussion: the Commodity Futures
Trading Commission, the U.S. Department of Agriculture, the
National Grain and Feed Association, the American Soybean
Association, the Senate Committee on Agriculture, Nutrition and
Forestry, the House Committee on Agriculture, the General
Accounting Office, and the Center for the Study of Futures and
Options Markets at Virginia Polytechnic and State University. We
express our thanks.
The primary authors wish to extend a special word of apprecia
tion to Michael Brennan, Merton Miller, Richard Roll, Hans Stoll and
Lester Telser, who served as members of the Resource Panel for the
study. While key strengths of the study reflect their input, ultimate
responsibility for the analysis rests with the primary authors.
For more than 130 years the grain contracts of the Chicago Board
of Trade have contributed to the health and well-being of American
agricultural economy. It is our hope that the analysis presented in
this study will help to continue that tradition into the next century.
ix
The Grain Futures Delivery Process:
An Overview
The grain futures markets of the Chicago Board of Trade (Board
or CBT henceforth) are among America's most venerable financial
institutions, with a history spanning almost 130 years. During that
long period the interconnections between the grain and futures mar
kets have evolved remarkably with changing production, storage, and
trading techniques, communication and transportation systems,
identities and sizes of market participants, domestic and export
demand conditions, and still other phenomena. In such a dynamic
milieu, institutions can become outmoded unless they are reviewed
periodically, and revised when appropriate.
This report examines the recent performance and future
prospects of a crucial aspect of grain futures contracts--the delivery
process. Delivery links futures and spot markets, and is essential to
the efficient performance of a grain futures contract. Both hedging
effectiveness and the informativeness of futures prices depend cru
cially upon this linkage.
After examining a body of recent data, we have reached a number
of basic conclusions. First, the delivery process has worked well over
the past six years. Convergence has occurred regularly, and the few
deviations from convergence do not reflect any systematic failure of
the contracts. Second, despite the performance of the recent past, the
decline of terminal grain markets and the evolution of trading pat
terns suggests that the futures price converges to a decreasingly rele
vant cash price. This evolution has significantly reduced the
importance of Chicago and Toledo as cash grain markets, and prices
there can no longer serve as the sole measure of value for the very
large number of hedgers who are now oriented toward markets other
than Chicago!I'oledo. Third, there is no radically different substitute
mechanism apparent that possesses superior attributes to the one
now in use. A change to an "economic-par" delivery system including
xi
xii MAl Grain Study
a delivery point on the Mississippi River in addition to the existing
points of Chicago and Toledo, however, may well produce a signifi
cant improvement in hedging effectiveness at out-of-position loca
tions. Fourth, the delivery process is an unimportant means of
transferring ownership of grain. Fifth, due to transportation costs
and the nature of trading patterns grain markets are susceptible to
manipulation, so proper regulatory and contract design safeguards
are desirable.
In what follows, Chapter 1 provides an overview of the role of
futures markets in order to provide a perspective against which to
evaluate their performance. There we discuss the distinction between
forward markets in general and the highly constrained form known
as a futures market, exploring the reasons for the popularity of the
latter. As that chapter emphasizes, futures contracts perform numer
ous complex functions that complement spot markets. In practice, the
functions are inseparable, but in our analysis we separate them con
ceptually to obtain a more precise understanding of their values to
the economy, the means by which that value could be more fully real
ized, and the dangers posed by ill-considered modifications in the
contracts or exchange rules. Several issues are raised in Chapter 1
that are more fully addressed in later chapters. For instance, the
price data for spot and forward transactions are fundamentally dif
ferent from futures transaction prices precisely because of the
uniqueness of the former versus the standardization of the latter.
The chapter also notes that the theoretically better hedging that
would seem to flow from improved correlation between spot and
futures prices if the contract set were expanded must be traded off
against the liquidity that is provided by more highly standardized
contracts.
Chapter 2 uses recent data to investigate the ability of the deliv
ery mechanism to link spot and futures markets; i.e., to assure price
convergence. The evidence shows that convergence has been quite
good during the sample period used. The chapter also discusses the
effects of the decline of Chicago and Toledo as terminal markets (and
terminal markets in general) on the viability of the Board's existing
delivery mechanism, and examines some alternatives to this mecha
nism.
Chapter 3 investigates the use of delivery for trading the under
lying commodity, which some recent scholarly literature has empha
sized.1 The belief that futures markets are ill-suited for
merchandising had previously been axiomatic. Which of the compet
ing beliefs is more reflective of our economy is the central question of