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Future markets
Futures markets An alternative for stabilizing secondary materials markets?
Roger C. Dower and Robert C. Anderson
The
authors
present in
secondary discuss
the trading
are
a
and
on the
commodity. to
impacts
These the
potential
effects
conclude
with
participation
and
a scrap
market.
authors
Environmental Connecticut Washington,
United States Agency is
with
are l_aw
Institute,
Avenue DC 20036,
the 1346 NW,
USA.
Richard Grace Pearce and ’ David recently reviewed some of the merits of a buffer stock scheme aimed at stabilizing waste paper prices (Resources Policy, Vol 1976, pp 118-27). They 2, No 2, concluded that such a scheme may reduce revenue to the supply industry and might prove very costly to the stock holding agency. * For a more complete discussion of the market imperfections affecting resource recovery, see Talbot Page, Conservation and Economic Efficiency: An Approach to Materials Policy, The Johns Hopkins University Press, Baltimore, 1977.
230
Futures markets in waste paper or ferrous scrap may be a more effective mechanism for market stabilization than a buffer stock scheme, and may also achieve market stabilization at a lower cost to society.’ Additionally, by stabilizing producer and consumer income and decreasing uncertainty in the market place, an organized futures market should induce increased recovery of secondary materials.
for the They
for public
initiating
Financial si!pport from the Environmental Protection gratefully acknowledged. The
impacts
markets
a rationale
of
market
are assessed.
in
for briefly
cash
materials
secondary
economic
markets
possible
applied
futures
the
materials
futures for
an
extramarket
for
justification intervention
Economic
rationale for scrap futures markets
In an economic environment characterized by certainty, competitive markets for all goods and services, no externalities, and no institutional barriers to market operations, all resources would automatically flow to their highest value and best use. In terms of the markets for secondary materials, this means that the socially optimal amount of industrial and consumer residuals would be recovered and recycled for use as inputs into production processes. In reality, the amount of scrap materials recovered may differ significantly from that deemed socially optimal. Uncertainty over future prices, subsidized waste disposal, subsidized extraction of primary inputs, pollution from materials extraction and processing and other market imperfections act to distort efficient resource allocation in secondarv input markets.* This paper considers just one of these market imperfections, that of market uncertainty. The optimal allocation of resources to competing uses requires that producers and consumers know the present and all future prices for each resource. In practice, all future prices are known only with a degree of uncertainty. The relevant question is whether future prices are inherently more uncertain for some resources than for others. The degree of uncertainty of the future prices of different resources will affect the investment decisions of risk-averse producers. In turn, these investment decisions may create a divergence between the observed patterns of resource allocation and the allocations which would lead to highest social welfare or Pareto optimality.
RESOURCES
POLICY
December
1977
Futures Table 1. Coefficient of variation wholesale orices for selected commodities, 1971-I 975
of
Coefficient of variation
Commodity All industrial commodities Refined petroleum products Woodpulp (all grades) Waste paper (all grades) Paperboard products Iron ore Iron and steel scrap (all grades) Iron and steel products Copper wirebar (domestic origin) Copper scrap (base) Aluminium scrap (base) Primary aluminium ingot Lead pig (common) Scrap lead (battery plates) Nickel cathode sheets Scrap nickel anodes Tin pig, grade A Block tin pipe scrap Zinc slab (prime Western) Old zinc, New York
0.143 0.393 0.425 0.440 0.219 0.175 0.458 0.229 0.169 0.286 0.361 0.218 0.210 0.289 0.175 0.223 0.367 0.250 0.044 0.236
Source: All prices taken from Wholesale Prices and Price Indexes. US Department of Labor, Bureau of Labor Statistics, Annual Supplements.
3 The coefficient of variation is a measure of the relative variation in a data series. It is calculated by dividing the standard deviation by the mean. A value of zero indicates no variation: the higher the value the more variation. 4 F.A. Cardin. Secondary Fiber Recovery Analysis, a report to Office of Research and Development, US Environmental Protection Agency. 1974. K.L. Robinson, 5 W.G. Tomek and Agricultural Product Prices, Cornell University Press, Ithaca, NY, 1972, p 285.
RESOURCES
POLICY
December
markets:
An
alternativeJor
stabilization
All markets are affected by uncertainty over future prices, but secondary materials appear to have an unusually high degree of price variability. Table 1 lists the coefficient of variation for selected primary and secondary materials. 3 In all cases but one the secondary commodities show larger price variation. The largest variation is with waste paper and ferrous scrap. The lack of a stable base from which to predict future prices for secondary materials affects both the short- and long-run allocation of resources in the scrap industry. In the short run, scrap dealers and scrap users have great difficulty in planning their market activities. Without the benefit of future prices, production and inventory decisions cannot be made rationally. As a result, producers show preference for primary over secondary inputs, even when quality and other dimensions are comparable. In the long run, uncertainty constrains investment in recycling since scrap users discount expected returns from technology, investment in secondary processing facilities more heavily than investment returns from primary processing technology. The direct effects of uncertainty over future prices can often be mitigated if risk markets exist. If those who deal in commodities having volatile and unpredictable prices could insure against the effects of future price changes, the adverse impact of price uncertainty on resource allocation would be largely eliminated. Two common methods of insuring against the effects of price uncertainty are forward contracting and vertical integration. Forward contracting has not been used with success in the US ferrous scrap and waste paper industries. Because of the high price uncertainty, buyers and sellers of scrap are not willing to enter into long-term agreements, even though industry members admit that forward contracting is necessary to stabilize demand and supply conditions. Nor does vertical integration by user mills back to the scrap dealers represent a realistic possibility. First, management of large user mills have developed a major commitment to primary input sources for tax purposes and other reasons. Second, the geographically diverse nature of the market makes it unsuitable, in the eyes of the mills, for acquisition. Third, and probably most importantly, there is a social stigma attached to scrap dealers in general which deters mill management from getting involved in the market.4 Various devices and approaches have been offered as possible solutions to the problem of price uncertainty in secondary material markets. Some examples include government sponsored marketing reports, demand and supply research, and price forecasting. None of these provides a mechanism through which the effects of volatile prices can be insured. One mechanism which simultaneously attacks the problems of uncertainty and insurance against risk is a government financed buffer stock scheme. A highly simplified version of such a system would have the government estimate the long-run equilibrium price for the commodity and be ready to buy any offerings and sell from its inventory at this price. Pearce and Grace found such a system would have high costs and uncertain effectiveness.’ Furthermore, sufficient funds must be assured to buy the necessary stocks. The international buffer stock scheme in tin, the first of its kind, failed to halt huge price increases because adequate stocks had not been established.5
1977
231
Futures markets: An alternativefor
stabilization
Scrap futures markets could be used as an alternative approach to deal with the twin issues of price uncertainty and risk insurance. A futures market only directly affects one of the market imperfections discussed above - that of expected price uncertainty. Removal or reduction of uncertainty in secondary materials markets will not by itself allow efficient resource allocation. In this sense, futures markets need to be considered together with other policy alternatives directed at other sources of market future. Nonetheless, a futures market would lower one of the barriers to achieving socially optimal levels of resource recovery.
Economic
impacts of futures markets
The economic impacts of futures trading on the cash market6 may usefully be divided into three general categories - the impacts on pricing in the cash market, the impacts of risk management, and the impacts on market information.
Pricing function offutures markets
6Throughout this paper the term ‘cash’ refers to market transactions that do not involve futurity. 7 R.W. Gray and D.J.S. Rutledge, ‘The economics of commodity futures markets: Review of Marketing and A survey’, Agricultural Economics, Vol 39, 1971, p 73. a B.A. Goss and B.S. Yamey, eds, The Economics of Futures Trading, John Wiley and Sons, New York, 1976, p 36. ‘This is possible because futures contracts can be legally cancelled by offset. A seller of a July copper futures contract can cancel his commitment to deliver copper in July by buying a July futures at any time before the delivery date. Of course, he also has the option of delivering the copper if it suits his needs. ‘OThe authors are keenly aware of the realistic definition of hedging more initially developed by Working. The notion that all hedgers use futures markets in a routine fashion and do not attempt to anticipate future price movements, and thus act as speculators, is admittedly naive. All the same, the simplified notions of hedging described here were felt to be useful for the purposes at hand. A detailed discussion of the broader definition of hedging can be found in H. Working, ‘Futures trading and hedging’, American Economic Review, Vol43, June 1953, or in H. Working, ‘New concepts concerning futures trading’. American Economic Review, Vol 52, February 1960.
232
Futures markets are often described as price discovery mechanisms. They act as central clearing devices for traders in a commodity. These traders buy and sell futures contracts (which call for delivery of a specified quantity and quality of a commodity at some future date), based on their expectations and information concerning current and future demand and supply conditions. Traders with good forecasting tools and skills and better information are rewarded at the expense of less skilled traders - the competitive nature of a futures market tends to ensure good prediction of future prices. The prices generated on futures markets through the actions of buyers and sellers of futures contracts represent unbiased predictions of future cash prices based on the currently available market information.’ Futures markets thus act as price discovery mechanisms, by providing a forum for the assimilation of market information and expectations. The futures prices act as signals to decision makers on when to produce, consume or hold stocks. In turn, fluctuations in demand and supply are dampened and inventories assume a greater role as a price buffer. Therefore, in general, one would expect a ‘dampening of intraseasonal and inter-seasonal price movements’ in a commodity for which there is futures trading.8
Risk managementfunction offutures markets As well as being a price discovery mechanism, futures markets can be used to manage or insure against the inherent risk of an uncertain market environment. Traders on futures markets are usually grouped into two classes - speculators and hedgers. Of these two groups, only hedgers use futures markets for risk management. Speculators buy and sell futures contracts in the hope of profiting from favourable movements in the futures prices. They have no position in the cash market, and never intend to make or take delivery of the commodity in which they are trading.9 Hedgers, on the other hand, use the futures markets to reduce the risk of an unfavourable movement in the cash price that would affect a position they hold or plan to hold in the cash market.” Normally, a hedge involves taking a position in the futures market that is the opposite of a planned or actual position held in the cash market. A
RESOURCES
POLICY
December
1977
Futures
markets:
An alternative for stabilization
buyer in the cash market would be a seller of futures contracts, and vice versa.” While providing a tool for risk management, the hedging role of futures markets also stabilizes producer and consumer income. This is when risk is defined as variance in implied by risk management, income. Since losses or gains in the cash market can be offset, albeit imperfectly, by losses or gains in the futures markets, vagaries in income tend to be lessened. A futures market tends to be most effective in stabilizing income when income variability is due mainly to price fluctuation.12~13
” Since futures prices and cash prices tend to move together, a loss in one market will be offset by a gain in the other. For example, a cooper scrap dealer who is offered a forward contract for scrap from a buyer and does not have the scrap on hand can hedge against the risk of a price rise over the period by buying an equivalent amount of copper futures. Since the price of copper scrap is highly correlated with the cash price of copper which, in turn, is highly correlated with current month copper futures prices, such a purchase would protect him from a rise in his purchasing price to a point that he cannot receive a normal return from the sale of the copper scrap as per the contract terms. I2 R J McKinnon, ‘Futures markets, buffer stocks, and income stability for primary producers’, Journal of Political Economy, Vol75. 1967, pp 844-861. l3 Routine hedging of expected output can cause greater income instability if the main source of uncertainty is output variation. Generally, if the variation in the basis, which is the difference between the cash price and a near futures price, is less than the cash price variation, returns will be more stable, assuming hedges can be placed over a period long enough to cover the period of price instability. I4 C.G. Cox. ‘Futures trading and market information’, Journal of Political Economy, Vol 84, 1976, pp 1215-1237. 151bid, pp 1217-1218.
RESOURCES
POLICY
December
Market information function offutures markets Closely allied with the pricing function of futures trading is its increased flow of market information. Exchanges regularly publish statistics on trading volume, prices, and other information for the commodities traded on their floors. Commission houses publish supply and demand estimates and make price forecasts available to their customers. Traders use this information, as well as information from agencies, etc, in forming other sources, such as government expectations of future market conditions. The information is reflected in the futures prices generated on the exchange. The futures prices are quoted daily in most major newspapers and so are readily available to the general public. By providing a central marketing place, by increasing the number of traders in a commodity market, and by lowering the transaction costs of information exchange, a futures market increases the quality and quantity of information flowing into the market. Although the market information effect of futures trading has long been recognized, its importance, relative to the risk management and forward pricing role of futures trading, has been underplayed. In a recent article, Cox elevates this role of futures trading to the level of the other two. He states that as a result of more fully informed traders ‘market prices provide more accurate signals for resource allocation when there is futures trading in a commodity’.14
Potential impacts of futures trading in secondary markets
materials
The most direct impact of futures trading in secondary materials would be on the formation of price expectations. By increasing market information flow, one would expect a corresponding decrease in uncertainty over future market conditions. The actual impact depends on how decentralized the traders in the market were before initiation of futures trading. The more traders and the more decentralized the market, the greater the impact of futures trading in increasing market information flow.15 For the US ferrous scrap and waste paper industries, this is of major importance, since the lack of a central marketing place is one of the major constraints to information flows. From increased information flows in the scrap materials markets, one would expect an increase in the responsiveness of demand and supply to price signals. In turn, prices for scrap commodities should become more stable. Besides reducing price uncertainty for scrap materials, a futures market would provide scrap buyers and sellers with a mechanism for
1977
233
Futures markets: An alternativefor
stabilization
coping with part of the remaining risk through hedging. This would also stabilize income to both scrap dealers and buyers. The net outcome of futures trading in secondary materials would be the elimination of one of the disincentives that favour use of primary materials over secondary materials. A futures market would provide unbiased predictions of future prices for scrap materials. Production and inventory decisions for scrap commodities could be made in a more certain market environment. Large losses from commitments to scrap purchases either by a buyer or a seller could also be reduced by appropriate hedging plans. Longer run impacts are less clear. Trading in futures contracts rarely extends more than l+ years into the future, and in this sense a futures market represents only a short-run decision tool. In general, though, reduced uncertainty would act to encourage increased investment in recycling technology. There are two general differences between futures markets and other stabilization alternatives. First, a futures market directly impacts a part of the cause of price instability by increasing the flow of market information and decreasing uncertainty over expected prices. Second, initiation of futures trading in a commodity is a decision made in the private sector. Historically, the government’s role, vis-a-vis futures markets, has been one of regulator or, in the case of some agricultural commodities, of inspector. Other stabilization schemes, such as buffer stocks, are initiated by the government which then accepts the responsibility for its success.
Potential role for public participation
r6All commission houses are required to deposit in exchange accounts a portion of requirements posted by the margin customers of the houses The exchange returns the funds when an account is cleared, but retains the accrued interest. During periods of high interest rates, interest paid on clearing funds may represent the largest single source of income to the exchange. An exchange also receives clearing fees, which are generally a small percentage of the commission fees paid by commission house customers. Many exchanges obtain revenue from real estate holdings and other investments. Annual dues paid by exchange members for the privilege of trading on the exchange are a fourth source of income, which is normally insignificant.
234
All commodity futures exchanges in the USA are non-profit organizations - their main purpose is to serve the needs of their members. To stay in existence the exchange must generate enough revenue to cover the variable costs of operation. Exchanges have several sources of revenue, of which the three most important generally are interest on clearing funds, clearing fees, and investments.i6 The value of the first two revenue sources makes exchanges extremely interested in increasing trading volume on their floors and in initiating new contracts that will attract substantial trading interest. Given that it is in an exchange’s interest to initiate new contracts, the question arises as to whether or not there is any reason for government participation in this process. Is there any reason to believe that an exchange will initiate less than the optimal number (from the viewpoint of society as a whole) of futures contracts? Because futures trading creates a public good we argue that there is indeed an economic justification for government involvement in the research and initiation of futures contracts. Public good aspect offutures trading The public good aspect of market information, which is generated through active trading of futures contracts in a commodity, is one important rationale for governmental support of the commodity exchanges’ functions. An exchange is able to recoup part of the value of the risk insurance role of futures trading through commissions paid by traders. However, since the market information contained in the
RESOURCES
POLICY
December
1977
Futures
markets:
An alternativefor
stabilization
futures prices can be used by anyone without trading, an exchange will not be compensated for the full value of this information. In this sense, futures trading generates a public good. There is no way to exclude a potential user from the futures prices, and one individual’s use of the information does not impair its usefulness for another - ie the opportunity cost to an exchange of extending consumption to another person is zero, or at least close to it. Public goods theory demonstrates that since the private sector does not receive the appropriate demand signals for an efficient production level, less than the socially optimal amount of the good will be prb, .lced. The proper role for the public sector is to ‘aggregate consumers’ demand for these goods and express it to the private sector’. ” In terms of futures markets, the ‘publicness’ or ‘semipublicness’ of the market information produced through futures trading may result in exchanges researching and initiating, for futures trading, less than the socially optimal number of commodities. The government, then, is responsible for providing the necessary signals to an exchange to induce the optimal production of futures contracts. The public good aspect of futures trading is directly applicable to a scrap futures contract. If an exchange were to decide against trading such a contract because of a projected lack of trading interest, there is a justification for public intervention - such as subsidies to commodity exchanges - to insure listing of scrap for trading, assuming that the projected social benefits exceed the costs of the public intervention. The public agency is also justified, on economic grounds, in providing legal, educational or political tools and expertise to remove existing barriers to successful trading.
Conclusion
‘l N.M. Singer, Public Microeconomics. Little Brown and Company, Boston, Mass, 1972, p 95. I8 At least two studies have attempted to answer the first part of this question. See D. Bradford and H. Kelejian, The Value of Information for Crop Forecasting in a Market System, prepared for Office of Applications, National Aeronautics and Space Administration by Econ Inc. 1975, and Y. Hayami and W. Peterson, ‘Social returns to public information services: Statistical reporting of US farm commodities’, American Economic Review, Vol 62, 1972, pp 1 19-l 30. Both presented a framework for measuring the social benefits from improvements in the information which is supplied in the markets for agricultural commodities. We will not attempt to summarize their views here, except to say that in both studies significant positive changes in consumer welfare were found to result from more accurate market information.
RESOURCES
POLICY
December
A futures market has two distinct advantages over other stabilization schemes, such as buffer stocks. First, a futures market is more than just a stabilizing force - futures markets decrease uncertainty over expected prices for a commodity by increasing market information flows. At the same time, they provide a risk management tool to enable industry members to cope with the remaining price risk. Price and income stabilization are outgrowths of these two aspects of futures markets. Second, a properly designed futures market acts in concert with the existing market structure and requires minimum, if any, government participation. The public costs of a futures market will be zero in the case where an exchange decides to trade a commodity on its own. More typically, the government may choose to incur small costs by taking responsibility for inspection of deliveries. If, to trade a commodity, other forms of government intervention such as subsidies, educational campaigns, research programmes, etc are needed, the costs would increase, but probably not to the level of a viable buffer stock plan. At least two issues remain to be resolved. First, the level of government intervention in the process of researching and initiating a futures contract should be based on the equation of marginal social costs and to marginal social benefits. This may prove cumbersome while social costs are relatively easy to delineate and estimate, social benefits are more elusive. What is the benefit of greater information flows or a more efficient allocation of resources?18
1977
235
Futures markets: AII alternativefor
stabilization
Another set of questions that we have not addressed, but which are important to the concept, involve the feasibility of futures trading in scrap. Can scrap materials be traded on organized exchanges? Can a standard grade for trading be developed? Are there sufficient buyers and sellers in the market for scrap to ensure competition? While these questions remain to be answered, they do not appear to constitute major barriers to futures trading in waste paper or ferrous scrap. Our preliminary results indicate that most of the technical details of a scrap futures market can be worked out, given a sufficient degree of interaction between the exchange, industry members, and interested government agencies.
236
RESOURCES
POLICY
December
1977
Roger C. Dower and Robert C. Anderson
The
authors
present in
secondary discuss
the trading
are
a
and
on the
commodity. to
impacts
These the
potential
effects
conclude
with
participation
and
a scrap
market.
authors
Environmental Connecticut Washington,
United States Agency is
with
are l_aw
Institute,
Avenue DC 20036,
the 1346 NW,
USA.
Richard Grace Pearce and ’ David recently reviewed some of the merits of a buffer stock scheme aimed at stabilizing waste paper prices (Resources Policy, Vol 1976, pp 118-27). They 2, No 2, concluded that such a scheme may reduce revenue to the supply industry and might prove very costly to the stock holding agency. * For a more complete discussion of the market imperfections affecting resource recovery, see Talbot Page, Conservation and Economic Efficiency: An Approach to Materials Policy, The Johns Hopkins University Press, Baltimore, 1977.
230
Futures markets in waste paper or ferrous scrap may be a more effective mechanism for market stabilization than a buffer stock scheme, and may also achieve market stabilization at a lower cost to society.’ Additionally, by stabilizing producer and consumer income and decreasing uncertainty in the market place, an organized futures market should induce increased recovery of secondary materials.
for the They
for public
initiating
Financial si!pport from the Environmental Protection gratefully acknowledged. The
impacts
markets
a rationale
of
market
are assessed.
in
for briefly
cash
materials
secondary
economic
markets
possible
applied
futures
the
materials
futures for
an
extramarket
for
justification intervention
Economic
rationale for scrap futures markets
In an economic environment characterized by certainty, competitive markets for all goods and services, no externalities, and no institutional barriers to market operations, all resources would automatically flow to their highest value and best use. In terms of the markets for secondary materials, this means that the socially optimal amount of industrial and consumer residuals would be recovered and recycled for use as inputs into production processes. In reality, the amount of scrap materials recovered may differ significantly from that deemed socially optimal. Uncertainty over future prices, subsidized waste disposal, subsidized extraction of primary inputs, pollution from materials extraction and processing and other market imperfections act to distort efficient resource allocation in secondarv input markets.* This paper considers just one of these market imperfections, that of market uncertainty. The optimal allocation of resources to competing uses requires that producers and consumers know the present and all future prices for each resource. In practice, all future prices are known only with a degree of uncertainty. The relevant question is whether future prices are inherently more uncertain for some resources than for others. The degree of uncertainty of the future prices of different resources will affect the investment decisions of risk-averse producers. In turn, these investment decisions may create a divergence between the observed patterns of resource allocation and the allocations which would lead to highest social welfare or Pareto optimality.
RESOURCES
POLICY
December
1977
Futures Table 1. Coefficient of variation wholesale orices for selected commodities, 1971-I 975
of
Coefficient of variation
Commodity All industrial commodities Refined petroleum products Woodpulp (all grades) Waste paper (all grades) Paperboard products Iron ore Iron and steel scrap (all grades) Iron and steel products Copper wirebar (domestic origin) Copper scrap (base) Aluminium scrap (base) Primary aluminium ingot Lead pig (common) Scrap lead (battery plates) Nickel cathode sheets Scrap nickel anodes Tin pig, grade A Block tin pipe scrap Zinc slab (prime Western) Old zinc, New York
0.143 0.393 0.425 0.440 0.219 0.175 0.458 0.229 0.169 0.286 0.361 0.218 0.210 0.289 0.175 0.223 0.367 0.250 0.044 0.236
Source: All prices taken from Wholesale Prices and Price Indexes. US Department of Labor, Bureau of Labor Statistics, Annual Supplements.
3 The coefficient of variation is a measure of the relative variation in a data series. It is calculated by dividing the standard deviation by the mean. A value of zero indicates no variation: the higher the value the more variation. 4 F.A. Cardin. Secondary Fiber Recovery Analysis, a report to Office of Research and Development, US Environmental Protection Agency. 1974. K.L. Robinson, 5 W.G. Tomek and Agricultural Product Prices, Cornell University Press, Ithaca, NY, 1972, p 285.
RESOURCES
POLICY
December
markets:
An
alternativeJor
stabilization
All markets are affected by uncertainty over future prices, but secondary materials appear to have an unusually high degree of price variability. Table 1 lists the coefficient of variation for selected primary and secondary materials. 3 In all cases but one the secondary commodities show larger price variation. The largest variation is with waste paper and ferrous scrap. The lack of a stable base from which to predict future prices for secondary materials affects both the short- and long-run allocation of resources in the scrap industry. In the short run, scrap dealers and scrap users have great difficulty in planning their market activities. Without the benefit of future prices, production and inventory decisions cannot be made rationally. As a result, producers show preference for primary over secondary inputs, even when quality and other dimensions are comparable. In the long run, uncertainty constrains investment in recycling since scrap users discount expected returns from technology, investment in secondary processing facilities more heavily than investment returns from primary processing technology. The direct effects of uncertainty over future prices can often be mitigated if risk markets exist. If those who deal in commodities having volatile and unpredictable prices could insure against the effects of future price changes, the adverse impact of price uncertainty on resource allocation would be largely eliminated. Two common methods of insuring against the effects of price uncertainty are forward contracting and vertical integration. Forward contracting has not been used with success in the US ferrous scrap and waste paper industries. Because of the high price uncertainty, buyers and sellers of scrap are not willing to enter into long-term agreements, even though industry members admit that forward contracting is necessary to stabilize demand and supply conditions. Nor does vertical integration by user mills back to the scrap dealers represent a realistic possibility. First, management of large user mills have developed a major commitment to primary input sources for tax purposes and other reasons. Second, the geographically diverse nature of the market makes it unsuitable, in the eyes of the mills, for acquisition. Third, and probably most importantly, there is a social stigma attached to scrap dealers in general which deters mill management from getting involved in the market.4 Various devices and approaches have been offered as possible solutions to the problem of price uncertainty in secondary material markets. Some examples include government sponsored marketing reports, demand and supply research, and price forecasting. None of these provides a mechanism through which the effects of volatile prices can be insured. One mechanism which simultaneously attacks the problems of uncertainty and insurance against risk is a government financed buffer stock scheme. A highly simplified version of such a system would have the government estimate the long-run equilibrium price for the commodity and be ready to buy any offerings and sell from its inventory at this price. Pearce and Grace found such a system would have high costs and uncertain effectiveness.’ Furthermore, sufficient funds must be assured to buy the necessary stocks. The international buffer stock scheme in tin, the first of its kind, failed to halt huge price increases because adequate stocks had not been established.5
1977
231
Futures markets: An alternativefor
stabilization
Scrap futures markets could be used as an alternative approach to deal with the twin issues of price uncertainty and risk insurance. A futures market only directly affects one of the market imperfections discussed above - that of expected price uncertainty. Removal or reduction of uncertainty in secondary materials markets will not by itself allow efficient resource allocation. In this sense, futures markets need to be considered together with other policy alternatives directed at other sources of market future. Nonetheless, a futures market would lower one of the barriers to achieving socially optimal levels of resource recovery.
Economic
impacts of futures markets
The economic impacts of futures trading on the cash market6 may usefully be divided into three general categories - the impacts on pricing in the cash market, the impacts of risk management, and the impacts on market information.
Pricing function offutures markets
6Throughout this paper the term ‘cash’ refers to market transactions that do not involve futurity. 7 R.W. Gray and D.J.S. Rutledge, ‘The economics of commodity futures markets: Review of Marketing and A survey’, Agricultural Economics, Vol 39, 1971, p 73. a B.A. Goss and B.S. Yamey, eds, The Economics of Futures Trading, John Wiley and Sons, New York, 1976, p 36. ‘This is possible because futures contracts can be legally cancelled by offset. A seller of a July copper futures contract can cancel his commitment to deliver copper in July by buying a July futures at any time before the delivery date. Of course, he also has the option of delivering the copper if it suits his needs. ‘OThe authors are keenly aware of the realistic definition of hedging more initially developed by Working. The notion that all hedgers use futures markets in a routine fashion and do not attempt to anticipate future price movements, and thus act as speculators, is admittedly naive. All the same, the simplified notions of hedging described here were felt to be useful for the purposes at hand. A detailed discussion of the broader definition of hedging can be found in H. Working, ‘Futures trading and hedging’, American Economic Review, Vol43, June 1953, or in H. Working, ‘New concepts concerning futures trading’. American Economic Review, Vol 52, February 1960.
232
Futures markets are often described as price discovery mechanisms. They act as central clearing devices for traders in a commodity. These traders buy and sell futures contracts (which call for delivery of a specified quantity and quality of a commodity at some future date), based on their expectations and information concerning current and future demand and supply conditions. Traders with good forecasting tools and skills and better information are rewarded at the expense of less skilled traders - the competitive nature of a futures market tends to ensure good prediction of future prices. The prices generated on futures markets through the actions of buyers and sellers of futures contracts represent unbiased predictions of future cash prices based on the currently available market information.’ Futures markets thus act as price discovery mechanisms, by providing a forum for the assimilation of market information and expectations. The futures prices act as signals to decision makers on when to produce, consume or hold stocks. In turn, fluctuations in demand and supply are dampened and inventories assume a greater role as a price buffer. Therefore, in general, one would expect a ‘dampening of intraseasonal and inter-seasonal price movements’ in a commodity for which there is futures trading.8
Risk managementfunction offutures markets As well as being a price discovery mechanism, futures markets can be used to manage or insure against the inherent risk of an uncertain market environment. Traders on futures markets are usually grouped into two classes - speculators and hedgers. Of these two groups, only hedgers use futures markets for risk management. Speculators buy and sell futures contracts in the hope of profiting from favourable movements in the futures prices. They have no position in the cash market, and never intend to make or take delivery of the commodity in which they are trading.9 Hedgers, on the other hand, use the futures markets to reduce the risk of an unfavourable movement in the cash price that would affect a position they hold or plan to hold in the cash market.” Normally, a hedge involves taking a position in the futures market that is the opposite of a planned or actual position held in the cash market. A
RESOURCES
POLICY
December
1977
Futures
markets:
An alternative for stabilization
buyer in the cash market would be a seller of futures contracts, and vice versa.” While providing a tool for risk management, the hedging role of futures markets also stabilizes producer and consumer income. This is when risk is defined as variance in implied by risk management, income. Since losses or gains in the cash market can be offset, albeit imperfectly, by losses or gains in the futures markets, vagaries in income tend to be lessened. A futures market tends to be most effective in stabilizing income when income variability is due mainly to price fluctuation.12~13
” Since futures prices and cash prices tend to move together, a loss in one market will be offset by a gain in the other. For example, a cooper scrap dealer who is offered a forward contract for scrap from a buyer and does not have the scrap on hand can hedge against the risk of a price rise over the period by buying an equivalent amount of copper futures. Since the price of copper scrap is highly correlated with the cash price of copper which, in turn, is highly correlated with current month copper futures prices, such a purchase would protect him from a rise in his purchasing price to a point that he cannot receive a normal return from the sale of the copper scrap as per the contract terms. I2 R J McKinnon, ‘Futures markets, buffer stocks, and income stability for primary producers’, Journal of Political Economy, Vol75. 1967, pp 844-861. l3 Routine hedging of expected output can cause greater income instability if the main source of uncertainty is output variation. Generally, if the variation in the basis, which is the difference between the cash price and a near futures price, is less than the cash price variation, returns will be more stable, assuming hedges can be placed over a period long enough to cover the period of price instability. I4 C.G. Cox. ‘Futures trading and market information’, Journal of Political Economy, Vol 84, 1976, pp 1215-1237. 151bid, pp 1217-1218.
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Market information function offutures markets Closely allied with the pricing function of futures trading is its increased flow of market information. Exchanges regularly publish statistics on trading volume, prices, and other information for the commodities traded on their floors. Commission houses publish supply and demand estimates and make price forecasts available to their customers. Traders use this information, as well as information from agencies, etc, in forming other sources, such as government expectations of future market conditions. The information is reflected in the futures prices generated on the exchange. The futures prices are quoted daily in most major newspapers and so are readily available to the general public. By providing a central marketing place, by increasing the number of traders in a commodity market, and by lowering the transaction costs of information exchange, a futures market increases the quality and quantity of information flowing into the market. Although the market information effect of futures trading has long been recognized, its importance, relative to the risk management and forward pricing role of futures trading, has been underplayed. In a recent article, Cox elevates this role of futures trading to the level of the other two. He states that as a result of more fully informed traders ‘market prices provide more accurate signals for resource allocation when there is futures trading in a commodity’.14
Potential impacts of futures trading in secondary markets
materials
The most direct impact of futures trading in secondary materials would be on the formation of price expectations. By increasing market information flow, one would expect a corresponding decrease in uncertainty over future market conditions. The actual impact depends on how decentralized the traders in the market were before initiation of futures trading. The more traders and the more decentralized the market, the greater the impact of futures trading in increasing market information flow.15 For the US ferrous scrap and waste paper industries, this is of major importance, since the lack of a central marketing place is one of the major constraints to information flows. From increased information flows in the scrap materials markets, one would expect an increase in the responsiveness of demand and supply to price signals. In turn, prices for scrap commodities should become more stable. Besides reducing price uncertainty for scrap materials, a futures market would provide scrap buyers and sellers with a mechanism for
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coping with part of the remaining risk through hedging. This would also stabilize income to both scrap dealers and buyers. The net outcome of futures trading in secondary materials would be the elimination of one of the disincentives that favour use of primary materials over secondary materials. A futures market would provide unbiased predictions of future prices for scrap materials. Production and inventory decisions for scrap commodities could be made in a more certain market environment. Large losses from commitments to scrap purchases either by a buyer or a seller could also be reduced by appropriate hedging plans. Longer run impacts are less clear. Trading in futures contracts rarely extends more than l+ years into the future, and in this sense a futures market represents only a short-run decision tool. In general, though, reduced uncertainty would act to encourage increased investment in recycling technology. There are two general differences between futures markets and other stabilization alternatives. First, a futures market directly impacts a part of the cause of price instability by increasing the flow of market information and decreasing uncertainty over expected prices. Second, initiation of futures trading in a commodity is a decision made in the private sector. Historically, the government’s role, vis-a-vis futures markets, has been one of regulator or, in the case of some agricultural commodities, of inspector. Other stabilization schemes, such as buffer stocks, are initiated by the government which then accepts the responsibility for its success.
Potential role for public participation
r6All commission houses are required to deposit in exchange accounts a portion of requirements posted by the margin customers of the houses The exchange returns the funds when an account is cleared, but retains the accrued interest. During periods of high interest rates, interest paid on clearing funds may represent the largest single source of income to the exchange. An exchange also receives clearing fees, which are generally a small percentage of the commission fees paid by commission house customers. Many exchanges obtain revenue from real estate holdings and other investments. Annual dues paid by exchange members for the privilege of trading on the exchange are a fourth source of income, which is normally insignificant.
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All commodity futures exchanges in the USA are non-profit organizations - their main purpose is to serve the needs of their members. To stay in existence the exchange must generate enough revenue to cover the variable costs of operation. Exchanges have several sources of revenue, of which the three most important generally are interest on clearing funds, clearing fees, and investments.i6 The value of the first two revenue sources makes exchanges extremely interested in increasing trading volume on their floors and in initiating new contracts that will attract substantial trading interest. Given that it is in an exchange’s interest to initiate new contracts, the question arises as to whether or not there is any reason for government participation in this process. Is there any reason to believe that an exchange will initiate less than the optimal number (from the viewpoint of society as a whole) of futures contracts? Because futures trading creates a public good we argue that there is indeed an economic justification for government involvement in the research and initiation of futures contracts. Public good aspect offutures trading The public good aspect of market information, which is generated through active trading of futures contracts in a commodity, is one important rationale for governmental support of the commodity exchanges’ functions. An exchange is able to recoup part of the value of the risk insurance role of futures trading through commissions paid by traders. However, since the market information contained in the
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Futures
markets:
An alternativefor
stabilization
futures prices can be used by anyone without trading, an exchange will not be compensated for the full value of this information. In this sense, futures trading generates a public good. There is no way to exclude a potential user from the futures prices, and one individual’s use of the information does not impair its usefulness for another - ie the opportunity cost to an exchange of extending consumption to another person is zero, or at least close to it. Public goods theory demonstrates that since the private sector does not receive the appropriate demand signals for an efficient production level, less than the socially optimal amount of the good will be prb, .lced. The proper role for the public sector is to ‘aggregate consumers’ demand for these goods and express it to the private sector’. ” In terms of futures markets, the ‘publicness’ or ‘semipublicness’ of the market information produced through futures trading may result in exchanges researching and initiating, for futures trading, less than the socially optimal number of commodities. The government, then, is responsible for providing the necessary signals to an exchange to induce the optimal production of futures contracts. The public good aspect of futures trading is directly applicable to a scrap futures contract. If an exchange were to decide against trading such a contract because of a projected lack of trading interest, there is a justification for public intervention - such as subsidies to commodity exchanges - to insure listing of scrap for trading, assuming that the projected social benefits exceed the costs of the public intervention. The public agency is also justified, on economic grounds, in providing legal, educational or political tools and expertise to remove existing barriers to successful trading.
Conclusion
‘l N.M. Singer, Public Microeconomics. Little Brown and Company, Boston, Mass, 1972, p 95. I8 At least two studies have attempted to answer the first part of this question. See D. Bradford and H. Kelejian, The Value of Information for Crop Forecasting in a Market System, prepared for Office of Applications, National Aeronautics and Space Administration by Econ Inc. 1975, and Y. Hayami and W. Peterson, ‘Social returns to public information services: Statistical reporting of US farm commodities’, American Economic Review, Vol 62, 1972, pp 1 19-l 30. Both presented a framework for measuring the social benefits from improvements in the information which is supplied in the markets for agricultural commodities. We will not attempt to summarize their views here, except to say that in both studies significant positive changes in consumer welfare were found to result from more accurate market information.
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A futures market has two distinct advantages over other stabilization schemes, such as buffer stocks. First, a futures market is more than just a stabilizing force - futures markets decrease uncertainty over expected prices for a commodity by increasing market information flows. At the same time, they provide a risk management tool to enable industry members to cope with the remaining price risk. Price and income stabilization are outgrowths of these two aspects of futures markets. Second, a properly designed futures market acts in concert with the existing market structure and requires minimum, if any, government participation. The public costs of a futures market will be zero in the case where an exchange decides to trade a commodity on its own. More typically, the government may choose to incur small costs by taking responsibility for inspection of deliveries. If, to trade a commodity, other forms of government intervention such as subsidies, educational campaigns, research programmes, etc are needed, the costs would increase, but probably not to the level of a viable buffer stock plan. At least two issues remain to be resolved. First, the level of government intervention in the process of researching and initiating a futures contract should be based on the equation of marginal social costs and to marginal social benefits. This may prove cumbersome while social costs are relatively easy to delineate and estimate, social benefits are more elusive. What is the benefit of greater information flows or a more efficient allocation of resources?18
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Another set of questions that we have not addressed, but which are important to the concept, involve the feasibility of futures trading in scrap. Can scrap materials be traded on organized exchanges? Can a standard grade for trading be developed? Are there sufficient buyers and sellers in the market for scrap to ensure competition? While these questions remain to be answered, they do not appear to constitute major barriers to futures trading in waste paper or ferrous scrap. Our preliminary results indicate that most of the technical details of a scrap futures market can be worked out, given a sufficient degree of interaction between the exchange, industry members, and interested government agencies.
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