Risk, Futures Pricing, and the Organization of Production in Commodity Markets

Abstract

This paper examines equilibrium in a spot and futures market with both primary producers (growers) and intermediate producers (processors). For a commodity that is subject to output shocks, processors tend to hedge long, in contrast with Hick's theory of futures hedging. Nevertheless, if transaction costs are low, the two-stage production process brings about a downward futures price bias, consistent with Hick's pricing prediction. But if costs of trading futures are high, growers tend to be differentially driven from the futures market, reversing the direction of the bias. Futures trading may also affect the organization of industry; when demand is inelastic, futures trading can serve as a substitute for vertical integration as a means of diversifying risk because the risk positions of growers are complementary with those of processors.