Futures markets and the supply of storage with rational expectations

Abstract

onsider an individual holding a commodity that is subject to price risk be-C cause of factors affecting the future demand for this commodity. For example, the commodity might be a raw material whose price fluctuates randomly because of cyclical disturbances. If a futures market exists for the commodity, this individual can protect himself against price risk by hedging; i.e., by selling short in the futures market. Whether he decides to do this and to what extent will be determined by the relationship of the futures price to the distribution of spot prices at the time he is ready to sell the commodity, the correlation-if any-between the spot price and the amount of the commodity he is holding, and, the degree to which he is risk averse.In recent papers, Holthausen (1979) and Feder, Just, and Schmitz (1980) have analyzed production decisions when producers confronted with price risk make optimal use of futures markets. Discussing the effects on output, Holthausen (1979, p. 993) writes:The existence of forward or future markets therefore induces a firm to increase output, ceteris paribus, assuming its optimal hedge is positive.' It is my intention in this article to consider precisely this issue in a market-equilibrium setting where equilibrium is characterized by rational expectations. I shall look at the storage decision rather than the production decision because the predominant demand for hedging is commonly considered to come from individuals or firms involved in the storage or processing processes; i.e., from those holding stocks of the commodity in question.Market-equilibrium models of storage were presented more than two decades ago by Brennan (1958) and Peston and Yamey (1960). This article can be consid- consider the effect of greater output on both the market price and the forward price.

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“…In turn, the futures price would be a biased estimate of the spot price at maturity. This observation is consistent with Britto's (1982) perspective on how the existence of futures markets affects the amount of a good stored for sale in the next period.…”

“…By assuming rational expectations, Britto (1982) finds that traders would buy futures from merchants and farmers to reduce the amount sold in the initial period and increase the amount stored. This situation occurs when traders can better use the correct price distribution to face demand fluctuations.…”