Types of Markets

• We are now going to discuss how markets operate and how different types of markets serve different purposes.
• Besides the obvious need to agree on quality, quantity, and price of the goods, three other important matters must be decided when a buyer and a seller arrange a trade:

  • The time of delivery of the goods
  • The mode of settlement
  • Any conditions that might be attached to this transaction

1. Spot Markets

• In a spot market, the seller delivers the goods immediately and the buyer pays for them on the spot.
• No conditions are attached to the delivery
• A spot market has the advantage of immediacy
  • As a producer, I can sell exactly the amount that I have available
  • As a consumer, I can purchase exactly the amount I need
• Unfortunately, prices in a spot market tend to change quickly
  • A sudden increase in demand(or a drop in production) sneds the price soaring because the stock of goods available for immediate delivery is limited
  • A glut in production or a dip in demand depresses the price

Spot markets also react to news about the future availability of a commodity

• Large and unpredictable variations in the price of a commodity make life harder for both suppliers and consumers of this commodity

2. Forward Contracts and Forward Markets

• If an acceptable price can be agreed, it is ready to sign a contract with farmer now for the delivery of his wheat harvest in a few months' time

• This forward contract specifies the following:

  • The quantity and quality of the wheat to be delivered
  • The date of delivery
  • The date of payment following delivery
  • The penalties if either party fails to honor its commitment
  • The price to be paid

• Since a lot of that information is publicly available, the estimates of both parties at any given time are unlikely to be very different

• However, the price agreed for the contract may differ from the best estimates because of differendces in bargaining positions

• The difference between his expectation of the spot market price and the price agreed in the forward contract represents a premium that he is willing to pay to redudce his exposure to a downward price risk
  

  • If the spot price at the time of delivery is higher than the agreed price, the forward contract represents a loss for the seller and a profit for the buyer

    When agreed price went $\pi_2$, buyer's profit would be area labeled as B+D+F and seller's profit would be area labeled as A

  • If the spot price is lower than the agreed price, the forward contract represents a loss for the buyer and profit for the seller

    When agreed price went $\pi_1$, buyer's profit would be area labeled as F and seller's profit would be area labeled as A+B+D

• Forward contracts make if possible for parties to trade at a price acceptable to both sides and hence provides a way to share the price risk

  • If their estimates of future spot prices are unbiased, in the long run the difference between the average spot price and the average forward price should be equal to the average premium
  • The party that gets the premium is therefore being remunerated for the acceping the price risk

3. Futures Contracts and Futures Markets

• The existence of a secondary market where producers and consumers of the commodity can buy and sell standardized forward contracts helps these parties manage their exposure to fluctuations in the spot price

• A speculator can sell a contract first, hoping to buy another one later at a lower price

  Since theses contracts are not baked by physical delivery, they are called futures contracts rather than forwards

  • As the date of delivery approaches, the speculators must balance their position becuase they cannot produce, consume, or store the commodity
  • If the markets are sufficiently competitive and all participants have access to enough information, the forward price should reflect the consensus expectation of the spot price

• Shareholders in some companies expect stable but not extraordinary returns

  The managers of these risk-averse companies therefore try to limit their exposure to risks that might reduce profits significantly below expectations

• Shareholders in companies that engage in commodity speculation hope for very high returns but should not be surprised by occasional large losses

  The management of theses rist-loving companies is therefore free to take significant risks in order to secure large profits

• By diversifying into markets for different comodities, they further reduce their exposure to risk

  4. Options

• Futures and forward contracts are firm contracts in the sense that delivery is unconditional

• Such contracts are called options and come in two varieties: calls and puts

  • call option gives its holder the right to buy a given amount of a commodity at a price called the exercise price
  • put option gives its holder the right to sell a given amount of a commodity at the exercise price

• When an option contract is agreed, the seller of the option receives a nonrefundable option fee from the holder of the option

5. Contracts for Difference

• Producers and consumers of some commodities are sometimes obliged to trade solely through a centralized market
• Since they are not allowed to enter into bilateral agreements, they do not have the option to use forward, futures, or option contracts to reduce their exposure to price risks

  In such situations, parties often resort to contracts for difference that operate in parallel with eh centralized market

  • They agree on a strike price and an amount of the commodity

• Once trading on the centeralized market is complete, the contract for difference is settled as follows:
  • If the strike price agreed in the contract is higher than the centralized market price, the buyer pays the seller the difference between these two prices times the amount agreed in the contract
  • If the strike price is lower than the market price, the seller pays the buyer the difference between these two prices times the agreed amount

6. Managing the Price Risks

• Firms that produce or consume large amounts of a commodity are exposed to other types of risk
• Will generally try to reduce their exposure to price risks by hedging their positions using a combination of forward, futures, options, and contracts for difference
• The volume of trades in the spot market therefore typically represents only a small fraction of the volume traded on the other markets

  While the spot market volume may be relatively small, the spot price is the signal that drives all the other markets

7. Market Efficiency

• If such transactions are to happen quicly and easily, the market must be liquid
• There sould always be enough participants willing to buy or sell goods

  • Finally, the costs associated with trading should represnet a small fraction of the value of each transaction
  • These transaction costs are considerably smaller if the commodity traded is standardized in terms of quantity and quality
  • A market that satisfies these criteria is said to be efficient

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