The Role of Commodity Futures Markets
Commodity futures markets play a very important role in the global economy and in society in general for many reasons. We are going to talk about 3 of the main ones below.
1. Reduces Price Volatility and Risk
The market mechanism of commodity futures markets helps to reduce price volatility by letting human nature (invisible hand of self-interest) work freely. If there is a glut of some product in the market, the price will fall as demand weakens and producers lower there prices and then produce less. If there is a shortage of some product in the market, the price will rise as producers raise there prices and produce more. This brings things in balance as the market constantly adjusts to the current market situation. This is like a see-saw and this continual re-balancing helps avoid boom and bust cycles.
Additionally, the system of hedging reduces risk for all parties and helps to promote economic growth as farmers, consumers, producers, distributors, etc. can lock in prices of their crops, raw material costs or other input costs. This allows market participants to better plan their production output, consumption and capital spending budgets. As risks are reduced, more stability is brought to the market place and the overall economy. (See examples of hedging below)
By using either a Sell or Buy hedge, the Futures Price moves in opposite direction of the physical Price so the approximate net change is near zero and the hedger has locked in their price.
*The costs of hedging such as commission charges are not included in the example.
2. Price Determination
Supply and demand are never in perfect harmony and so there has to be a mechanism to determine the price of a commodity. Commodity futures markets provide the perfect system and place for buyers and sellers to use all of the available information in the market to determine the market price at that moment. In a nutshell it comes down to basic supply and demand and the decisions of thousands of market participants that together determine the market price of the commodity through futures exchanges around the world.
3. Balances Production and Consumption
The market place for commodity futures helps to keep a balance between consumption and production as price adjustments are constantly being made in the market based on supply and demand. Producers and consumers alike decide how much to produce or consume based on market prices. These individual decisions on production and consumption levels based on daily pricing through commodity futures exchanges around the world helps to keep levels in balance. As the old adage goes; "the cure for high prices is high prices".