Agricultural & Applied Economics Association

Forward and Futures Contracts as Preharvest Commodity Marketing Instruments

Author(s): Ray D. Nelson
Source: American Journal of Agricultural Economics, Vol. 67, No. 1 (Feb., 1985), pp. 15-23
Published by: Blackwell Publishing on behalf of the Agricultural & Applied Economics
Association
Stable URL: http://www.jstor.org/stable/1240819
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Forward and Futures Contracts as
Preharvest Commodity Marketing
Instruments

Ray D. Nelson

Empirically significant differences between forward and futures contracts evidence their
imperfect substitutability as preharvest marketing instruments. Certain combinations of
market conditions make the two types of contracts complementary rather than
interchangeable. Forwards and futures differ conceptually because of lumpiness,
marking-to-market, and basis. Of these differences, basis constitutes the most important
factor. Although lumpiness may affect smaller producers, it represents an
inconsequential detail for larger traders. In given years, interest income (cost) resulting
from futures margin requirements may reach important absolute amounts. Relative to
size of basis and price changes, this factor fails to attain a magnitude of practical
significance.

Key words: basis, forwards, futures, hedging, lumpiness, marking-to-market.

Farmers making preharvest hedges must and futuresas marketinginstrumentsand illus-

choose between forwardand futurescontracts
when makingmarketingplans. Oversimplifica-
tion or exclusion of either of these marketing
instruments may result in suboptimal strate-
gies. Economists sometimes overemphasize
the common ability of forwardsand futuresto
facilitate advanced sales by treating the two
contracts as though they were perfectly inter-
changeable. Many farmers clearly view for-
wards and futures as distinct marketingop-
tions since they evidently prefer the former,
yet they foregopossible complementaritiesbe-
tween the contractsby excludingfuturesfrom
their decision set.1 Forwards and futures do
not substitute perfectly nor does clear domi-
nance of one allow safe exclusion of the other.
Both types of contracts belong in the market-
ing decision opportunityset.
This paper conceptually and empirically
evaluates the differences between forwards
trates their potential complementarity. The
evaluation proceeds in the following steps.
First, a brief summarycontrasts the charac-
teristics of the two contracts. Second, a dis-
cussion of their use as hedging instruments
illustrates how each generates different cash
flows and revenues. Third, integrating for-
wards and futures into the farm portfolio al-
lows an assessment of their value within the
context of preharvestproductionand market-
ing decisions. Finally, the summarystates the
conclusions and ventures some implications.
ContractCharacteristics
Detailed descriptions of forward and futures
contracts in the economics and futures litera-
ture make an extensive review of their charac-
teristics unnecessary.2In order to establish a

Ray D. Nelson is an assistant professor of agricultural economics, 2

University of California, Davis.
The author gratefully acknowledges the contributions of two
anonymous referees yet retains complete responsibility for any
remaining errors.
Review was coordinatedby RichardT. Crowder, associate
editor.
I The manuscript 1977 report, Farmers' Use
of Forward Con-
tracts and Futures Markets establishes farmers' preference of
forwards over futures. This report summarizes the results of a
survey jointly conducted by the USDA and CFTC.
Chicago Board of Trade; Roy; and Paul, Heifner, and Helmuth
extensively discuss the characteristics of all types of forward and
futures contracts. This literature reveals that forwards fit into two
categories, depending on the mechanism stipulated for determin-
ing the price and quantity of the traded commodity. In the first
group, the contracts specify the price and quantity at the time of
contractsignature.In the secondgroup,deferredpricingallows a
farmerto set a price at any time prior to delivery by using a
predeterminedformula.Basis contractsrepresenta good example
of this secondcategory.Elevatorsoftenquotefarmer'spricesas a
differentialto the futuresprice. Basis contractsfix the size of the

Copyright 1985 American Agricultural Economics Association

16 February 1985
foundation for further discussion, however,
table 1 summarizes the significantattributes
and differencesof the two types of contracts.
Although legal consultation costs and bro-
kerage fees constitute importantpracticalde-
tails, their size relative to the value of the
commodities traded render them insignificant
within the context of the present study.
Futuresand Forwardsas Hedges
Recent articles demonstrate that contrasting
contract characteristics cause futures and
forwards to assume different market values.
Black adapts the seminal Black-Scholes op-
tions pricing model to commodity contracts.
Jarrowand Oldfield;Cox, Ingersoll,and Ross;
and Richardand Sundaresanall generalizethe
Black model to determinethe exchange value
of commodity contracts. The emphasis in all
three of these papers on the unique payment
mechanisms of forwards and futures invites
empirical investigation into the practical sig-
nificance of this contractualdifference.
The present paper's methodology does not
utilize the future orientation of the market
value methodology used in the recent com-
parisons of forwards and futures but rather
relies on the historicalperspective of an alter-
native procedure, valuation as a traditional
hedge. Comparingforwardsand futuresin this
way generatesthe expressionsneeded to make
conceptual and empirical comparisons. The
discussion demonstrates that the lumpiness,
revenue, and basis differences between the
contracts arise because of their dissimilar
standardization, payment, and settlement
characteristics.
Lumpiness
The first difference,lumpiness, arises because
of the standardizedquantities of futures con-
tracts. After appraisingthe availableproduc-
tion and price informationduringany prehar-
vest period, a producermay elect to make an
advanced sale. An expected price decline es-
pecially enhances the attractivenessof such a (1) x, p(t, t*) + (q - x,) . p(t*, t*).
.
commitment.After deciding the magnitudex, At harvest, the producerevaluatesthe wisdom
differentialbut allow a farmerto monitormovementsin futures
prices and thus postpone the final price level determinationfor
his crop. This paperconsidersonly the first group,or fixed price but rather the optimal producer-determined proportionof that
contracts, since this type correspondsto those most commonly expectation.
used in Californiagrainmarkets,the locationcorrespondingto the
empiricaltests which follow.
Amer. J. Agr. Econ.
of the desired sale, the producer can often
specify this exact quantity in a forward con-
tract.3Futurescontracts, however, only trade
in standard quantities such as the 5,000
bushels required in the Chicago Board of
Trade's wheat contract or 1,000 bushels for
the same product at the MidAmericanCom-
modity Exchange. Therefore, the futures
hedge may not exactly match the amount of
the desired sale. This mismatch results in an
advanced futures commitment of xf bushels
rather than the desired amount x, and gives
the differencex, - x,, called lumpiness. For a
small producer,the amountof lumpinessmay
represent a substantial portion of output.
Many largeproducers,on the other hand, per-
ceive lumpiness as an inconsequentialdetail.
Revenue
The second difference between forwardsand
futures results because unique payment and
settlement patterns cause the contracts to
generate differentrevenue flows. The forward
contract produces revenue only at its matu-
rity. Because forwardcontract signaturepre-
dates completionof the productionprocess, at
harvest the producer may encounter one of
two alternative situations. First, low yields
caused by unanticipatedproductioncomplica-
tions may force the producer to make spot
market purchases in order to satisfy the for-
ward commitment.Alternatively,an abundant
harvest may leave unexpected stocks avail-
able for spot marketingconcurrentwith for-
ward contract execution. In both cases, spot
transactionsinterminglewith forwardcontract
satisfaction.
Duringthe preharvestperiodt, the producer
contracts to deliverx, bushels duringthe har-
vest period t*. At harvest, the producer re-
ceives the forward price p(t, t*) for the x,
bushels delivered. If q denotes the total quan-
tity marketedat time t*, thenq - x, represents
the net sales or purchases made at the cash
price p(t*, t*).4 Therefore, the producer re-
ceives
3 The quantityxP does not correspondto the expected output
4 The forwardpricep(t*, t*) actuallybecomes a spot price at t*
since such a contractrequiresimmediatedelivery.
Nelson Forward and Futures Contracts 17

Table 1. Characteristicsof Forwardand Futures Contracts

Futures Forwards

Standardization Uniform quantity, quality, Specifications tailorable to fit the

location, and delivery time needs of the contracting party

Liquiditya Commensurate with trading Almost no fungibility

volume at organized exchange

Integritya Guaranteed by exchange's Same as any legal contract

clearinghouse

Payment Overthe life of the contractvia Lumpsumcash transferat

the marginmechanism contractexecution
(marking-to-market)

Settlement Cancellationthroughoffsetting Spotdelivery

transaction

Transactions Brokeragefees andmargin Possiblelegalfees

costs income(cost)

a Telser and Telser and Higginbothamdevote majorportionsof their articlesto discussionof the liquidityand integrityadvantagesof
futuresover forwardsas they suggestthat organizedfuturesmarketsfacilitatetrade amongstrangers.

of havingforwardcontractedthe amountxp by brokeragefirm. If marginexpenses accrue at

comparing the difference between the cash the ratermkin each periodk of the open futures
price p(t*, t*) and the forward price p(t, t*). position, the compounded margin cost ac-
The farmer indulges in self-congratulations cumulated between t and t* becomes
when prices decline between t and t* and t*- 1

self-castigation when they increase. Algebraic (3) m H (1 + rmk)- m.

manipulationof expression (1) highlightsthe k=t

importanceof forward cash price changes to This expression, however, excludes the effect
forwardrevenues: of marking-to-market.
- - -
(2) q p(t*, t*) x, [p(t*, t*) p(t, t*)]. Marking-to-marketmeans that as futures
. prices fluctuate,those holdinglosing positions
Rather than a single installment revenue must add to their marginaccounts, while win-
payment at harvest, the futures hedge gener- ners can withdrawtheir surplus. Since profit
ates a flow of revenues and costs which span payments span the contract's life, their in-
the life of the contract. Because the exchange vestment earns additional income. Traders
clearinghouserequiresthat potentiallosses be holding losing positions incur actual and op-
covered throughmaintenanceof a marginac- portunity interest costs. These income and
count, this tradingprerequisitemay entail ac- cost flows compoundover the span of the fu-
tual or opportunityinterest costs. Depending tures hedge.
on the quantity and form of their personal The difference between the futures prices
assets, futures traderscan choose from many f(k, T) - f(k + 1, T) represents the daily
alternative schemes to satisfy m, the initial tradingprofitsfrom a short position in a con-
marginrequirements.Traderswith substantial tract with maturityT. These profits or losses
futures positions and significantpersonal as- augmentor diminishthe marginaccount. The
sets may use T-bills to comply with the initial marginfunds earn interest or accrue expense
marginobligation. Such margindeposits con- at the rate rrk applicableto the size of accumu-
tinue to earn interest as though the T-bills lated tradingprofitsat time k. Interest income
were still in their owner's safety deposit box. (cost) from trading profits of a short futures
Inadequateassets may force other traders to position initiated at time t and closed at t*
leave borrowed cash idle in the account of a results in the per bushel amount:
18 February 1985 Amer. J. Agr. Econ.
<
t*-- 1 t*- 1
(4) [f(k, T) -f(k + 1, T)] J7 tures prices and their relative changes be-
tween t and t*, however, represent important
k=t k'=k+1
relationshipsfor the futures hedge. If futures
(1 + r,k,) - [f(t, T) - f(t*, T)]. prices decline relative to the forward cash
The sum of the initialmargin(3) and marking- price between t and t*, futures tradingprofits
to-market income (cost) in (4) gives the net exceed cash losses. This representsa positive
revenues i arising from futures margin re- basis change. Another circumstance which
quirements. generates a positive basis change happens
Ratherthan makingdelivery on the futures when forwardcash price rises outstripfutures
contractsxf, the producerrepurchasesthem at increases causing forward cash gains to ex-
t* at the pricef(t*, T) and concurrentlysells q ceed futures losses.
bushels in the spot market for p(t*, t*). The If b(k, t*, T) denotes the forward basis in
sum of spot revenue, futures tradingprofits, period k, then the futures price during the
and marginincome (cost) gives the net reve- same periodexpressed in terms of the forward
nue correspondingto the futures hedge: price and basis is
(5) q p(t*, t*) + xf - [f(t, T) (6) f(k, T) = p(k, t*) - b(k, t*, T).
.
Replacingfutures prices in expression (5) by
- f(t*, T) + i].
In summary, forward revenue payments their forward minus basis equivalents em-
occur only at harvestand resultfromtwo tem- phasizes the effect of basis on the futures
porally different cash prices. Futures hedge hedge, i.e.,
revenues originate in the cash and futures (7) q p(t*, t*) + xf [p(t, t*)
markets and generate additional interest in- . -
b(t, t*, T) - p(t*, t*)
come (cost) over the life of the contract. + b(t*, t*, T) + i].
The change in the basis between harvest and
Basis hedge placementeither enlargesor diminishes
futures revenues.5
Notational economy results from substitut-
The location and maturitystandardizationof for the change in the forward price
futurescauses the thirdand importantconcep- ing Ap -
p
tual distinction between the two contracts. basis(t*, t*) p (t, t*) and Abfor the changein the
b(t*, t*, T) - b(t, t*, T) to give
Spatialand temporalmarketdimensionsoften
make forwardand futuresprices diverge. The (8) q . p(t*, t*) + xf - [-Ap + Ab + i].
difference between these prices, defined as
the basis, is important because the relative Expressions (2) and (8) reflect the contract
changes between forward cash and futures differences with respect to standardization,
quotes affect only the profitabilityof the fu- payment, and settlement and together com-
tures hedge. prise the foundation needed to evaluate for-
Althoughdefiningthe basis as the difference wards and futures as marketinginstruments.
between the forward and futures prices de-
viates from the more common cash minus fu-
tures convention, this definition nonetheless Comparison as Marketing Instruments
representsthe correct relationshipfor the cur-
rent ex post evaluation of forwards and fu- Integrating forward and futures hedges into
tures. Preharvestsale for immediatedelivery the whole of the farm production-marketing
of an immaturecrop does not constitute a via- problem highlights the ways each contract's
ble marketing alternative for a commodity
producer. The forward cash price at time t, Expression (5), rewritten in a more traditional form, shows
futures hedge revenue as the sum of the terms shown below:
rather than the cash price, indicates the mar-
ket's assessment of the commodity's value. (q - x,) - p(t*, t*) + xf - [f(t, T) + b(t*, t*, T) + i].
This makes the difference at time t between The first term represents the market value at t* of the unhedged
quantity. The second indicates the quantity hedged x, earns profits
the cash and futures prices, the customary at a rate equal to the sum of the futures price at the time of the
basis definition, irrelevant for preharvest deci- short hedge, the current basis, and interest income (cost). Since a
forward price with immediate delivery equals the current cash
sion evaluations of marketing choices. price, the basis value in the above expression corresponds to its
The difference between the forward and fu- traditional definition.
Nelson Forward and Futures Contracts 19

characteristicsaffect their utility as marketing second and third terms respectively refer to
options. In this context, possible forward-fu- these differences.
tures complementaritiesarise because of fu- The strength of the lumpiness effect de-
tures liquidity. pends on not only the quantities specified by
After a comparisonof forwardsand futures the futures contracts used to hedge but also
as conceptual marketingsubstitutes, the em- the size of the optimaladvancedcommitment.
piricalinvestigationestablishes lumpinessand In the case of the MidAmericanCommodity
basis as the practical differences. Then some Exchange's wheat contract, for example, the
examples illustrate the complementarity of amount of lumpiness ranges between -1,000
forwardsand futuresin capturingbasis swings to 1,000 bushels. These figures, however,
and adjustingadvanced sales. must be considered relative to the size of the
desired sale. A producer seeking a 7,600
Forwards and Futures as Substitutes bushel advancedcommitmentcould either un-
derhedge by 600 bushels through selling six
Comparingtwo alternativemarketingscenar- contractsor overhedgeby 400 bushels through
ios establishes the imperfections of futures selling seven. The respective lumpiness pro-
and forwards as substitutes. The two sce- portions are -.079 and .05. Compare these
narios assume two producers who are iden- amountswith those of a largerproducerdesir-
tical in all productionand marketingdecisions ing a 47,600 bushel advanced commitment.
except in their preferences for forward and For the same absolute 600 bushel underhedge
futures contracts. The first hedges using only and 400 bushel overhedge levels, the lumpi-
forwards;the second only futures. At time t, ness proportionsonly reach -.01 and .01, re-
both make preharvest commitmentsto sell a spectively. As the size of the desiredadvanced
proportionof their expected output. The first sale increases, the strength of the lumpiness
producer writes a forward contract for x, effect declines and ultimately approaches
bushels and receives the revenue given by ex- zero.
pression (2). The second would also like to The second term in (9) implies basis change
hedge exactly that amountbut, because of fu- expectations should influence the choice be-
tures contract lumpiness, must settle for a tween forwards and futures. A positive basis
short futurespositionx,. Expression(8) corre- change makes expression (9) larger, and thus
sponds to the resulting revenue. contributes to the dominance of a futures
The difference between the total revenue hedge. A negative basis change diminishes
received by producerstwo and one averaged revenues, making a forward hedge more
over the size of the desired hedge x, gives the profitable.
expression needed to compare forward and
futures contracts as marketing alternatives. Practical Differences as Marketing
Dividingthe differencebetween (8) and (2) by Alternatives
x, and simplifyinggives
Althoughlumpiness, basis, and marginclearly
(9) - Ap + Ab + - i. comprise conceptual differences between for-
(Xxx, XP) xp xLf
xPj wards and futures, establishingtheir practical
?
importance requires empirical investigation.
This suggests that contract lumpiness, basis This necessitates estimating and comparing
changes and margin requirementsconstitute the change in the forwardprice, the change in
the potentialempiricaldifferencesbetween fu- the basis, and interest income (cost). Expres-
tures and forward contracts as marketingal- sion (9) then links these three components to
ternatives. establish the empirical magnitudeof the dif-
The coefficient (x, - x,)/x, in (9) represents ference between forwardsand futures as mar-
the proportion of futures lumpiness relative to keting alternatives.
the desired hedge. Because lumpiness causes Notwithstanding the numerous possible
either underhedging or overhedging, a propor- combinations of forward market locations, fu-
tion remains exposed to price changes as indi- tures exchanges, and futures contracts which
cated by the first term. The proportion x/xp, could qualify for the investigation, the avail-
successfully hedged using futures does not ability of data quickly narrows the set of feasi-
evade basis risk nor escape margin require- ble choices. Since forward contracts result
ments with the resulting income (cost). The from one-on-one negotiations, seldom do for-
20 February 1985 Amer. J. Agr. Econ.

ward prices find the same extensive circula-
tion as those of organized exchanges. The
Bureauof MarketNews at the CaliforniaDe-
partmentof Food and Agriculture,however,
publishes wheat prices paid to farmers. This
includes forwardcontract quotes for October
throughMay, the plantingand growingstages
for wheat, with delivery duringthe June-July
harvest period.
In orderto use the reporteddatato makethe
empiricalex post comparisonsof forwardand
futures contracts, the analysis assumes that a
hypotheticalproducerplaces a futures hedge
at the closing price of the Chicago Board of
Trade Septemberwheat contract on each day
which corresponds to a reported forward
wheat contract. Because the Bureauof Market
News does not report actual harvest deliv-
eries, the averagechange in the forwardprice,
the average change in the basis, and the aver-
age accrued interest income (cost) between
the day the contractis writtenand all possible
delivery dates are determined. The calcula-
tions of interestincome (cost) assume satisfac-
tion of initial margin by using T-bills. The
amountsof initial marginrequiredto maintain
the simulated hedges vary in the analysis in
order to match exactly marginchanges man-
dated by the ChicagoBoardof Tradebetween
1972-80. A ready assets account receives all
tradingprofitsand satisfies all tradinglosses.6
Table 2 reports the average forward price
change, basis change, and interest income for
the Californiawheat marketingsituation cor-
respondingto hedges placed duringOctober-
December, January-February,March-April,
and May. Positive values for Ap indicate for-
6 Threeothercombinationsof formand sourceof
marginfunds
give almost identicalresults.
ward price increases. As mentioned previ-
ously, positive basis changes Ab result when
either futures prices decrease relative to the
forwardcash or forwardcash prices increase
relative to the futures. In the 1972/73 crop
year, for example, both prices increased.
Since the forward cash price rose relative to
the futures, the basis change was positive. Al-
though prices also climbed in 1978/79,the fu-
tures rise exceeded the spot movement,result-
ing in a negative basis change.
At first glance, some of the interest income
(cost) statistics in table 2 may appear ex-
tremelysmallgiven the size of the margincalls
needed to maintainthe futures positions. The
reason the eight-one cent price increase re-
ported for October-Decemberhedges during
the 1978/79crop year only costs .74gbecomes
apparent when examining the path of price
movements between October-Decemberand
June-July.Since significantprice increases do
not occur until May and June of 1979, the
producer does not receive large margincalls
until late in the hedge. Although the margin
calls ultimatelytotal a substantialamount,the
short span of time that the money remains in
the marginaccount does not allow the accrual
of large interest costs.
In given years, interest income (cost) can
reach significantabsolute magnitudes. When
prices declined by $1.28 during 1974/75, for
example, hedges placed during October-
Decemberearnedan averageof 3g per bushel.
Relative to price and basis changes duringthis
same period, however, the interest income
(cost) still represents a small amount.
The results summarizedin table 2 support
two noteworthy conclusions. First, the size
and variability of changes in the forward
prices exceed those of the basis. This comes

Table 2. Components of Forward-Futures Differences (Cents/Bushel)

October-December January-February March-April May

Interest Interest Interest Interest

Forward Basis Income Forward Basis Income Forward Basis Income Forward Basis Income
Change Change (Costs) Change Change (Costs) Change Change (Costs) Change Change (Costs)
Crop Year Ap Ab i Ap Ab i Ap Ab i Ap Ab i

1972/73 NAa NA NA 64.67 22.25 -0.03 62.20 4.79 -0.31 29.94 9.72 -0.10
1973/74 10.12 6.03 -0.33 -80.46 -9.59 2.00 -23.59 -13.35 0.89 54.13 - 11.30 -0.19
1974/75 -128.29 20.86 3.07 -43.05 15.56 0.84 -20.72 5.21 0.33 7.37 -5.85 0.01
1975/76 -29.70 -3.06 0.79 -31.94 -11.44 0.18 -18.57 -15.61 0.12 9.19 -4.74 -0.06
1976/77 NA NA NA NA NA NA -23.44 11.63 0.13 -10.47 5.29 0.04
1977/78 52.17 9.76 -0.58 37.65 -5.41 -0.57 20.60 9.72 -0.11 0.44 5.92 0.00
1978/79 81.35 -32.05 -0.74 85.64 -33.07 -0.96 82.63 -30.59 -0.80 56.25 -22.89 -0.35
1979/80 -48.31 -15.78 2.06 -45.68 -7.91 1.30 -12.75 -12.51 0.29 2.67 -4.24 0.03

' NA indicates data are not available.

Nelson Forward and Futures Contracts 21

Table 3. Differencesin Centsper BushelbetweenFuturesand ForwardRevenuesfor Different

Levels of Desired Hedges
x, = 600 Bushels x, = 7,600 Bushels x, = 47,600 Bushels

Under Over Under Over Under Over

Hedge Hedge Hedge Hedge Hedge Hedge No
Xf = 8,000
= 47,000 x, = 48,000
Crop Year x, = 0 Xf = 1,000 x, = 7,000 x, Lumpiness

1972/73 62.20 -34.00 9.04 1.44 5.21 4.00 4.48

1973/74 -23.59 -5.04 -13.34 -11.88 - 12.60 -12.37 - 12.46
1974/75 -20.72 23.04 3.46 6.92 5.21 5.76 5.54
1975/76 -18.57 - 13.43 - 15.73 - 15.32 -15.52 -15.46 -15.48
1976/77 -23.44 35.22 8.97 13.61 11.31 12.05 11.75
1977/78 20.60 2.28 10.48 9.03 9.75 9.52 9.61
1978/79 82.63 -107.41 -22.39 -37.39 -29.95 -32.35 -31.39
1979/80 -12.75 -11.86 -12.26 -12.19 -12.22 -12.21 -12.22

Note: Hedge initiationmonths:Marchand April;hedge terminationmonths:June and July

as no surprise since hedging attempts to re-
place the largerprice risk with the smallerrisk
of the basis. Second, net interest income and
costs fail to reach significantmagnitudesrela-
tive to price and basis changes and thus can be
ignored without any great loss of accuracy.
Table 3 uses expression (9) to give the net
differences between forwards and futures as
marketingalternatives for different levels of
desired hedges. Positive entries indicate com-
binationsof lumpiness, forwardprice change,
basis change, and interestincome (cost) which
make futures hedges more profitablethan for-
wards. During the 1978/79crop year, for ex-
ample, the forward price rose substantially.
Since the futures increasedmore than the for-
ward price, however, the basis change was
negative. The risingfuturesprices also caused
the futures hedge to accrue a net interestcost.
Overhedgingaccumulatedthe negative effects
of the forwardprice increase, basis decrease,
and interest costs for all sizes of producers.
This combinationof Ap, Ab, and i in the 1978/
79 crop year resulted in profitableunderhedg-
ing for small producers, i.e., those with x, =
600. The adverse basis change, however,
dominated the forward price change for the
underhedgedintermediateand larger traders,
those with = 7,600 andx, = 47,600 bushels,
xP
causing the superiority of forward contracts
duringthis year.
These results clearly demonstratethat for-
wards and futures can generate significantly
differentrevenues. In the case of a very small
producer,lumpinesscan stronglyinfluencethe
difference between the revenues generated
by the two types of contracts. For March-
April hedges during 1978/79,for example, a
farmerwho made the choice to underhedgea
desired 600 bushelpreharvestcommitmentre-
ceived 82.63g per bushel more than a similar
farmer who chose forward contracts. During
the same year, the farmerwho used futuresto
overhedge received 107.41gless than the for-
ward contract-preferringfarmer.
The data also illustratethe decliningimpor-
tance of futures lumpiness as the size of the
desired advanced sale increases. Comparing
the change in the basis data in table 2 with the
differences between futures and forwardsfor
largeproducersin table 3 shows that the basis
constitutes almost the entire difference be-
tween the two types of contracts.
Forwards and Futures as Complements
The liquidity of futures multipliestheir value
as an alternativeas well as a complement to
forwards.This becomes apparentwhen view-
ing marketingas an ongoingprocess occurring
in the context of changingproduction, price,
and basis information.Three examples of mul-
tiple period decision situations illustratehow
these dynamic market conditions may make
forward and futures contracts complemen-
tary.7
7 Althoughthe present discussionfocuses on fixed price con-
tracts, viewing marketingas a continuousprocess allows brief
mentionof the way deferredpriceforwardcontractsofferfarmers
the opportunityto capturea favorablebasis even when expecting
priceincreases.If marketconditionsin periodone leadthe farmer
22 February 1985 Amer. J. Agr. Econ.

Rather than restricting advanced sales to Lumpinessand basis, however, cause an im-
only forwardsor only futures, as done previ- perfect advancedcommitmentreductionsince
ously, the illustrationsassume that the pro- the nonzero xf adds the effect of Ab and i to
ducer trades both types of contracts. Adding revenue.
expressions (2) and (8) ratherthan subtracting The producer in illustrationtwo originally
gives the revenue jointly generated by for- selects futures over forwards in period one
wards and futures: because of positive basis changeexpectations.
Suppose that futuresprices drop more rapidly
(10) q* p(t*, t*) - (x,, + xf) Ap than forwardcash prices between periods one
' + xf" Ab + xf, i. and two causing the realizationof the antici-
In this case, q* represents the total quantity pated positive basis change. If the period two
deliveredor sold in the spot marketat harvest. marketinformationsuggests a decrease in the
Summingthe forwardand futureshedges x,, + basis between periods two and three, the pro-
xf gives the combinedadvancedcommitment. ducer can capturethe realizedfavorablebasis
Instead of assuming the producer makes change by selling forwardsand buyingout the
only a preharvestplanculminatedat harvest, a futures hedge.
three-periodanalysis allows the producer to Finally, in the last illustration, changed
makeadvancedsales in time intervalone, alter market conditions between periods one and
the strategyin two, and consummatethe plan two now reverse the previous expectationof a
in three. All three illustrationssurmisethat in price decline. Althoughhedged, the producer
period one, the producerexpects prices to de- desires to profit from the expected price in-
cline and thus makes short advancedcommit- crease. The producercan eliminateeithertype
ments. In expression (10) this means that of short hedge by once again purchasingfu-
E[Ap] < 08 encouragesthe producerto make tures contracts. In the case of the forward
x, + x, > 0. As discussed previously, the pro- hedge, however, a long futuresposition imper-
ducer prefers futures when expecting a posi- fectly cancels the previous advanced sale.
tive basis change, i.e., E[Ab] > 0, and for-
wards, otherwise. With updated production,
basis, and price informationin periodtwo, the Summary and Implications
producer evaluates the advanced sales and
makes adjustments. The lumpiness, basis, and interest income
(cost) differences between forwards and fu-
In the first illustration,period one market
informationcauses the producerto expect fu-tures as hedges arise from their unequalstan-
dardization, integrity, payment, and settle-
tures to decline less rapidlythan forwardcash
ment characteristics. Practically speaking,
prices. Because of the resulting anticipated
large traders find only basis as a significant
negative basis change, the producerhedges in
differencebetween forwardsand futureswhen
period one using forward rather than futures
comparingthe two contracts as marketingal-
contracts. If adverse weatherbetween periods
one and two reduce the amount of expected ternatives. Very small producers should also
output, the producermay face an overhedged carefully consider the impact of lumpiness.
Although farmers definitely prefer forwards,
situationin periodtwo. In this instance, a for-
ward contract could transformthe producer in given years futures provide a superiorop-
tion. Addinginformationdynamicsto the pro-
from seller to net purchaserin the harvestspot
market. The producercan partiallyneutralizeduction-marketing problem illustrates the
such a commitment through a futures pur- value of the liquidity of futures contracts
within the farm portfolio. In this context,
chase. In terms of expression (10), purchases
combinations of forward and futures hedges
of futuresx, < 0 reduces the effective size of
the advanced commitment to x,) + xf < x,,. may form optimal strategies.
The results of this analysis imply that econ-
to expect prices to increase and basis to decrease, such a producer omists should not freely interchange forward
wants to lock in the basis immediately yet still retain the opportu- and futures prices within their models. Accu-
nity to profit from the expected price rise. The producer accom-
plishes both objectives by writing a basis contract in period one. rate, realistic planning methodology should
Hopefully by period two, prices have increased allowing the consider both forward and futures contracts as
farmer to fix the price at that time. At delivery in period three,
such a procedure reaps the profits from the attractive basis in
possible marketing activities. The futures
period one and the price increase between periods one and two. hedge specification should incorporate the
8 The symbol E refers to the expectation operator. basis as an important component. Depending
Nelson Forward and Futures Contracts 23

on the size of the advanced commitments,fu- Cox, J., J. Ingersoll, and S. Ross. "The Relationship
tures contract lumpiness can exert a sig- Between Forward Prices and Futures Prices." J.
nificanteffect. The relative smallness of inter- Financ. Econ. 9(1981):321-46.
est income allows its exclusion from the mod- Jarrow, R., and G. Oldfield. "Forward Contracts and
Futures Contracts."J. Financ. Econ. 9(1981):373-
eling process. 82.
[Received July 1983;final revision Paul, A. B., R. G. Heifner,and J. W. Helmuth.Farmers'
received August 1984.] Use of Forward Contracts and Futures Markets.
DC: U.S.
Washington of
Department Agriculture,
Nat. Econ. Analysis Div., Econ. Res. Serv. Agr.
Econ. Rep. No. 320, March 1976.
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EquilibriumModel of ForwardPrices and Futures
Black, F. "The Pricing of Commodity Contracts." J. Prices in a MultigoodEconomy." J. Financ. Econ.
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CorporateBonds." J. Polit. Econ. 81(1973):637-54. DanvilleIL: InterstatePrintersand Publishers,1972.
Chicago Board of Trade. Commodity Trading Manual. Telser, L. G. "Why There Are OrganizedFutures Mar-
WilmetteIL: Belveal and Co., 1966. kets." J. Law and Econ. 24(1981):1-22.
CommodityFuturesTradingCommission.ForwardCon- Telser, L. G., and H. N. Higginbotham."OrganizedFu-
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