Example Economics Essay. Futures and Options in the Commodities Market.

Example Economics Essay. Futures and Options in the Commodities Market.
The agreement to buy and sell such commodities is made through contracts tobring in legality in trading as it involves cash payments margins, delivery ofgoods and scope for profit maximisation. The emergence of contract systemeventually led to trading in contracts whereby a middlemen stands in betweenbuyers and sellers. The active trading in such contracts broughtstandardisation which in turn led to the development of futures contracts.
A futurecontract is a standardised, binding agreement to make or take delivery of aspecified quantity and grade of a commodity at an established point in futureat an agreed upon price.The organization of merchants involved in the trading these commodities evolvedinto an organisation that standardised the contracts and trading practises andcame to be known as - The Futures Exchange such as the New York Board of Trade(NYBOT) and the London International Financial & Futures Exchange. Oneessential objective of the exchange is to provide the dealers with allnecessary information with regard to price volatility i.e. the magnitude ofprice movement in either direction. Note that it measures price risk andvolatility but does not remove or eliminate risks. The exchange provides thebenchmark for the determination of price by making price margins mandatory foreffective fair trading.

Futurestransactions do not require full advance payments for the commodity (just themargin), the buyer of a futures contract which increases in value (or theseller of futures contract which decreases in value) can realize a profit whichcan be substantial in relation to the commitment of capital.

Brazil today is the world largest producer of coffee. Considering this figures,it is not surprising to note that it has attracted considerable amount ofspeculation and ever increasing susceptibility to price volatility.

Coffeeproduction have direct linkage with weather besides many other factors such asworld coffee prices. A coffee drink manufacturer will buy coffee beans from acoffee producer at an agreed price if he/she expects to have drastic climaticchanges which will result in coffee being expensive at a future date. A suddendrop in the production in future will cut supply and make it more expensive. He/Shecan, therefore, avoid unnecessary risk by buying a futures contract that willguarantee him delivery of coffee at a future date at a price fixed now.However, it must also be noted that he/she will suffer loss if the futurecurrent/spot price of coffee beans were to fall drastically due to improvedproduction and competitions.

Take an exampleof Brazil - The Brazilian Crop was initially expected to produce about 50 millionbags of coffee. Seasonal disturbances such as rain, harvest delays and qualityproblem caused production to fall to 33.5 million bags. Due to severe droughtin Viet Nam coffee production dropped by almost 1 million bags.These shortages of coffee output distort the supply level which leads to aglobal rise in prices.

So what rolesdoes the future markets play in the production and selling of coffee ? Takingthese points into account the next chapter looks at the Indian and world coffeemarkets and the role future market plays in its pricing. In the analysis, Ihave made use of some articles from the Times of India newspaper and otherwebsites.

It is logical to state that at times of shortage prices tend to go up due tohigher demand and which in turn puts pressure on sellers to sell their productat a lower price. We know from our analysis before that a buyer will resort tofutures contract if he expects the prices to go up in future. Howeverconsidering that the production too has been low the chances of producing therequired amount to meet the demand is less which adds to speculation in themarket.

The report also suggests one sourceas saying that it is better to pay penalty and cancel a contract rather thanto loose significant amount of money by fulfilling it. Note that sometimes thewhole idea of futures contract is not meet the obligation in terms ofdelivering the commodity but to profit from the speculation that theseuncertainties give rise to.

The world coffeeproduction in 2003/2004 was estimated to be around 105.3 million 60 kilogrambags down nearly 2 percent from forecast made in June and down 15 percent fromthe 2002/03 season. Factors such as lower production contribute to great extentthe price determination.For the year 2004/2005 it was widely believed that Brazilian coffee productionto be around 33-35 million bags but due to substandard weather and low level ofinvestment the production is likely to be below 30 million bags.This drop in production is likely to cut the supply level and Brazil being theworld largest producers, any drop in its output will affect the world supplyand thereby raise the price.

Theseuncertainties lead to prices going up in the futures markets. It has long beenfelt that some traders hold stocks to push the prices up and then sell it tomake supernatural profits.

Let's look atthe graphical representation of prices of Robusta class of coffee as determinedat the International Coffee Organisation (ICO) to assess the trends in themarket. The graph below shows that since November 2004 Robusta coffee priceshave increased at a slow and steady pace. However, a report that appeared onthe Economic Times suggests that volatility in the world prices over the lastfew days have affected trading in coffee in the markets.The ICO in its Coffee Market Report seems to suggest that the downturn inmid-April caused a slight fall of 3.19 percent in the monthly average of theICO Composite Indicator Price which dropped from 101.44 cents/lb in March to98.20 cents/lb in April.It also suggests that this has been due to high level of activity from variousinvestment funds.

Comparing theresults put forward by the ICO to the recent reports in the Economic Timesnewspaper (24/05/2005) the volatility in the world prices have triggered abullish trend in the Indian markets which explains why trading in the coffeeauctions markets have suffered. Estimates shows that there was a 40 percentdrop in the overall quantum sold when compared to the previous ICTA auction.

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