A bit of history about exchanges and futures
CBOT and the plight of Chicago farmers
Derivatives contracts go quite far in the past (ancient Babylonia), and the first exchange go to 1710 in Japan (rice exchange). The first US experiment with exchanges, go back to 1848 with the Chicago Board of Trade.
Chicago was always a center of commerce for commodities. Farmers would come to Chicago’s central market to sell their crop. They would meet buyers, agree on quality, quantity, prices. Hands would be shaken and crop delivered to warehouses vs cash. But when flour millers and bread-makers had eventually enough cereals for their needs, farmers would find no more buyer. Prices would drop precipitously. The farmers arriving late in the season would regularly abandon their crop in the street to spare themselves another (high!) transportation cost, and come home empty-handed. The effect was dramatic.
The CBOT exchange was introduced in 1848. It introduced the first futures contract. The main benefits of contracts is the capacity to agree to a trade, but deliver at a later date. Farmers could sell their crop without bringing it. Buyers could reduce their warehouse and storing costs, knowing that a new delivery would be arriving 3 or 6 months later.
The nature and role of speculators
Derivatives exchanges introduced a new type of market player – speculators. These are financial actors who are trading for profit at their own risk and who are not industry participants. In the case of CBOT’s history, these investors were not interested in wheat or corn, only their futures. They would never take delivery or deliver any grain of cereal.
Let’s look at their influence on an example, and assume that Corn is on average $400 per bushel. If the futures with delivery in 6 months suddenly trades at $300 under no specific announcement (a statistically rare, cheap, and fundamentally ab-normal price), while the futures with delivery in 9 months trade at $500 (also a statistically rare, expensive, and fundamentally ab-normal price), then the speculator could take the bet to buy the 6M futures, sell the 9M futures or both. Statistically, and fundamentally, these abnormal futures prices should revert to $400, and the spread converge to zero. There is no guarantee of this outcome, but the speculator is likely to gain.
If many speculators agree to this analysis and repeat the trade, the 6M future will progressively rise from $300, to $310, to $320, to $330… while the 9M futures would drop from $500 to $490, to $480, to $470…
All these speculators trading together prevent abnormal prices to happen. They reduce the occurrences of fundamentally abnormal prices to happen. Together speculators reduce price volatility.