The Economy by Peter R. Crabb: Derivatives market and others can be good teachers

PETER R. CRABB, professor of finance and economics at Northwest Nazarene University in NampaAugust 27, 2013 

Peter Crabb

Mothers and fathers are giving their kids lots of advice as they return to school this month. One common refrain is “Listen to your teachers.” Policymakers in Washington, D.C. and here in Idaho would do well to listen to some of the best teachers on the economy — the financial markets.

The financial markets offer a wealth of information for business managers, consumers and policymakers alike. The most forward-looking of these markets is that for financial derivatives.

Many policymakers think of the derivatives markets, which include futures and options, more as casinos. Rather than seeing a source of good information, they like to place blame here for the last recession. But these markets have valuable tools used by investors and business managers to manage large amounts of real capital.

As such, the futures and options markets are the most unbiased forecasts of future economic and business conditions. You can survey economists and others all you like, but only in these markets are people putting real money to work.

The president’s 2014 fiscal year budget projects 3.4 percent growth in real gross domestic product during 2014. The current Idaho Economic Forecast from the Division of Financial Management expects a similar growth in personal income.

Both reports suggest policymakers expect our economy to be back to normal next year. The outlook in the futures markets is not so rosy.

A futures contract is a standardized agreement to deliver or take delivery of an asset, such as corn or gold, at some time in the future. Since the contract is standardized, only the price is determined by traders in futures contracts. The actual contract specifies all other particulars, such as the quantity of the asset delivered and the ending date of the contract.

The current price of a futures contract is closely related to the price of the underlying asset being sold each day by producers and users. However, the price of a futures contract tells us more. If supply and demand conditions for the commodity change, the current, or spot, price changes, but the futures price is also affected.

When the price for exchanging the good today rises, the futures price is also likely to rise. But it is possible that some traders expect the rise in the spot price to be temporary and that the futures value will be lower. Thus, futures prices reflect market participants’ expectation of spot prices in the future. Lower futures prices reflect an expected decline in spot prices; higher futures prices reflect an expected increase.

Recent activity in the commodities markets suggests falling oil prices in the future. For example, the spot price of Light Crude Oil as traded on the New York Mercantile Exchange (NYMEX) is around $107 per barrel. But if you don’t want to take delivery of the oil you need until December of 2014, you can pay less than $94 per barrel for the futures contract. This represents an expected decrease of more than 12 percent.

Many other commodity prices are forecasted to fall. Commodity prices generally fall when the economy is weak.

We can also look at stock market futures for an overall forecast of the economy. Futures contracts on the value of stock market indexes like the Dow 30 and the S&P 500 are currently priced lower than the spot value. There is no expectation for economic growth here.

Knowing the expected level of prices for commodities, interest rates, or stock values helps business managers plan better. Policymakers can do the same.

Rather than just wishing for better economic growth, policy makers need to listen to the “teachers.” They need to listen to the markets.

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prcrabb@nnu.edu

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