Grain Futures Contracts An Economic Appraisal PDF

GRAIN
FUTURES
CONTRACTS:
AN ECONOMIC APPRAISAL
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GRAIN
FUTURES
CONTRACTS:
by
S. Craig Pirrong
David Haddock
Roger Kormendi
with
Michael Brennan
Merton Miller
Richard Roll
Hans Stoll
Lester Telser
A MIDAMERICA Institute Research Project

Library of Congress Cataloging·in·Publication Data
Grain futures contracts : an economic appraisal / by S. Craig Pirrong,

David Haddock, Roger Kormendi with Michael Brennan ... [et al.].
p. cm.
"A MIDAMERICA Institute Research Project."
Includes bibliographical references and index.
ISBN 978-1-4613-6423-8 ISBN 978-1-4615-3238-5 (eBook)
DOI 10.1007/978-1-4615-3238-5
1. Commodity futures--United States. 2. Grain trade·-United
States. 3. Chicago Board of Trade. 1. Pirrong, Stephen Craig,
1959· . II. Haddock, David D., 1944- . III. Kormendi, Roger C.
HG6047.G8G7 1993
332.63'28--dc20 92-44334
CIP
Copyright © 1993 by Springer Science+Business Media New York

Originally published by Kluwer Academic Publishers in 1993
Softcover reprint ofthe hardcover Ist edition 1993
AII rights reserved. No part of this publication may be reproduced, stored in a retrieval
system or transmitted in any form or by any means, mechanical, photo-copying, record ing,
or otherwise, without the prior written permission of the publisher, Springer Science+
Business Media, LLC.
Printed an acid-free paper.

Contents
Foreword IX
The Grain Futures Delivery Process: An Overview xi
CHAPTER 1
The Economic Function of Futures Trading 1
CHAPTER 2
The Role of the Futures Delivery Process 9
CHAPTER 3
Futures Contracts as a Merchandising Tool:
The Role of Delivery as a Means of Ownership Transfer 51
CHAPTER 4
Maintaining the Integrity of Grain Futures Contracts:
The Economics of Manipulation and Its Prevention 63
CHAPTER 5
The Economic Effect of Potential Grain Futures
Contract Redesign 107
CHAPTER 6
Summary and Conclusions 139
References 147
Index 183
v
vi
Tables • Graphs • Figures
TABLE 2-1: Corn

Range of Futures Price in Relation
to Cheapest-to-Deliver Cash Price Showing Extent
of Arbitrage Violations Between Cash and Futures Prices 152
TABLE 2-2: Soybeans
of Arbitrage Violations Between Cash and Future Prices 154
TABLE 2-3: Wheat
of Arbitrage Violations Between Cash and Future Prices 156
TABLE 2-4
Summary Statistics by Contract for Basis
During the Delivery Month 158
TABLE 2-5
Receipts at Primary Markets as a Fraction of U.S. Output 160
TABLE 2-6
Receipts at Chicago as a Fraction of U.S. Output 161
TABLE 2-7
Chicago, Toledo, and St. Louis Receipts as a Fraction of
Receipts at all Terminal Markets 162
TABLE 3-1
Deliveries as a Fraction of Open Positions 1980·1989 163
TABLE 3-2
Deliveries as a Fraction of EFPs + Deliveries 1983·1989 164
TABLE 3-3
Total Soybean Delivery Regression Results 165
TABLE 3-4
Total Corn Delivery Regression Results 166
TABLE 5-0
Delivery Option Regression Results 167
vii
TABLE 5-1
Soybean Hedging Effectiveness
Under Alternative Delivery Specifications 168
TABLE 5-2
Corn Hedging Effectiveness
Under Alternative Delivery Specifications 170
TABLE 5-3
Soybean Percentage Price Change Correlations 172
TABLE 5-4
Corn Percentage Price Change Correlations 173
GRAPH 1
Soybeans Basis: Contracts for March Delivery by Year 174
GRAPH 2
Soybeans Basis: Contracts
for September Delivery by Year 175
GRAPH 3
Corn Basis: Contracts for March Delivery by Year 176
GRAPH 4
Corn Basis: Contracts for September Delivery by Year 177
GRAPH 5
Wheat Basis: Contracts for March Delivery by Year 178
GRAPH 6
Wheat Basis: Contracts for July Delivery by Year 179
FIGURE 1
Competitive Equilibrium in a Futures Market 180
FIGURE 2
Non-Unique Competitive Futures Market Equilibirum 181
FIGURE 3
Futures Contract Manipulation by a Large Trader 182
Foreword
This study is an independent scholarly analysis of the economics

of the grain futures contracts of the Chicago Board of Trade. The
study was made possible by a research grant to the MidAmerica
Institute from the Chicago Board of Trade, and we gratefully
acknowledge this financial support, as well as the information and
vast body of experience made available to us by the Division of
Economic Analysis and members of the Exchange.
Several other organizations also provided invaluable help from
the inception of this study through the full process, either in the form
of information, or through discussion: the Commodity Futures
Trading Commission, the U.S. Department of Agriculture, the
National Grain and Feed Association, the American Soybean
Association, the Senate Committee on Agriculture, Nutrition and
Forestry, the House Committee on Agriculture, the General
Accounting Office, and the Center for the Study of Futures and
Options Markets at Virginia Polytechnic and State University. We
express our thanks.
The primary authors wish to extend a special word of apprecia-
tion to Michael Brennan, Merton Miller, Richard Roll, Hans Stoll and
Lester Telser, who served as members of the Resource Panel for the
study. While key strengths of the study reflect their input, ultimate
responsibility for the analysis rests with the primary authors.
For more than 130 years the grain contracts of the Chicago Board
of Trade have contributed to the health and well-being of American
agricultural economy. It is our hope that the analysis presented in
this study will help to continue that tradition into the next century.
ix
The Grain Futures Delivery Process:
An Overview
The grain futures markets of the Chicago Board of Trade (Board

or CBT henceforth) are among America's most venerable financial
institutions, with a history spanning almost 130 years. During that
long period the interconnections between the grain and futures mar-
kets have evolved remarkably with changing production, storage, and
trading techniques, communication and transportation systems,
identities and sizes of market participants, domestic and export
demand conditions, and still other phenomena. In such a dynamic
milieu, institutions can become outmoded unless they are reviewed
periodically, and revised when appropriate.
This report examines the recent performance and future
prospects of a crucial aspect of grain futures contracts--the delivery
process. Delivery links futures and spot markets, and is essential to
the efficient performance of a grain futures contract. Both hedging
effectiveness and the informativeness of futures prices depend cru-
cially upon this linkage.
After examining a body of recent data, we have reached a number
of basic conclusions. First, the delivery process has worked well over
the past six years. Convergence has occurred regularly, and the few
deviations from convergence do not reflect any systematic failure of
the contracts. Second, despite the performance of the recent past, the
decline of terminal grain markets and the evolution of trading pat-
terns suggests that the futures price converges to a decreasingly rele-
vant cash price. This evolution has significantly reduced the
importance of Chicago and Toledo as cash grain markets, and prices
there can no longer serve as the sole measure of value for the very
large number of hedgers who are now oriented toward markets other
than Chicago!I'oledo. Third, there is no radically different substitute
mechanism apparent that possesses superior attributes to the one
now in use. A change to an "economic-par" delivery system including
xi
xii MAl Grain Study
a delivery point on the Mississippi River in addition to the existing

points of Chicago and Toledo, however, may well produce a signifi-
cant improvement in hedging effectiveness at out-of-position loca-
tions. Fourth, the delivery process is an unimportant means of
transferring ownership of grain. Fifth, due to transportation costs
and the nature of trading patterns grain markets are susceptible to
manipulation, so proper regulatory and contract design safeguards
are desirable.
In what follows, Chapter 1 provides an overview of the role of
futures markets in order to provide a perspective against which to
evaluate their performance. There we discuss the distinction between
forward markets in general and the highly constrained form known
as a futures market, exploring the reasons for the popularity of the
latter. As that chapter emphasizes, futures contracts perform numer-
ous complex functions that complement spot markets. In practice, the
functions are inseparable, but in our analysis we separate them con-
ceptually to obtain a more precise understanding of their values to
the economy, the means by which that value could be more fully real-
ized, and the dangers posed by ill-considered modifications in the
contracts or exchange rules. Several issues are raised in Chapter 1
that are more fully addressed in later chapters. For instance, the
price data for spot and forward transactions are fundamentally dif-
ferent from futures transaction prices precisely because of the
uniqueness of the former versus the standardization of the latter.
The chapter also notes that the theoretically better hedging that
would seem to flow from improved correlation between spot and
futures prices if the contract set were expanded must be traded off
against the liquidity that is provided by more highly standardized
contracts.
Chapter 2 uses recent data to investigate the ability of the deliv-
ery mechanism to link spot and futures markets; i.e., to assure price
convergence. The evidence shows that convergence has been quite
good during the sample period used. The chapter also discusses the
effects of the decline of Chicago and Toledo as terminal markets (and
terminal markets in general) on the viability of the Board's existing
delivery mechanism, and examines some alternatives to this mecha-
nism.
Chapter 3 investigates the use of delivery for trading the under-
lying commodity, which some recent scholarly literature has empha-
sized. 1 The belief that futures markets are ill-suited for
merchandising had previously been axiomatic. Which of the compet-
ing beliefs is more reflective of our economy is the central question of
xiii
the chapter. We provide new empirical evidence that indicates that

delivery is relatively unimportant quantitatively as a tool for com-
modity trading. Indeed, the model that advances delivery as a mer-
chandising tool is shown to have unresolved theoretical weaknesses,
and the empirical results presented here are inconsistent with that
model's predictions. That implies that changes in contract design
intended solely to facilitate merchandising might well be injurious to
the futures market and the traditional roles it has filled.
Chapter 4 presents the economics of commodity market manipu-
lation, then investigates features of the grain markets that render
them particularly subject to manipulation. Transactions costs, first
introduced in Chapter 2, are shown to be crucial for predicting where
futures markets will be vulnerable to manipulation. We note that
measures designed to lessen the likelihood of a long manipulation
automatically increase the profitability, and hence probability, of
short manipulations. Chapter 4 also discusses four means of deter-
ring manipulation, which we call ex ante enforcement, ex post
enforcement, contract design, and informal enforcement through rep-
utational loss. It is argued that multi-pronged deterrence is apt to be
more appropriate than a mechanism relying on a single control tech-
nique.
Finally, Chapter 5 presents an empirical analysis of the economic
effects of the creation of an economic-par, mUltiple-delivery-point sys-
tem for grains. Models of futures and options prices are used to simu-
late hedging effectiveness and to evaluate the prospective benefits
from an expansion of the set of allowable delivery points. The results
depend crucially upon assumptions concerning the invariance of spot
price distributions to changes in the delivery mechanism. Given
these assumptions, the results indicate that corn and soybean hedg-
ing effectiveness could increase considerably in Central Illinois, the
Gulf, Central Iowa, Kansas City, Minneapolis, and areas tributary to
St. Louis, with the addition of St. Louis as a delivery point at a differ-
ential that reflects the typically higher price of corn and soybeans
there. Although this evidence highlights some important benefits
associated with an economic-par delivery mechanism, the effects of a
move to such a mechanism on the costs of arbitrage and the balance
of power between shorts and longs must be considered. Chapter 5
provides a theoretical analysis of these issues.
Chapter 6 summarizes the analysis presented in the preceding
chapters.
xiv MAl Grain Study
Although the Board of Trade was chartered in 1848, futures trad-

ing per se did not begin until some time thereafter. The exact date at
which true futures trading began is a matter of some dispute. The
commonly accepted view is that futures trading evolved during the
Civil War (1861-1865). The Board first promulgated formal rules gov-
erning this form of trading in 1865.
'Williams (1986); Williams (1987).

GRAIN
FUTURES
CONTRACTS:
1 • DIe Economic Function of Futures Trading
To evaluate properly the function of the delivery process, and

therefore how changes in delivery specification influence the larger
economy, it is necessary to understand the economic role of futures
markets. We discuss that role in this chapter, paying special atten-
tion to the factors that differentiate futures markets from other for-
ward markets.
Forward and Futures Markets

A forward market is one in which parties agree to transactions
that are to occur later. A forward contract specifies what is to be
delivered, the quantity, when delivery is to occur, where it will be
made, and possibly even how. In addition, the contract specifies what
compensation will be paid by the receiving party, when it will be
paid, and where. The parties are free to agree to any idiosyncratic
specifications that they choose. If either party defaults on a forward
contract, the other party may demand compensation for any injury
that has resulted, and if necessary may sue in court to obtain recov-
ery.
A futures market is a special sort of forward market. In particu-
lar, a futures market is a very standardized, simplified, and therefore
limited forward market. Futures contracts are traded on organized
exchanges at the specified times that the exchange is open, whereas
forward contracts can be negotiated anywhere, at any time.
According to a futures contract, what is to be delivered must be
selected from a small set of possibilities. For instance, not every
grade of wheat is deliverable on every futures exchange. Nor would a
mixed load of equal parts of wheat, com, and barley be deliverable,
even though the combination might be perfectly appropriate for the
operations of some livestock feeder. And on a futures exchange one
S. Craig Pirrong et al., Grain Futures Contracts:An Economic Appraisal

© Kluwer Academic Publishers 1993
2 Grain Futures Contracts, an Economic Appraisal
can only contract to deliver integer multiples of a standard lot size; a

carload and one-half will not suffice, even if that is exactly the
amount that two potential trading partners want to sell and buy.
Similarly, on a futures market the period during which delivery
may occur is limited to only a few relatively brief periods during a
year (which vary from commodity to commodity), and deliveries must
take place at a single "deliverable" location, or for some commodities
at a location selected from among two or three options. That is true
even though other periods and places may be more appropriate for
delivery for many, or even most, of the contracting parties using an
exchange. And finally, if a futures contract is breached, the resulting
claims for damages entangle the individual parties with the futures
exchange itself, not with a party on the other side of the agreement.
In other words, the exchange is responsible for providing the requi-
site compensation to the breached-against party, and the exchange
must undertake any action necessary to secure damages from the
breaching party. So at least three entities are involved in a dispute
on a futures exchange, not two.
Given the extremely limited nature of the contracts that can be
negotiated on a futures exchange, it comes as a surprise to the unini-
tiated that futures contracts are substantially more actively traded
than are forward contracts. For some reason, traders must prefer
trading futures contracts, which rarely (if ever) offer the precise spec-
ifications that the traders desire, to trading forward contracts, where
any conceivable mutually agreeable specifications are attainable.
On the other hand, forward contracts are much more likely to
result in actual delivery of the physical commodity than are futures
agreements. Prior to expiration, most futures contracts are "offset"
through the purchase of a counterbalancing obligation. For example,
before the futures contract "expires" (delivery comes due) a party who
is obliged by the contract to deliver a quantity of soybeans to Chicago
during a particular period will usually cancel his obligation by pur-
chasing an identical contract and transferring his previous obligation
to the party from whom he purchased the contract.
Rather than being "collected" in physical soybeans, that right
may then be turned over to still another party to offset some other
obligation, and so on. In that way, many different contracts can be
offset by a single lot of soybeans receipted and registered in an eleva-
tor regular for delivery. Indeed, in theory all outstanding contracts in
every traded commodity could be offset without a single lot of any
commodity being delivered. Again the uninitiated observer wonders
what the function of such a contracting system could be.
In this chapter, we discuss the economic value of forward con-

tracts in general, including futures contracts as a subcategory. We
also discuss the particular value that accrues from trading a con-
stricted futures contract, rather than a more flexible forward contract
that can be molded to any specification. It is the latter that accounts
for the popularity of futures markets over other forms of forward
market and which points to the economic injury that would material-
ize if the operation of futures markets became impaired.
The Economic Function of Futures Markets

Commercial traders use forward contracts (including the special-
ized variety of these agreements, futures contracts) in order to
"hedge" the risks of their operations. That is, forward trading facili-
tates the transfer of risk. For example, consider an exporter with a
commitment to deliver 1 million bushels of corn to a foreign customer
one month hence. In order to fill this order, the exporter must buy
corn in the United States. Since it may take some time to purchase
the entire amount of grain, the exporter is vulnerable to increases in
the price of corn prior to the completion of his purchases.
The exporter can protect himself against such price changes by
purchasing 1 million bushels of corn forward at a fixed price to offset
his one million bushel sales commitment. By doing so, the risk of ris-
ing prices is transferred to the trader who sold corn forward to the
exporter. It must also be noted that by engaging in this hedge trans-
action (i.e., buying corn forward to offset a forward sales commit-
ment) the exporter foregoes the opportunity of profiting from a
decline in the price of corn which would allow him to fulfill his obliga-
tions at lower cost. That is, by hedging a trader reduces risk (the
variability of his wealth) by reducing vulnerability to loss but also
sacrificing opportunities to profit.
Hedging transfers risk from those who bear it at a high cost to
those who do so at a low cost. Moreover, hedging facilitates commerce
by facilitating credit arrangements. Banks may be unwilling to lend
to traders who are vulnerable to large risks of adverse price moves. A
hedger is less vulnerable to such outcomes, however, and is therefore
more creditworthy. Given the importance of credit, by making it eas-
ier to obtain, hedging plays a crucial role in reducing the costs of
commerce.
There are decided advantages for the exporter to purchase
futures contracts traded on an organized exchange in order to exe-
cute his hedge. Most importantly, the transactions costs of negotiat-
ing a futures contract are significantly lower than the costs of
negotiating a tailored forward contract. To execute a forward con-

tract, the exporter would have to search for and negotiate contract
terms with a counterparty or counterparties. Such search and negoti-
ation are costly. By trading on a centralized futures exchange, how-
ever, search and negotiation are unnecessary. Other traders
(including other hedgers and speculators) are constantly submitting
orders to the futures market, and some traders (local traders and
position traders) stand by willing to take the other side of a trade if
the order flow from off the floor is temporarily imbalanced; the con-
tinuous trading on the centralized exchange thereby eliminates the
necessity of searching. Moreover, the standardized features of the
futures contract eliminate the need to negotiate all but one term of
the forward transaction-price.
Importantly, futures market institutions including the margin
system, the clearinghouse, and exchange rules on trader conduct and
responsibility also standardize a very important attribute of a con-
tract-contractual performance. The parties to a forward contract
must take costly precautions (such as credit checks and evaluation of
reputation) to ensure each will perform his obligations. Such evalua-
tion is largely unnecessary in the futures market due to the extensive
safeguards against default in place.
In sum, then, futures markets facilitate hedging by minimizing
the transactions costs of entering forward agreements. Thus, futures
markets are liquid markets where forward contracts are traded con-
tinuously at low cost. This is an extraordinarily important function.
The effectiveness of a futures hedge is greater, the greater the
correlation between the price of the future and the price
paid/received by those trading in the cash market. Our exporter, for
example, may be purchasing corn in Iowa and Central Illinois, but
trading corn futures requiring delivery in Chicago. Since the Iowa
price and the Chicago price do not necessarily move in lockstep, the
losses (gains) the exporter incurs on his futures position may not
exactly offset the gains (losses) he incurs when purchasing grain in
the former location. Thus, effective hedging requires a close relation-
ship between prices of the deliverable commodity (or commodities)
and the prices traders pay when buying or selling on the cash mar-
ket.
This fact, and the fact that the standardized terms of a futures
contract-including the standardized delivery terms-must ensure
both a high degree of correlation between futures prices and cash
prices, and also facilitate contract liquidity. It should be noted that in
markets for commodities like grain, correlations differ dramatically.
The correlation between the Chicago price and the Peoria price dif-
fers from the correlation between the St. Louis price and the Peoria
price. Moreover, liquidity is enhanced by concentrating futures trad-
ing in a single contract. It is uneconomical, therefore, to offer two
separate futures contracts, one allowing delivery in Chicago, and the
other in St. Louis. These realities complicate the task of providing
the appropriate delivery specification. Namely, it is unlikely that
there is a single delivery point which offers maximum price correla-
tions for all geographically dispersed hedgers. Indeed, one of the
major innovations of the present work is to evaluate empirically how
different delivery specifications affect grain hedgers located at a vari-
ety of important points throughout the United States.
Centralized futures trading offers another significant benefit in
addition to facilitating hedging. In particular, continuous trading on
a centralized exchange determines prices that embody information
concerning supply (such as information on weather and insect infes-
tations) and demand (including export orders and processor needs) in
the possession of myriad individuals. Those who possess such infor-
mation can profit by trading on the futures market. This trading, in
turn, affects supply and demand on the futures market, thereby
affecting the market price. Moreover, the ability to profit gives
traders incentives to collect new information. 1
The revelation of widely dispersed information in futures prices
improves resource allocation. Consider producers or processors of
soybeans. In order to determine the proper amount of beans to plant,
or the correct amount of beans to crush (and the timing of the crush),
it is necessary to have accurate information concerning the value of
soybeans and soybean products. The futures price embodies this
information, and agents who rely upon it to make decisions therefore
employ the information possessed by myriad individuals they never
meet or communicate with. Thus, the existence of a futures market
improves economic efficiency by generating informative prices that
individuals use to make economic decisions.
The importance of this so-called "price discovery" function of
futures markets implies that the futures price should be as represen-
tative of general market conditions as possible. If the futures price
accurately reflects supply and demand conditions at an isolated point
or for a rare grade of a commodity, it does not provide as valuable a
signal to decision makers as would a futures price reflective of more
important grades/locations.
The hedging and price discovery functions of futures markets
may be compromised by strategic behavior of some traders. In partic-
ular, large traders can sometimes force the futures price away from
economic value by making or taking too many deliveries. This is typi-
cally called a "manipulation." Such actions distort prices not only
during the delivery period, but before it as well. 2 These distortions
reduce the correlations between futures prices and cash prices, inject
noise into futures prices, and reduce the incentives of traders to col-
lect and trade on information. Thus, economic efficiency is enhanced
by a delivery specification that reduces a contract's vulnerability to
such strategic behavior.
In conclusion, organized futures markets offer many valuable
services. In particular, futures exchanges dramatically reduce the
costs of forward contracting by standardizing salient terms-includ-
ing the timing, location, and quality of delivery-and (perhaps most
importantly) by reducing the likelihood and costs of default. Since
forward contracting allows a more efficient allocation of risk and
facilitates the extension of credit, futures markets perform a valuable
economic function. Moreover, futures markets allow individuals in
possession of material, fundamental information about supply and
demand conditions to trade on this knowledge. As a result of this
informed speculation, futures prices efficiently summarize a vast
amount of information that would otherwise remain dispersed
throughout the economy or not be collected at all. Decision makers
can rely upon the knowledge embedded in futures prices in order to
make better resource allocations, thereby increasing aggregate
wealth.
The delivery mechanism plays a crucial role in assuring a futures
market performs these vital functions of improved risk bearing and
price discovery. A good delivery specification leads to more effective
hedging and more efficient prices. A bad one does the opposite. In
particular, a good delivery specification does the following: 1) allows
effective hedging by assuring a high correlation between cash and
futures prices; 2) contributes to market liquidity, thereby reducing
the costs of trading; 3) generates a futures price that is broadly repre-
sentative of prices in general; and 4) is relatively invulnerable to
manipulation by large traders.
The following chapters examine the delivery system of the
world's most venerable futures contracts-the grain and oilseed con-
tracts traded on the Chicago Board of Trade. We evaluate how the
contracts have performed in the past the four functions outlined in
the preceding paragraph, and how the specifications can be changed
in order to improve this performance in the future.
'See Grossman (1977).
'See Pirrong (1992).

2 • TlJe Role of the Futures Delivery Process
The delivery terms of futures contracts specify the types and

grades of deliverable goods, and denote the places and times of deliv-
ery that must be met to avoid default on an outstanding contract. It
is exceedingly difficult to ascertain proper specifications for a futures
contract. But if the contractual terms are improperly specified, too
few buyers or too few sellers of the contract will appear in the market
at any given price, and the contract will fail.
As a very simple example, suppose that techniques are known that
permit manufacturers to produce either of two qualities of widget, with
low-quality widgets cheaper to produce than high-quality ones.
However, nobody wants a low-quality widget, given the cost/quality
tradeoff, which determines the minimum price for profitable sale of a
low-quality widget. Consequently, only high-quality widgets are ini-
tially being produced. Further suppose that it takes substantial time to
produce a widget, and widget makers wish to be assured of a price
before beginning the production of any batch. As a result, some widget
makers offer to go short on a futures contract for widgets. If widget
buyers also find it agreeable to hedge, a number of contracts may be
concluded between widget makers and widget buyers.
But when the specified delivery period arrives, those who have
"gone long" on the contract-those who have agreed to pay a specified
price in exchange for the widgets-will discover that only low-quality
widgets are delivered. Low-quality widgets cost less to produce, so if
the contract price is fixed without regard to quality, only low-quality
widgets will be produced. But then, during the following production
period no widget buyers will offer to pay high-quality widget prices
for the futures contracts that the widget makers are offering-there
are too few contract buyers to clear the market at that price. The
widget buyers would be willing to offer only the lower futures price
that is appropriate for low-quality widgets, since they would now

realize that only low-quality widgets will be delivered. But, by

hypothesis, no widget producer can profitably produce low-quality
widgets at that price-there are too few contract sellers to clear the
market at that price.
It is obvious that if the widget makers and widget buyers cannot
agree on a workable means of specifying widget quality in advance,
the widget futures contract will fail, even though both the buyers and
the makers of widgets wanted a futures contract to exist. It may hap-
pen that the contract fails because the best way to specify quality
and ascertain that the specification has been met is too costly to use.
But the contract could also fail because governmental mandates pre-
vent the parties from utilizing specifications that otherwise would be
the most appropriate. As we illustrate more fully below, the various
aspects of quality that are important for real-world futures contracts
are often subtle. Hence, they are easily neglected, and as a conse-
quence futures contracts can be easily damaged by careless alter-
ations in contractual terms.
A set of significant real-world futures contracts deal with grains. 1
Grain futures have traded at the Board for roughly a century and a
third. Given the dramatic changes in the nature of the grain business
over that long period, it is appropriate to appraise the performance of
the system and evaluate the contribution of potential changes, both
those being considered voluntarily by the Board, and those that
might be imposed by governmental compulsion.
Convergence and the Delivery Process: An Overview

Only a minority of the futures contracts that are concluded
between traders actually result in delivery of the contractually stipu-
lated commodity, but the potential for delivery plays a crucial role in
the operation of the system. Hence, an adequate appraisal of Board
futures contracts requires a firm understanding of the role of the
delivery option. In this chapter we focus on two aspects of the deliv-
ery process. First, we examine the function and performance of deliv-
ery as a means of ensuring that the price of an expiring futures
contract converges on "spot" prices. 2 Second, we inquire into the
potential of the delivery process to perform that function in the
future.
Most of those who are familiar with futures markets-traders,
hedgers, exchange officials, scholars, government regulators, etc.-
consider the delivery option's paramount purpose to be ensuring con-
vergence of futures and spot prices, not enabling traders to obtain the
contractual commodity. Indeed, the Board has stated that "futures
markets are not intended-and have never been intended-as a way

or place to acquire or deliver substantial quantities of the physical
commodity."3 Moreover, that is a position that the Board has long
held. In 1920, for instance, the Federal Trade Commission noted:
The Chicago Board is concerned with deliveries chiefly as a
check upon future prices and possible manipulation, and com-
paratively inattentive to the possible use of its futures as a
means of getting grain. Indeed, the gist of the complaint of
Chicago traders with the so-called natural corner in May,
1917, wheat was that the purchasers for our Allies bought
expecting to take delivery.4
The emphasis on convergence stems from a belief (discussed in
the previous chapter) that the prime function of any forward market
is to enable producers, processors, and merchants to "hedge"-to
reduce the price risk that they face-and to facilitate price discovery.
Achievement of both objectives requires the futures price and spot
prices to be closely related. If spot and futures prices diverge fre-
quently, hedgers will not be able to reduce their risk appreciably.
Similarly, large and chronic divergence between spot and futures
prices make the latter unreliable guides for the decisions of produc-
ers, processors, and marketers. Thus, if futures and spot prices do
not converge, something must be wrong with the hypothesis that
futures markets provide adequate opportunities to hedge, and hence
provide adequate signals to those making advance production deci-
SlOns.
The potential for delivery, however, is supposed to ensure that
the path of futures prices promptly mirrors new information relevant
for the spot price. The delivery potential achieves that result by link-
ing the futures price in the delivery month to a particular spot price,
or sometimes a small number of spot prices. 5 A close linkage between
futures prices in the delivery month and the spot price in that month
is, of course, consistent with the notion that those who hedged stocks
or transactions in the deliverable grade at the deliverable location in
the delivery month were able to assure themselves of a sensible price
in advance. That would thereby have enabled these hedgers to avoid
price risk for their own benefit. To the extent that spot prices for
other grades in other locations are correlated with the price of the
deliverable grade at the deliverable location in the delivery month,
hedgers in the other markets will also be able to reduce their expo-
sure to price risk through futures transactions.
The foregoing implies that convergence between spot and futures
prices is a desirable characteristic of futures markets. In order to

ensure convergence, traders must be able to arbitrage these markets.
If arbitrage were costless, for example, and if futures and deliverable
spot prices were to diverge in the delivery month, a trader could buy
the cheaper and sell the more costly, thereby reaping a riskless
profit. By so doing, the arbitrageur would bid up the price of the
cheap commodity while exerting a downward pressure on the price of
the other, thereby driving prices together.
Unfortunately, transportation costs plus what are known to econ-
omists as "transactions costs" preclude perfect arbitrage. For
instance, an arbitrageur must pay commissions and fees to engage in
a futures transaction. Similarly, he must incur search and negotia-
tion costs in order to buy or sell the commodity on the spot market.
An arbitrageur will engage in simultaneous spot and futures transac-
tions, then, only if the futures price and the deliverable spot price
diverge by enough to cover the transportation and transactions costs
of executing the arbitrage. Thus, deliverable spot and futures prices
will not always converge precisely. The greater the transportation
and transactions costs, the wider the range over which spot and
futures prices can vary, and thus the poorer the average convergence
of futures and deliverable spot prices."
Transactions and transportation costs also affect how well
futures prices correlate with non-deliverable spot prices. Arbitrage
relates futures prices to the prices of a deliverable commodity.
Arbitrage opportunities also relate the prices of non-deliverable and
deliverable commodities. Consider, for example, the price of corn at a
delivery point-Chicago-and at a point where delivery cannot be
made-Peoria. Local supply and demand conditions in Chicago and
Peoria potentially can lead to divergences between the prices in the
two cities. Such divergences cannot become too great, however, or
arbitrageurs could transport grain from the low-price location to the
high-price location. The lower the costs of engaging in such arbi-
trage-including the fee for transportation, as well as the search and
negotiation costs of buying and selling the grain-determine the
maximum extent of the divergence. Moreover, the degree of stability
of transaction and transportation costs determines the stability of the
relationship between the Peoria and Chicago prices.
In the foregoing example, the smaller and more stable the trans-
actions costs of arbitraging the Chicago and Peoria spot corn mar-
kets, and of arbitraging the futures and Chicago spot corn market,
the more highly correlated the futures price of the Chicago contract
and the Peoria spot price. The higher that correlation, the lower the
risk of hedging Peoria spot transactions through the use of Board

future contracts calling for delivery in Chicago.
Hence, the ability of delivery to ensure effective hedging depends
crucially upon many factors that are largely beyond the control of the
exchange. The transactions costs of dealing in spot markets and
demand and supply patterns for the spot commodity are particularly
likely to be beyond the Board's control. But the exchange can never-
theless optimize the design of the delivery process, given the parame-
ters at its disposal. Specifically, it can choose when delivery may
occur, what grades are eligible for delivery, and where delivery may
occur. The Board's proper objective is to make effective choices, given
the constraints it faces.
When choosing the delivery location(s), for instance, the nature of
cash markets at various points is of primary importance. The exis-
tence of storage facilities, access to transportation, supply and
demand elasticities, and proximity to other markets are all impor-
tant characteristics of a delivery market. These factors will affect the
delivery market's susceptibility to manipulation, the cost of arbi-
trage, the correlations between the futures price and spot prices at
other locations, and the variability of the futures price. When trans-
portation costs are important, moreover, the spatial distribution of
demand and supply also affect the correlation between spot prices at
delivery points (and hence the futures price if convergence occurs)
and the spot prices at locations where delivery does not occur. If the
demand for the commodity is concentrated at the delivery point,
there is effectively a single market for the good (even if it is produced
over a wide area), and consequently all demand and supply shocks
are communicated to all locations where the commodity is produced
and stored. Under these circumstances, out-of-position hedgers bear
little basis risk as relative prices between their market and the deliv-
ery market are extremely stable. If processors or exporters away
from the delivery market are important, however, transportation
costs isolate the various markets to some degree. Under these cir-
cumstances, relative prices may vary significantly, and large num-
bers of hedgers may be located away from the delivery market and
must bear the resulting basis risk. Thus, price relations-and there-
fore basis risk-also depend upon the distribution of demand and the
location of delivery points when transport is costly. All of these fac-
tors, in turn, affect the contract's hedging performance and the infor-
mational value of its price. The exchange must consider these factors
when establishing a delivery specification.
There are two important constraints in addition to those created
by transportation and transactions costs. First, the reliability of a

futures market for hedging depends crucially upon the market's liq-
uidity. Hedgers must be confident that they can execute futures
orders without adversely affecting price. But that means that futures
trading is a natural monopoly, because liquidity is enhanced by hav-
ing a single market for each distinct commodity.7 Because of the
importance of liquidity, it is rare for more than one futures contract
to survive for a particular commodity.8
If natural monopoly characterizes futures trading, an individual
exchange is unlikely to offer different contracts for very similar com-
modities. For example, an exchange would be unlikely to trade a corn
contract calling for delivery in Chicago, and another calling for deliv-
ery in New Orleans. Similarly, separate contracts for #1 and #2 soy-
beans would be surprising. If the underlying commodities are closely
related ones, the liquidity loss from bifurcating a market is too great
relative to the potential for improved pricing efficiency to make the
alteration worthwhile.
Just as "one size fits all" clothing fits no one perfectly, however, a
single futures contract cannot guarantee equally effective hedging
performance for all close substitutes. Thus, the choice of deliverable
location(s) and grade(s) inevitably involves a trade-off in hedging
effectiveness among the various specifications in which hedgers are
interested. 9
Second, the danger of manipulation constrains the design of a
futures contract. This has been a concern of futures markets users
since the inception of trading for deferred delivery. There is no neces-
sary relationship between the size of the open interest--the number
of futures contracts outstanding, that is-and supplies of the speci-
fied commodity that are in position for delivery. As a consequence, for
example, short traders who are surprised at the cost of offsetting
their contracts must sometimes incur substantial transactions and
transportation costs to obtain deliverable supplies. Hence, any entity
that finds itself with a dominant position on one side of the market
may be able to profit handsomely from the costliness for others of
resorting to the delivery process. 10 That trader then causes futures
and spot prices to diverge from their natural relationship, thus
decreasing the value of the contract for hedging.
Unfortunately from the viewpoint of the exchanges and hedgers,
a trader's profitable position at the moment of a contract's expiration
can arise from superior foresight on the part of the trader rather
than contrivances and maneuvering. Unless the sources of market
constrictions can be clearly separated, rules and actions intended to
curtail manipulation can also penalize, and hence discourage, pro-

ductive efforts to evaluate the future path of commodity prices.
As we discuss in Chapters 4 and 5 below, one means of reducing
the potential for profitable manipulation by a buyer of futures con-
tracts is to expand the set of commodities eligible for delivery. For
example, the exchange could allow delivery of several grades (e.g.,
either #1 or #2 corn) or delivery at several locations (e.g., Chicago or
Toledo). Similarly, the exchange could permit delivery over a longer
rather than a shorter span of days, thus making it easier to ship in
additional tonnage. Such expansions of the deliverable set would
reduce the costs of making delivery. That would temper the terms on
which a manipulator could force liquidation, which would deter
manipulation, and thereby improve hedging effectiveness for short
traders.
But the cure comes at a cost. A larger deliverable set could make
short manipulation easier. And potentially of more importance, a
larger deliverable set alters the correlations between futures prices
and spot prices. Enlarging the deliverable set may improve hedging
effectiveness for some locations and grades, but impair it for others.ll
In summary, it is of paramount importance that an exchange
design an efficient delivery process that ensures convergence. This
contributes to but does not assure hedging effectiveness and price
informativeness. An exchange must also ensure that the delivery
process results in convergence to a meaningful price. Any exchange
faces many constraints when undertaking such tasks. These con-
straints arise from the nature of spot markets and transactions and
transportation costs in these markets, and the nature of futures trad-
ing.
In the following section we examine the performance of the grain
delivery process at the Board in achieving the first objective of the
delivery mechanism-convergence between spot and futures prices-
during the 1984-89 period. In subsequent sections and chapters we
examine the economic considerations affecting the delivery mecha-
nism's success in achieving the delivery mechanism's other important
objectives: the avoidance of manipulation and the improvement of
hedging effectiveness.
The Convergence of Spot and Futures Prices: An Empirical Analysis of

the 1984-89 Period
To what spot price should the futures price converge? Strictly
speaking, during the delivery month the futures price for corn or soy-
beans should equal the price of a warehouse receipt for that commod-
ity; i.e., it should reflect the value of grain in store. There is no

explicit market for warehouse receipts, however, so it is impossible to
verify that such a convergence takes place. 12
The best alternative measure of convergence is the difference
between futures prices and spot prices paid by regular elevators.
Regular elevators make many of the deliveries,13 and readily can cre-
ate warehouse receipts for future delivery by purchasing on the spot
market for shipment to their regular facilities, and then elevating the
grain tendered. Their bids in the spot market should thus represent
their marginal valuation of a warehouse receipt net of the costs
(including the opportunity costs) required to make a delivery. That is,
they should be willing to sell a warehouse receipt (either by deliver-
ing it against a futures contract or selling it outright) for an amount
equaling the cost of replacing the sold grain. That cost equals the
delivered price of grain at their elevator, plus whatever transactions,
execution, and opportunity costs are incurred in the sale/delivery,
including the marginal cost of storage and elevation.
The United States Department of Agriculture (U.S.D.A.) surveys
on a daily basis the bids of terminal operators in Chicago, Toledo,
and a number of non-deliverable points. We use the Chicago and
Toledo data as a proxy for the marginal value of warehouse receipts
in the two delivery locations.
When using proxies, of course, one must be especially cautious.
There are two obvious reasons for special care when using such data.
First, the reported data are terminal bids, not transactions prices.
Consequently, they may give a misleading estimate of the marginal
cost of creating a warehouse receipt. If, for example, a warehouse
bids $6.00 per bushel for soybeans, but no seller accepts it, the mar-
ginal cost of creating a warehouse receipt is greater than $6.00, and
by an unknown margin. One would underestimate the market price
of soybeans by using the bid as a measure of market price under
these circumstances. Bids could also overestimate the equilibrium
price if warehouses receive more grain then they would like at the
price they post.
Second, there is often a considerable range in the bids made by
terminals at a given location on a given day. The dispersion can arise
from several factors. Imperfect information is one; terminals could
differ in their estimates of the minimum price required to obtain sup-
plies. Different transactions costs across operators are another. Or
different operators may simply value the grain differently. An eleva-
tor with a sizable export contract, for instance, may sensibly bid more
aggressively for grain than one lacking such a contract, for reasons
completely unrelated to spot-futures arbitrage considerations.

Similarly, an elevator operating near its effective capacity faces a
high marginal storage cost, and will reduce its bids accordingly.14
Together the two factors imply that the existing spot market bid
data can at best point toward upper and lower bounds for the range
of spot market prices. But observed futures prices may even fall out-
side that range during the delivery month. For example, all bids may
be above or below the market price. In the former instance all bids
are hit, but in the latter, none are hit.
Further, as noted earlier, the transactions costs of making and
taking delivery can drive a wedge between spot market prices and
futures prices. Consider the cost of buying a futures contract and
standing for delivery. Such a transaction will be uneconomical unless
the spot price exceeds the futures price by at least the cost of loading
out the grain, which has been $.06 per bushel throughout the study
period. A long must pay other expenses to take delivery as well.
These include the costs of weighing, grading, elevating, trimming and
blending the delivered grain. Moreover, if load-out is slow, a long
may incur ongoing storage costs and demurrage charges.
Similarly, the transactions and opportunity costs of making a
delivery may exceed the difference between the futures and spot
price. One of the main factors is the marginal cost of storage borne by
the warehouse operator. Making a delivery could tie up elevator
space needed to execute other transactions, which makes the oppor-
tunity cost of delivery positive. This is most likely to occur when reg-
ular storage elevators are operating close to capacity. Such a high
marginal cost of storage would tend to depress the spot bids relative
to the futures price. The marginal cost of storage and the fixed price
charged for public storage can also drive a wedge between the futures
price and the spot bid when the marginal cost of storage is low. When
the marginal cost of storage is below the fixed charge of $.0018 per
bushel per day, regular operators can capture this difference by deliv-
ering against the future and forcing a public customer to pay storage
until load-out. Their spot bids should reflect the profitability of this
action. Realizing the incentives of the regular houses, longs will bid
down the price of the expiring future relative to the deferred until the
spread compensates them for the storage charges. In other words, the
spot bids of a regular house should reflect the true marginal cost of
storage, while the futures price should reflect the fixed charge for
public storage. When the fixed charge exceeds the marginal cost, the
spot may exceed the future. Thus, a divergence between the bid and
the futures price sometimes results from storage charges that do not
reflect the marginal cost of grain storage. l5

Other factors can also cause a divergence between expiring
futures and spot prices. First, since the short can deliver at any time
in the delivery month, the futures price at any time prior to the last
trading day should equal the spot price minus the option to defer
delivery. By comparing the spot and futures prices within an entire
delivery month, we ignore this option. It will be most valuable in an
inverted market. Second, a grain merchandiser usually earns a posi-
tive spread-just as a market maker earns a bid-ask spread-
between his selling ("f.o.b.") price and his purchase price as
compensation for his specialized marketing resources. That spread
will vary as the demand for his services varies. He foregoes the
spread if he delivers, so he will not make a delivery unless the
futures price exceeds his spot bid by an amount in excess of the
spread he expects to earn. If the current spread is large, the futures
may exceed the spot by a considerable amount.
The effect of the spread that the merchandiser earns on the basis
is offset, to some extent, by the fact that a regular warehouseman
may earn a profit on load-out, elevation, trimming, blending and
ongoing storage on deliveries he initiates. When a long pays these
charges, the short receives them if the short is a warehouseman. If
the warehouseman's price for these services exceeds the marginal
cost of providing them, the difference contributes to his delivery
profit. Thus, the relevant opportunity cost to a warehouseman is the
sum of the bid price at which he buys the grain and the spread,
minus the net receipts received from load-out, elevation, etc.
The proxy for spot prices that we employ may differ from the true
spot prices due to the nature of data collection as well. Although the
U.S.D.A. attempts to survey the terminals around the end of futures
trading, and although some bids are basis bids, non-synchronous
data is a possibility. That is, spot bids and futures prices may not be
contemporaneous, which would be especially troubling when markets
are volatile.
We have taken such considerations into account in our conver-
gence analysis. In order to evaluate the effectiveness of convergence
for corn, soybeans, and wheat for each contract expiring from 1984
through 1989, we have determined how many times during the deliv-
ery month the futures settlement price is between the appropriate
low and high spot bid; between the low spot bid and the low spot bid
minus $.06/bu. (the cost of loading out the grain); less than the low
spot bid minus $.06/bu.; between the appropriate high spot bid and
the high spot bid plus $.06/bu.; and greater than the high spot bid
plus $.06/bu. This $.06 figure is a rough estimate of transactions

costs.
The "appropriate" low and high spot bids are defined as follows.
For soybeans, the appropriate low equals the Chicago low bid if it is
less than the Toledo low bid plus $.08/bu. (the Toledo delivery differ-
ential). Otherwise it equals the Toledo low bid plus $.08/bu.
Similarly, the appropriate high equals the Chicago high if it is less
than the Toledo high bid plus $.08/bu., and equals the Toledo high
plus $.08/bu. otherwise. Thus, the appropriate lowlhigh bid band
reflects the ability of shorts to deliver in either Toledo or Chicago.
For corn, the bands are identical except the delivery discount at
Toledo is $.04/bu. rather than $.08/bu., while for wheat it is $.02/bu.
If the true equilibrium spot price falls within the high/low bid
band, then we cannot reject the hypothesis that the futures and spot
prices have converged if the futures price falls within the band.
Failure to achieve convergence so defined can occur for any of several
reasons. First, transactions costs may limit the potential for arbi-
trage. We have chosen plus or minus $.06/bu. as reasonable esti-
mates of transactions costs. If futures prices fall within the· range
[low bid minus $.06, high bid plus $.06], which we call the "no-arbi-
trage" bounds, the futures price has converged as much as it can
through arbitrage. Second, the spot bids may not represent market
transaction prices. It is impossible to establish definitively whether
that accounts for non-convergence, but we argue below that it is a
likely explanation in certain instances. Third, futures prices may fall
outside the range [low bid minus $.06, high bid plus $.06] simply
because arbitrage does not occur.
Results for each contract for corn, soybeans, and wheat are pre-
sented in Tables 2-1, 2-2, and 2-3 respectively. Each table also pre-
sents summaries for each contract that aggregate across the entire
1984-89 period. The tables demonstrate that both the corn and soy-
bean futures prices almost always fall within the "no-arbitrage"
bands defined above. For corn, the delivery month futures price falls
within the no-arbitrage band for all but 44 of 423 days during deliv-
ery months. For soybeans, all but 55 of the 595 spot month futures
prices fall within the no-arbitrage band. For wheat, performance is
somewhat worse: 78 of 423 observations fall outside the bands. But
the tables also indicate that the futures price falls within the spot
low, spot high band less than 50 percent of the time for all three
crops. That is consistent with the notion that transactions costs pre-
vent complete arbitrage, and/or that the spot prices we use are
imperfect proxies for the value of grain in store. Ie
First consider the corn and soybean contracts. Taken as a whole,

the evidence in the tables indicates that the futures price almost
always converges to within +/-$.08/bu. of the spot price for both of
these commodities. 17 Moreover, an examination of the tables (and the
spot and futures data that underlie them) reveals that the apparent
violations of convergence are not random.
The most noticeable anomalies occurred during the summer of
1988. For soybeans, 36 of the 49 violations of the upper no-arbitrage
limit occurred during July, August, and September of 1988.
Similarly, 22 of the 43 violations of the corn upper no-arbitrage limit
occurred during July and September, 1988. The largest number of
violations in any other month is two for soybeans and five for corn,
and most months have either a single violation or none at all.
Given the relatively effective convergence during other months,
the behavior during mid-1988 seems puzzling. Closer examination of
the data coupled with an understanding of 1988 market dynamics
explains the unusual behavior, however. During that summer, stocks
on hand in deliverable locations were extremely high. Hence, it is
likely that the bids quoted by Chicago terminals were often below
market prices; those firms had little room to store additional grain,
and thus would have been relatively passive bidders. Consequently,
that the futures price remained well above Chicago bids throughout
the summer delivery months does not imply that convergence failed;
rather it indicates that the elevators were full and could not use
grain immediately. Operation at high capacity increased the mar-
ginal cost of storage, which drove a wedge between the value of grain
in store (Le., the value of a warehouse receipt) and the price ware-
housemen were willing to pay for more grain. Thus, these cash bids
are not an accurate proxy for the level of the cash market for grain in
store in these circumstances.
During July of 1988, grain and oilseeds in regular Chicago ware-
houses occupied 78.1 percent of the rated (nominal) capacity. The fig-
ure in Toledo was 80 percent (including a substantial quantity of
Commodity Credit Corporation [CCC] corn). Although the nominal
data make it seem that the Toledo warehouses were operating closer
to capacity than those in Chicago, the Chicago warehouses were actu-
ally near or at economic capacity, while the Toledo elevators still pos-
sessed extra usable storage space. IS Hence, the marginal cost of
storage in Chicago was very high, and thus the terminal operators
there were forced to reduce their bids for new supplies. 19
There is evidence to support such a conjecture. First, although
the Toledo soybean bids plus futures discount were as much as $.20
above Chicago bids, and the Toledo corn bids (adjusted for discounts)
were also well above Chicago corn bids, there were many deliveries in
Toledo. In July, 36 percent of all deliveries of soybeans occurred in
Toledo, while 43 percent occurred there in August, and 25 percent in
September. Twenty-three percent of July corn deliveries occurred in
Toledo. And the Toledo elevators received shipments from Iowa,
which almost never occurs. Most such shipments travel right through
Chicago on their way to Toledo, and almost certainly would have
stopped had storage space been available.
Significantly, in those months the deliveries of both corn and soy-
beans were sizable relative to other contracts in the 1984-89 period.
The regression analysis presented in Chapter 3 of the total number of
deliveries confirms that deliveries in that period were significantly
larger than one would expect, given the season and the stocks on
hand at the beginning of the month. A similar regression indicates
that Toledo corn and soybean deliveries were also unusually large
during the summer of 1988.
Large deliveries in Toledo on futures contracts, despite bids there
that were far in excess of those in Chicago, are consistent with the
hypothesis that the futures price was above the Toledo spot price.
That again implies that Chicago warehouses had cut their spot bids
due to the lack of space. .
A comparison of the futures prices in the July-September deliv-
ery months with the Toledo spot prices (adjusted for discounts) fur-
ther bolsters the conclusion that Chicago bids were below the spot
market price. For July 1988 soybeans, the futures price is in the
range [Toledo low bid +$.08/bu., Toledo high bid +.$.08/bu.J on eight
out of 13 days, and within $.06/bu. of that range on all but two of the
13 delivery days. As the delivery data suggests, the futures price
exceeded the adjusted spot prices + $.06/bu. on the two exceptional
days, making delivery profitable. For August and September soy-
beans, the futures price fell within the no-arbitrage bands for Toledo
for each day eligible for delivery. The story is much the same for July
and September corn, where the futures price converged to the Toledo
price, even though that was above the Chicago price. That also sug-
gests that the Chicago warehouses had cut their spot bids due to
inability to handle more grain efficiently.20
The foregoing analysis suggests that the apparent violations of
convergence that were evident in 1988 for corn and soybeans were
not real. Toledo had simply become cheaper to deliver in an economic
sense due to space constraints in Chicago. On the one hand, that rep-
resents the efficient operation of the Board's "safety valve" delivery
philosophy;21 additional capacity came on line when it was exhausted

in the par delivery location. Consequently, the soybean futures price
was distorted by no more than the $.08/bu. Toledo differential (while
the prevailing spot price was between $8.00/bu. and $9.00/bu.), while
the corn futures price was distorted by no more than $.04/bu. On the
other hand, one might argue that such a distortion meant that there
was too little capacity in Chicago.
Given that the space shortage may well have been artificial (see
footnote 19), and that the events were evidently unusual, the latter
argument is suspect. The anomaly during the summer of 1988 was
the full elevators. If full elevators were common, the operators would
have an incentive to expand capacity. But the elevators are seldom
full, so the benefits of expanding capacity merely to avoid a repeat of
the 1988 episode are surely less than the costs of such an expansion.
The cost of adding capacity is high, while the costs of a space short-
age in Chicago alone are bounded by the Toledo differential. Such a
shortage is rare, and a simultaneous shortage in Chicago and Toledo
is even more remote. The elevators bear the costs of both a capacity
shortage and any expansion that may be made to avoid the shortage;
they are in the best position to make capacity decisions. 22
The other apparent violations of convergence for corn and soy-
beans seen in the tables may also be spurious. Twelve of the viola-
tions of the no-arbitrage bands for soybeans occurred on the last day
of trading. Moreover, 10 of the 12 futures prices were too high; i.e.,
the violations were not symmetric. Five of the corn violations
occurred on the last trading day, and may well have occurred in the
closing minutes of trading, or when volume in the expiring option
was very small, and consequently there was no time for arbitrage.
There are several reasons to expect more violations on the last
trading day. First, trading in the expiring future ends at 12:00 noon
of the last trading day in the delivery month (with a one-minute call
auction following this hour), while the U.S.D.A. price surveys
attempt to gather prices synchronous with the 1: 15 p.m. trading
close. That could cause artificial violations of convergence, but its
importance is probably slight. The violations appear too large (rela-
tive to the volatility of grain prices) to be due to a one-hour mis-
match, and they should be symmetric if a mismatch were the
problem.
More likely explanations of the preponderance of violations on
the delivery month's last trading day are that the market is rela-
tively thin (i.e., volume is low) at that time, and that traders must
make or take delivery if they do not liquidate. Thin markets are ordi-
narily more volatile markets. Perhaps more importantly, many

shorts find it very costly to make delivery, and are willing to pay a
premium to liquidate their contracts. That would account for the pre-
ponderance of high futures prices on the last trading day.
The last major source of potentially spurious violations is market
volatility. In July 1984 corn, July 1986 corn, and January 1989 soy-
beans, the violations of the no-arbitrage bounds occurred on days
when either the spot or the futures price moved dramatically. If the
spot bids and futures settlement are non-synchronous, large price
movements could lead to spurious violations. Moreover, futures
prices are determined in an auction market, but spot bids are not,
and consequently may be "stickier," adjusting less rapidly to changes
in information concerning supply and demand than do futures prices.
In summary, even assuming that the apparent violations in the
no-arbitrage bounds represent real failures of arbitrage to drive spot
and futures prices together, the data from 1984-89 indicate that corn
and soybean futures prices effectively converged to the relevant spot
prices the vast majority of the time during that period. Moreover,
several of the violations recorded may be spurious. Thus, the delivery
process has performed effectively for these commodities during the
six years of our sample period.
The results for wheat are somewhat different. Here 78 of the 423
observations fell outside the $.06/bu. range. Moreover, the distribu-
tion of these violations is not symmetric: in 71 of the observations the
futures price exceeded the CTD high spot by more than $.06. These
violations were rare in 1984, 1985, and 1989, but were fairly common
in 1986-1988. Finally, they were most prevalent in the September
contracts: 32 of the 80 futures prices in September from 1984-1989
were "too high" by the $.06 standard.
The consistency of these violations suggests that there is some
systematic factor that causes higher spreads between spot month
futures and spot bids for wheat than for corn and soybeans. In partic-
ular, the behavior of the basis in September across years, and in 1988
across months, suggests that the shadow price of storage increases
the spread between spot futures and cash bids.
The higher frequency of September violations suggests that regu-
lar operators reduce wheat bids in that month in anticipation of the
harvest of corn and soybeans. That is, since 1) the value of storage
space for corn and soybeans increases around the time of the new
crop; 2) wheat competes for space with corn and soybeans; and 3)
warehousemen want to avoid handling three commodities simultane-
ously, they cut their wheat bids to ensure the availability of space for
these crops.
The prevalence of violations in 1988 may also reflect the effects of
the marginal cost of storage on futures-spot differences. As noted
above, storage space constraints were acute in 1988. During the sum-
mer months, elevators cut their bids on corn and beans to reflect the
high marginal cost of storage. A similar phenomenon occurred for
wheat.
Although these factors explain a large fraction of the arbitrage
violations for wheat, they do not explain all of them. Moreover, stor-
age space constraints appear to affect wheat more dramatically than
corn and soybeans. There is, for instance, no new wheat new crop
effect evident in the corn and soybean bases in May. Thus, it appears
that even though regular houses cut wheat bids to ensure they have
free storage space for incoming corn and soybeans, they do not simi-
larly cut bids on these commodities to free space for wheat.
The evidence suggests that wheat is a marginal commodity in
Chicago and Toledo. This statement is bolstered by the evidence pre-
sented in Table 2-4. The table gives the mean difference between
cash (measured as the average of the high and low cheapest-to-
deliver ["CTD"]) and futures for each commodity during the delivery
month, and the daily standard deviation of these differences (in
parentheses). An examination of the mean differences reveals that
the spot-futures difference is significantly larger (in absolute value)
for wheat than for corn or soybeans. Indeed, across all months and all
years, the wheat difference is slightly less than twice that for corn,
and slightly more than twice that for beans. 23
One can interpret this spot month basis as a bid-ask spread: the
regular elevators can be thought of as bidding for grain in the spot
market and offering it in the futures market. Since shorts can
deliver, if convergence of futures and spot selling prices occurs the
futures price equals the marginal sales price of a warehouse receipt,
while the bid equals the marginal price warehousemen are willing to
pay for grain. The average difference between the (selling) futures
price and the (buying) spot price, therefore, is the return that regular
elevators earn for their market-making services. Indeed, when load-
out and other regular warehouse revenues are added to the futures
price, these differences are negative for all grains for all months,
which suggests that these future-spot differences represent a bid-ask
spread.
The fact that wheat spreads are consistently wider implies that
the cash market makers-the regular warehouses-demand greater
compensation to make markets in wheat than in corn :md beans.
Since a larger spread is indicative of a less liquid market, this sug-

gests that the wheat market in Chicago and Toledo is far thinner
than that for corn or beans. This evidence bolsters the statement
made above that the wheat cash markets are marginal-relative to
corn and beans-in CBT wheat delivery locations. Given the pattern
of grain production, this result is not surprising. Nonetheless, it sug-
gests that the CBT wheat contract delivery specification is less viable
than that for corn and beans.
Although bid-ask spreads are wider for wheat than for corn and
beans, the standard deviation of the delivery month bases is not radi-
cally greater for wheat. This suggests that wheat converges as well
as the other commodities, but that it systematically converges to a
price that exceeds cash bids by a systematically larger margin.
In sum, we find that cash and futures grain prices consistently
converged in the 1984-1989 period for the CBT grain and oilseed
futures contracts. The data also indicate that Chicago and Toledo are
(relative to corn and beans) marginal cash wheat markets.
Given this analysis of price behavior within the delivery month,
we now examine basis behavior outside it. We then turn to an analy-
sis of the delivery process's future prospects, and potential changes to
it.
Basis Patterns Prior to the Delivery Month

The foregoing section demonstrated that corn and soybeans
futures prices do converge within the delivery month. In this section
we evaluate convergence outside the delivery month. In other words,
we examine the evolution of the basis over a contract's life. The
analysis is not directly relevant to the delivery process per se.
Delivery has a direct and immediate influence on the relation
between futures and spot prices only in the delivery month. Prior to
this time the interplay of factors is much more complex (due to the
complexity of the factors that determine the "rental" or "convenience"
value of grain) and is much less dominated by the effects of the
potential for delivery. To fully evaluate the performance of the
futures market, however, it is important to understand futures price
behavior prior to contract expiration.
We rely upon several figures to analyze the path of the spot-
futures basis. Each figure graphs the evolution of the basis of a par-
ticular contract month for each year 1984-89. For instance, the figure
labelled "SOYBEAN BASIS: Contracts for September Delivery by
Year" plots the basis for each of the six September soybean contracts
expiring in the 1984-89 period against the time remaining until the
last trading day. Basis is defined as the difference between the

futures price and the CTD spot price, where the CTD spot price
equals the minimum of the Chicago price, and the Toledo price plus
appropriate discounts. In the interest of brevity, we present charts
only for the March and September soybean and corn contracts, and
the March and July wheat contracts.
An examination of the figures reveals several salient features.
The most striking is that for both soybeans and corn the behavior of
the basis is notably different late in the crop year (in September or
July) than early in the crop year (in March). For soybeans, corn, and
wheat, consider the charts for March contracts. For each year, and
for each of those months, the basis was relatively stable; similar
results hold for November, January, and May soybeans, December
and May corn, and September and December wheat. Moreover, there
is little variation in the basis across years. In contrast the September
soybean and corn basis and the July wheat basis are extremely
volatile both within and across years; similar results are obtained for
July and August soybeans, July corn and May wheat.
The diverse pattern of basis volatility within and across contracts
is not surprising given the seasonal nature of grain production.
Nonetheless, it provides very important information about contract
performance. In particular, the rather sedate behavior of the basis
prior to the summer month contracts demonstrates that the futures
contracts are not inherently volatile. One would rightly harbor suspi-
cions about the rationality of the market if the basis were wildly
volatile throughout the year. The smooth convergence in the winter
and spring contracts in comparison with the variable summer month
behavior is consistent, however, with the notion that futures prices
respond to fundamental economic conditions, rather than speculative
excess.
That convergence tends to take place from below for contracts
expiring in the late fall, winter, and spring, but frequently takes
place from above in the contracts expiring in the summer bolsters the
conclusion that the futures-spot price relationship responds to funda-
mental economic considerations. That is, markets are frequently
inverted late in the crop year, but are seldom so early in the crop
year. Since the analysis does not take into account the time value of
money, or the cost of storage, the data are insufficient for an infer-
ence that futures were at full carrying charges. However, they do
show that more carrying charges were embedded in the futures price
earlier in the crop year. Again, that comports with an understanding
of the evolution of supply and demand over the crop year.
An examination of the spot and futures data underlying the fig-

ures is also illuminating, especially insofar as the summer contracts
are concerned. First, the "spikes" or reversals in the basis--especially
for contracts expiring in 198B-are due to limit price moves. Second,
there are sometimes dramatic decreases in the basis, as happened
with the September 1986 soybean futures contract about 20 days
prior to the end of trading, or the September 1984, 1985, and 1986
corn contracts about 50 to 60 days prior to the end of trading.
Moreover, the declines appear to be associated with substantial
moves in the spot price, rather than the futures price. Interestingly,
each episode occurs on approximately the date at which the preced-
ing futures contract ceased trading. For instance, the September
1984 corn basis dropped substantially due to a precipitous decline in
terminal spot bid prices for corn on the day that the July 1984 corn
futures contract ceased trading.
The four discontinuities are problematic: Why was corn on July
19, 1984, much more valuable than corn on July 20, 1984, for
instance? The data provide several clues to the answer of this ques-
tion. First, the large moves in the basis were due to a large move in
the Chicago spot bids while the deferred futures prices remained rel-
atively stable. No such move occurred in the spot bids at Toledo, St.
Louis, the Gulf, or elsewhere. Second, stocks were low during the
months in question. Third, the market was strongly inverted, which
is also indicative of low deliverable stocks. Fourth, processor bids did
not experience a similar, discontinuous decline around the expiration
of the July contracts. Chicago processor bids declined rapidly, but
continuously, over the July-September period for each of the three
years in question. Moreover, the bids declined to approximately equal
the spot future in September of each year. The pattern is similar to
that observed for Toledo, Central Illinois, and St. Louis bids over the
same period. The decline is consistent with the inverted markets
then in evidence. That the decline is continuous for processor bids in
Chicago, and processor and terminal bids elsewhere, is reflective of
an orderly convergence of an inverted market into the delivery
month. Such orderly behavior stands in stark contrast with the pre-
cipitous declines in Chicago elevator bids.
Together this evidence is indicative of a squeeze or congestion in
Chicago. Primarily as a result of government programs to support
prices (e.g., the payment-in-kind or "PIK" program), deliverable sup-
plies were short. This scarcity put upward pressure on the July
futures price. The data suggest that regular warehousemen increased
their spot bids in an attempt to attract additional supplies to
Chicago, in order to satisfy a demand for delivery that could have

seriously outstripped the supplies on hand. Once the contracts
expired and the pressure on the small deliverable stock relieved, the
warehousemen reduced their bids. This reasoning explains the pre-
cipitous nature of the price declines, and why they were confined to
Chicago regular warehouse bids: the price changes were driven by
the delivery process.
Taken together with the evidence of the preceding section, the
charts indicate a well-functioning market, although the four episodes
discussed above suggest one potential source of vulnerability.
Futures and spot prices converge into the delivery month, indicating
good performance of the delivery process in achieving its primary
objective, while the path to convergence outside the delivery month is
systematically related to seasonal factors that directly affect supply
and demand relationships. The only potential sources of concern here
are the four congestive events. These events indicate that the futures
price sometimes may converge to an imperfectly representative spot
price when deliverable supplies are short. This issue is discussed in
great detail in Chapter 4.
The Evolution of Grain Spot Trading Pattems and the Del/very Process:
Relative Price Variability and Convergence Issues
The previous analysis indicates that futures and spot prices
at delivery points have converged effectively over the past half-
decade. Although this is an important indication of a well-functioning
market, this evidence is not sufficient to conclude that the existing
delivery specification with delivery at Chicago and Toledo is optimal.
As noted earlier, in markets where transportation costs are impor-
tant-and given the low value to bulk ratio of wheat, soybeans, corn,
and oats, this certainly characterizes grain markets-relative spot
prices between commercially important locations may vary signifi-
cantly due to idiosyncratic variations in local supply and demand
conditions. This is due to the fact that transportation costs isolate
markets, and make arbitrage between them costly. Prices in these
markets consequently can vary idiosyncratically. Thus, even if con-
vergence occurs between the futures price and the price of spot grain
in the delivery market, hedgers will necessarily bear some basis risk
due to this relative price volatility.
The spatial distribution of demand may affect the severity of this
relative price volatility in very complicated ways. It certainly affects
the size of the population of hedgers who must bear it. Significantly,
this pattern has changed considerably in grain markets over the last
several decades. The primary effect of this change has been to reduce
the relative importance of Chicago, Toledo, and other Great Lakes
and East Coast markets. These markets have been supplanted by the
Mississippi River-Gulf of Mexico axis as the prime locus of grain
trading in the United States. This evolution is primarily the result of
changed demand patterns among grain-importing nations. Far
Eastern importers have grown in importance relative to European
and Mediterranean countries, and the Gulf serves Asian markets
more efficiently than the Great Lakes or East Coast.
For at least the 80 years of grain futures trading, Chicago was
the hub of the grain trade. As a result, the Great Lakes and the rail-
roads running east from the city were the major transportation
routes for grain for export and processing. This phenomenon was
largely due to the nature of transportation cost and the distribution
of consumption and production regions. Demand was concentrated in
the East, while production was concentrated in the Midwest.
Efficient transport required the consolidation of shipments from west
to east through central hubs. Terminal markets radiated railroads
into the growing regions, attracted shipments of grain from the coun-
try, and consolidated their flow via rail or lake steamer to consuming
regions either in bulk or as refined products (e.g., flour).
Europe's decline as an importer of grain, the development of very
large Soviet purchases and the rise of the Far East as a major
importer has dramatically altered this pattern of trade. The
Mississippi, rather than the Lakes, the railroads, and the Eastern
ports, is now the most important export route because while the
Lakes and the East Coast were frequently low-cost sources of grain
shipped to Europe, they are not the low-cost transportation points to
the Far East. The decline of exports to Europe and the increase to the
Far East has thus tended to reduce the importance of the Lakes as
export markets. This tendency has been exacerbated because the
Lake facilities cannot handle very large cargoes due to the restric-
tions on ship size imposed by the dimensions of the St. Lawrence sea-
way. Both of these factors have contributed to the relative growth of
the Gulf market. Grain processing facilities are no longer concen-
trated, moreover, in the terminal markets.
These changes are reflected in the marked decline in receipts of
grain (especially relative to total United States output) at primary
markets and in Chicago over the past 35 years. These results are
reported in Tables 2-5 and 2-6. The tables illustrate that shipments
to terminal markets in general, and to Chicago in particular, have
declined both absolutely and as a fraction of total grain production.
Both measures reflect the redirection of grain flows away from

Chicago.
These changes are potentially troubling for five reasons. First,
they affect the number of hedgers (relative to the total population
thereof) that must bear basis risk. Second, they may affect the vari-
ability of relative prices between the delivery market and other com-
mercially important markets; i.e., they may affect the level of basis
risk. Third, these changes can affect the liquidity of the Chicago and
Toledo cash grain markets, which can also affect basis risk. Fourth, a
continuation of these developments may increase the transactions
costs of arbitraging futures markets, which would make convergence
more tenuous in the future. Fifth, the decline in the Chicago market
makes it more vulnerable to long manipulation. We examine the first
four effects here; we defer our discussion of manipulation to Chapter
4.
An analysis of these five factors makes it clear that the effects of
this evolution of trading patterns on the magnitude of basis risk are
mixed. Some of these factors have tended to reduce basis risk, some
have tended to increase them.24 With respect to the desirability of
maintaining the existing grain and oilseed delivery points, however,
it is clear that the factors that have tended to reduce basis risk would
also benefit other, alternative delivery points. That is, the basis risk
reducing effects of the evolution in the grain trade are not specific to
Chicago and Toledo, but benefit other potential delivery points as
well. The negative aspects of the decline of the Chicago and Toledo
markets, however, tend to be peculiar to those points. Thus, the net
impact of this evolution upon the desirability of the Chicago-Toledo
delivery nexus has been decidedly negative.
We now analyze each factor in turn. The effect of the first one,
the number of hedgers who must bear basis risk, is unambiguous. As
noted earlier, when demand, supply, and transport costs are imper-
fectly correlated across locations, grain prices vary markedly and
unpredictably among different geographically separated markets. 25
Thus, prices in Chicago are not perfectly correlated with those in the
Gulf, or in Central Iowa. This imperfect correlation implies that
hedgers in regions that are not tributary to Chicago must bear basis
risk.
Given the level of basis risk, the smaller the fraction of grain
transactions executed in the delivery market or in markets tributary
thereto (and where prices thus differ from those in the delivery mar-
ket by the cost of transport), the larger the fraction of grain transac-
tions subject to this risk. That is, as the delivery market declines in
relative size, so that a smaller percentage of transactions occur there,

a larger fraction of hedgers must bear basis risk.
This factor makes the decline in the delivery market, as mea-
sured by receipts of grain there, a matter of some concern. It is clear
that the effect of the decline of the Chicago and Toledo markets has
been to increase the number of transactions executed outside of these
markets and their tributaries; the decline in the fraction of grain
shipped through terminal markets (let alone the decline in the
absolute quantity) is strong evidence of this change. In fact, a far
larger number of transactions now occur in areas tributary to the
Mississippi River and Gulf trades. Thus, the number of transactions
affected by basis risk could be reduced by connecting the futures
price to the prices in these markets; i.e., by allowing delivery at some
point(s) on the Mississippi River-Gulf of Mexico axis.
In addition to affecting the number of hedgers bearing basis risk,
the shift in trading patterns can also affect the level of this risk
hedgers bear. The fundamental intuition behind this result is
straightforward. Prices in two markets must move in tandem if ship-
ments flow from one market to the other. Thus, in the heyday of the
Chicago terminal market, when the vast majority of grain produced
in Illinois and Iowa (and elsewhere) moved through Chicago, prices
in the country in these states could only differ from the Chicago price
by the cost of transport from the country to the terminal. Prices in
two markets can move idiosyncratically, however, when there are no
commodity movements between them, if demand shocks in the mar-
kets are less than perfectly correlated. These idiosyncrasies create
basis risk when one of the locations is a futures delivery point. A
change in commodity flows-such as the decline of the Great
Lakes/Chicago region as a major transshipping point and the con-
comitant rise of the Gulf-therefore may affect price relations dra-
matically, and consequently increase or decrease the amount of risk
hedgers away from delivery points (i.e., "out-of-position" hedgers)
must bear.
Although this basic intuition is straightforward, Pirrong (1991)
shows that the specific effects of a shift in commodity flows on the
level of basis risk are quite complicated. In the context of a simple
spatial model with two consumption locations and a continuum of
production points, that paper demonstrates that idiosyncratic price
movements can occur in response to idiosyncratic demand move-
ments at the consumption locations, supply shocks, or transportation
cost shocks. The variability of these idiosyncratic price movements-
i.e., the variability of the basis--<lepends upon production levels, the
level and price sensitivity of demand curves, the level of transport

costs, the variability of the various supply, demand, and transport
cost shocks, and the covariances between them. The sensitivity of
basis risk to a change in any single parameter is complex. Although
it is true that increasing the variability of supply, demand, or trans-
port cost shocks increases the variability of the basis, changes in any
other parameter can either increase or decrease this variability
depending upon the levels of the other parameters. In general it is
impossible to determine the effect of changing a single parameter on
the variability of relative price movements without knowing all of the
parameters. Thus, a change in the elasticity of demand at one con-
sumption point may increase variability under One set of supply,
demand, and transport conditions, and decrease it under another set
of conditions.
Supply, demand, and transport cost changes have certainly
caused the change in commodity flows reflected in Tables 2-5 and 2-
6. Even if one could identify in broad terms the basic changes in the
relevant parameters that caused this shift, it is difficult to determine
a priori whether the decline in the Chicago/Toledo market has
increased or decreased the amount of risk hedgers away from the
delivery the market must bear. This is true because very precise
knowledge of the various parameters through time is required to
determine the evolution of basis risk. This implies that the net effect
of the evolution of spot market trading patterns and the associated
decline in the Chicago terminal market is ambiguous. A complex
relation between demand, supply, and transport cost conditions and
the variability of these conditions determines both the size of mar-
kets and the risk hedgers in markets not tributary to Chicago must
bear. These factors often have contradictory effects. Put simply, one
cannot infer that a particular out-of-position hedger bears more basis
risk because the market at a delivery point has declined. The hedging
performance he obtains from the futures contract could actually
improve under certain conditions.
It is important to note, however, that regardless of the net effect
of these changes on relative price variability, the impact is largely
independent of where delivery can take place. That is, given the vari-
ability in relative prices between two points, the level of basis risk in
a futures contract is independent of which of the two points is the
delivery point. If, for example, the net effect of the changes in trans-
port costs and demand distribution has been to reduce the variability
of the price in St. Louis relative to the price in Chicago, basis risk in
St. Louis when Chicago is the delivery point exactly equals basis risk
in Chicago when St. Louis is the delivery point. What changes is the
identity of the hedgers that bear the risk: when St. Louis is the deliv-
ery point hedgers in Chicago and environs bear the risk, while
hedgers in St. Louis and areas tributary bear it when Chicago is the
delivery point. Thus, it is quite possible that due to the evolution of
grain trading a larger number of traders are bearing smaller basis
risks than was the case prior to the development of the Mississippi-
Gulf axis; changing delivery points could, however, lead to a smaller
number of hedgers bearing this same, smaller basis risk.
Other effects of the changed trading patterns are more worri-
some. The decline in the "thickness" of cash trading in Chicago, for
instance, would tend to reduce the liquidity of that market. A reduc-
tion in liquidity, in turn, would tend to increase basis risk.
Essentially, a liquid market is one in which large orders to buy or sell
have a limited impact on prices. An illiquid market, on the other
hand, is one in which even relatively small purchases or sales of the
commodity can have a relatively large effect on prices. Thus, given
the variability in fundamentals (i.e., the variability of supply and
demand conditions), cash prices will be more volatile in an illiquid
market than a liquid one. Thus, basis risk will be larger in a less liq-
uid delivery market.
The volume of cash trading is an important determinant of cash
market liquidity. The larger the number of buyers and sellers inter-
acting in a market, the lower the cost of providing liquidity to that
market. As a market declines, and the thickness of the order flow
falls, the cost of liquidity increases. As a result the amount of liquid-
ity supplied falls and basis risk rises.
Grain merchants and regular elevator operators-such as
Cargill, Continental, Anderson's, and the Indiana Farm Bureau-are
the main suppliers of liquidity in grain markets. Ceteris paribus, the
decline in the Lakes market has increased the costs these market
participants must bear to supply this liquidity. Since liquidity suppli-
ers smooth demand shocks by buying for and selling from inventory,
supplying liquidity requires the holding of inventories of grain. The
growing isolation of Chicago and Toledo would tend, however, to
make the opportunity cost of holding such inventories there rela-
tively high. Conversely, the growth in the thickness of trading at
other points would tend to increase liquidity there. Thus, the liquid-
ity effect of the changed trading patterns makes Chicago and Toledo
less desirable delivery points while it makes Mississippi River-Gulf
points more desirable.
There has clearly been a decline in liquidity in the Chicago mar-
ket, and it is in large part an adverse consequence of the volume of

transactions in the market. The liquidity decline may also result in
part from a concentration of the cash market into fewer hands and
the fact that warehouse receipts are thus handled by fewer people.
There is another, somewhat related concern. The major grain
merchants operating regular warehouses are also the primary guar-
antors of convergence because they are the low cost arbitrageurs of
the futures market. As warehouse operators, they can originate
warehouse receipts for delivery. Moreover, they are engaged in
futures and spot market transactions on an ongoing basis, and conse-
quently incur relatively low transactions costs to buy or sell grain as
part of an arbitrage program.
In order to carry out this function, however, it is necessary that
they retain storage facilities and engage in merchandising activities
in the delivery market. The profitability of doing so, however, is
adversely affected by the decline of Chicago and Toledo as grain mar-
kets. It is possible that the benefits of retaining such facilities in
Chicago and Toledo will decline to the point that some firms may exit
the market. Such exit has not yet occurred, but it is a distinct possi-
bility given the decline in cash grain trading in Chicago and Toledo,
the aging of some of the facilities, and the increase in the opportunity
costs of keeping them open. 26 Such exit would adversely affect conver-
gence, and the liquidity of the Chicago cash market as well.
Taken together, these various effects of the dramatic change in
grain trading patterns on the viability of Chicago and Toledo as
delivery points are quite complex. Given the improved efficiencies in
transportation and the relationships between market demand elas-
ticities and basis risk, it is quite possible that this risk has actually
fallen even as these markets have declined.
Even if this is the case, however, this would not imply that reten-
tion of the existing delivery mechanism is optimal because the major
factors tending to reduce basis risk, namely the reduction in trans-
portation costs, would reduce basis risk for any delivery specification
while the factors that increase basis risk or the size of the population
bearing it are peculiar to Chicago and Toledo. Reduced transporta-
tion costs, for example, reduce relative price variability regardless of
whether Chicago or St. Louis is the primary delivery point. Such
changes in the general economic environment redound to the benefit
of any or all delivery points.
When determining the optimal delivery specification, then,
one must consider the advantages and disadvantages peculiar to par-
ticular delivery points. When one does so, it is apparent that the rela-
tive decline in cash markets at the existing delivery points, Chicago

and Toledo, has reduced the benefits of retaining these as the exclu-
sive sites of grain futures deliveries. The reduction in the number of
grain transactions in these markets and their tributary supply areas
relative to those in other markets, the reduction in market liquidity
in Chicago and Toledo relative to other markets, and the potential for
reduced future commercial participation in these markets all reduce
the viability of Chicago and Toledo as delivery markets relative to
alternative delivery points.
These considerations suggest that Chicago and Toledo are cur-
rently less desirable delivery points for Chicago Board of Trade grain
contracts than was once the case. When grain futures trading began,
and for a good time afterwards, Chicago was undeniably the only
plausible delivery market. That is no longer true. Given the change
in grain market trading patterns, it is plausible that a change in the
delivery specification that reflects these new patterns may improve
hedging performance. See Chapter 5 for a thorough theoretical and
empirical analysis of this matter.
It is easier to diagnose the source of potential problems with the
existing system, however, than it is to devise an alternative frame-
work. Any such alternative should, of course, attempt to ensure a
strong linkage between delivery market prices and spot prices in
other markets to reduce relative price variability; i.e., basis risk, and
the number of hedgers who bear it. Moreover, a delivery market
should also be relatively immune from manipulation, and have
enough storage space and sufficient access to efficient transportation
to allow effective arbitrage. The choices available to the CBT to
achieve these objective are constrained, however, by other factors.
We now briefly analyze three basic changes to the delivery sys-
tem. The consideration of many relevant issues requires development
of additional analytical material, so the discussions of these issues
presented in this chapter are relatively brief and focus upon the
effects of these changes on basis risk. We reexamine some of these
alternatives in more detail in subsequent chapters, following the
development of the required analysis.
We consider three primary alternatives to the existing system: 1)
the replacement of the current delivery points with others, and/or the
addition of new delivery points; 2) the creation of new delivery mech-
anisms corresponding to existing cash market practices; and 3) a
replacement of delivery altogether with a cash settlement mecha-
nism. We consider each point in turn.
Changing or Adding Delivery Points

The first alternative available to the CBT is to retain the current
delivery procedure, i.e., delivery via the transfer of a warehouse
receipt, but either to add new delivery points to the existing set or to
replace these with new ones.
Consider first the latter change. Any new delivery points should
have sufficient storage space, access to multiple transportation
modes, and a close connection with the existing pattern of cash trad-
ing. Unfortunately, no single delivery point (or even pairs of points)
dominates the existing Toledo and Chicago delivery points in each of
these dimensions. Storage and transport facilities amenable to the
existing delivery system are most well-developed at terminal mar-
kets. Despite the decline of Chicago and Toledo, however, they are
still the largest such markets by a large margin. Table 2-7 demon-
strates that Chicago and Toledo receipts account for a large fraction
of all terminal market receipts for corn and soybeans. During the
1984-1989 period, on average 71.2 percent of corn and 78.1 percent of
soybeans shipped to terminal markets went to Chicago or Toledo.
Only approximately a quarter of shipments went to the remaining
terminal markets of Duluth, Indianapolis, Kansas City, Milwaukee,
Minneapolis, Omaha, Peoria, St. Louis, St. Joseph, Sioux City or
Wichita. Thus, for these commodities, the designation of a new pri-
mary delivery point would not strengthen-and might in fact
weaken-the delivery mechanism.
Adding one or more additional delivery points to the existing set,
however, could improve cash-futures price linkages and futures mar-
ket performance while ensuring access to sufficient quantities of stor-
age and transport. We consider this issue so important that we
devote a separate chapter-Chapter 5-to an empirical analysis of
the effects on futures price performance of adding a new delivery
point. We find that adding even a single delivery point which is
directly astride the primary grain transport route and located in the
middle of large growing and processing regions-St. Louis-would
improve the contract price performance of corn and soybeans consid-
erably under certain conditions. Moreover, this change would
improve the deterrence of long manipulation. As we discuss in
Chapter 5, the major drawbacks to such a change would be that it
may increase the cost of arbitraging the futures and spot markets,
and alter the balance of power between short and long traders.
A Delivery Mechanism Tied to Current Commodity Rows

The second alternative means of addressing the effects of changes
in the nature of spot markets is to devise a completely different deliv-

ery mechanism that exploits the current nature of corn, soybean, and
wheat trade flows. A contract that requires delivery via a shipping
certificate, for instance, would connect the grain futures market to
the substantial export trade conducted along the Mississippi River
and its tributaries. 27 Under such a system, grain elevators that load-
out vessels or barges for shipment would issue claims against their
throughput capacity in the form of a shipping certificate. The owner
of such a certificate could tender it to the issuing elevator, present a
vessel or barge to be loaded, and receive grain into his vessellbarge
from the elevator in an amount specified by the receipt.
The primary reason for using a shipping certificate is that,
although substantial quantities of grain pass through river terminal
facilities, storage capacity at elevators there is limited and expensive.
River elevators specialize in shifting large quantities of grain from
one transportation medium (e.g., trucks or trains) to another (e.g.,
ships or barges). They maintain just enough storage space to carry
out such transfers efficiently. Storing grain for long periods in such a
facility reduces its throughput capacity, and thus its efficiency.
Consequently, storage in such locations is very expensive. Shipping
certificates, in contrast, would serve as a claim upon an elevator's rel-
evant capacity-its throughput rather than storage capacity.
This mechanism mimics important current cash market prac-
tices, just as delivery via warehouse receipt reflected the cash market
practices that prevailed during the development of, and much of the
history of, the CBT grain futures markets. The major design issues
concerning this delivery system are contract size and delivery point
location. Most throughput elevator transactions on the river north of
the Gulf ports are in barge size (50,000 bushel) and multi-barge lots,
while in the Gulf ports vessel size (1,200,000-2,000,000 bushel) lots
are typical. Although it would facilitate delivery to match contract
size to shipment size, this creates some problems. In particular, it
exacerbates the indivisibility problem inherent in futures contracts.
Larger contracts make it more difficult to match the size of futures
positions to the size of the cash position to be hedged. Larger con-
tracts also drive out small, marginal traders due to the larger dollar
risk for a given per-bushel price move. This factor also makes it cost-
lier to scalp futures. These considerations conspire to reduce liquid-
ity, and may be of considerable importance. In fact, some contracts
(notably the COMEX silver and CBT gold futures) have suffered in
the past due to the choice of an inappropriate contract size. 28
While small contracts avoid these liquidity-related problems,
they make it costlier to arrange for delivery, particularly (as must

certainly be the case) if several elevators are eligible for delivery. A
long faces the risk of receiving too few receipts at one location, and
thus either eschewing taking delivery or paying the added costs of
taking partial shipments at several elevators. These problems exist
to some degree in the current warehouse receipt system as well, and
if it becomes sufficiently acute this would create a niche for brokers
of the shipping receipts who could facilitate the transfer of the
receipts among longs to ensure a more efficient distribution thereof.
Such brokerage is costly, however, and may take time. This delay
imposes additional expenses if longs incur storage, particularly if the
storage rate reflects the high cost of storage at throughput facilities.
Delay can also force the long to incur demurrage expenses. It is possi-
ble, moreover, that shorts could exploit these costs in order to induce
longs to liquidate at favorable prices rather than pay the costs of tak-
ing possibly inefficient deliveries. 29
These problems would be most acute in the Gulf ports where ves-
sel-sized lots are common and thus the mismatch problem is likely to
be severe. They would be less acute upriver, although to the extent
that loading several barges simultaneously at a single location is effi-
cient it would impair the efficiency of the delivery process there as
well. These factors could also create difficulties if the facilities eligi-
ble for delivery are widely dispersed.
Given the radical nature of the change in the delivery process
this change in the specification implies, and the possibility that a
more modest change, such as the addition of St. Louis as a delivery
point, would offer some of the same pricing benefits, it is premature
to contemplate an immediate shift to such a system. If the more mod-
est measures do not achieve the desired benefits, however, this speci-
fication should receive serious consideration, particularly if it is
possible to design or administer the shipping receipt futures contract
so as to address the potential difficulties noted above. In addition to
offering pricing benefits, the analysis in Chapter 4 implies that it
would reduce the susceptibility of grain futures to long manipulation.
We note in Chapters 4 and 5, moreover, that the provision for
delivery at throughput facilities in and around St. Louis at a discount
(from the St. Louis price) or on an emergency basis could address
some of the problems implicit in adding that city as a delivery point
with a warehouse receipt delivery mechanism. Thus, in the context of
a multiple delivery point system the adoption of delivery via shipping
receipt can complement delivery via warehouse receipt rather than
serve as a substitute for it.
Cash Settlement of Grain Futures Contracts

An alternative means of linking spot and futures markets is to
eliminate the delivery process altogether and implement a cash-set-
tlement mechanism like that used for stock index futures (e.g., the
S&P 500 stock index futures), feeder cattle, and Eurodollars. For a
cash-settlement contract some market price, average, or index of
market prices is used to estimate the value of the commodity against
which the futures contract is traded. so
There are obstacles to implementing such a settlement mecha-
nism in grain markets, the most apparent being that it is difficult to
ascertain spot market prices for grains. The prices most commonly
used to measure grain prices are not actual transactions data.
Instead they are bids by processors and elevators to buy grain. Such
data can mislead because they represent only the demand side of the
market; a bid that is not accepted is not a relevant market price.
Moreover, spot market bidders with futures positions who realize
that their bids may influence the futures settlement price, and thus
their futures profits, may have an incentive to submit artificial bids
in order to increase profits.
A far more desirable cash-settlement index would rely upon the
prices derived in actual spot transactions. Implementing such an
index would require grain market participants to report the transac-
tions, which they are apparently loath to do. Even if the important
spot market players participated, however, there would be other diffi-
culties in implementing a reliable cash-settlement system. First, the
potential for manipulation still exists. Traders could either report fic-
titious transactions, or report bona fide transactions made at artifi-
cial prices in order to affect the index. Even if both the buyers and
sellers report the same transaction price, but the counterparties in a
trade have opposite futures positions, they might make and agree to
report artificial transactions if the joint manipulative gains are suffi-
ciently large. Even if one party loses, the other would be able to com-
pensate him and still retain some positive gain. Deterring such
behavior would require the transactors to yield discretion over the
prices that they report to the exchange or clearinghouse, which would
make spot market participants less likely to contribute to the cash-
settlement process. 3!
The other main procedural difficulty with a cash-settlement
index is that it would almost necessarily incorporate prices from het-
erogeneous transactions. Prices in grain markets differ by size, qual-
ity, mode, and time of delivery, origin and destination of shipment,
and the time the transaction is negotiated (i.e., transactions are non-
synchronous). Although the index could attempt to control for that, it

is unlikely that the index will always represent the transaction price
of a homogeneous transaction, due to non-synchroneity alone. That
would introduce noise into the settlement index.
A delivery mechanism avoids all of the problems addressed here.
Since the making and taking of a delivery requires the exchange of
money for a homogeneous commodity and the terms of the exchange
are established and public, there is no difficulty of determining
whether a delivery transaction is a bona fide exchange. Moreover,
due to the standardization of the futures contract, heterogeneity and
non-synchroneity arising in cash settlement are mitigated. Although
(as we discuss in Chapter 4) delivery settlement contracts are subject
to manipulation, manipulation is frequently easy to detect and a
deterrence mechanism is in place.
Some have argued that multiple deliverable grades and locations
in existing futures contracts represent a source of uncertainty that is
perhaps more potentially damaging than that associated with the
incorporation of heterogeneous transactions in a settlement index.
There is an important difference between the sources of uncertainty,
however. The range of variation in the multiple deliverable futures
contract is known ex ante, and the relationships between the prices of
deliverables can be quantified in order to determine their influence
on the futures price. 32 Indeed, those results show that the "uncer-
tainty" arising from multiple deliverables actually redounds to the
benefit of some hedgers due to a diversification effect. A cash-settle-
ment index that aggregates prices of various grades and locations
could produce some of the same improved hedging performance for
grades/locations not now deliverable as a result of the same diversifi-
cation effect. Nonetheless, some of the variability in the settlement
index is mere noise, and has no economic relevance.
The problems with cash settlement for grain futures contracts
make its adoption at the present time risky. There are other more
subtle objections that are perhaps more telling, however. For
instance, cash settlement would eliminate an important spot-physi-
cals market with some desirable transactions costs characteristics-
the delivery month futures market. Even if the importance of the
delivery month futures market as a spot market has declined with
the terminal markets, that does not imply that it should be discarded
altogether. Although we argue in the following chapter that the cen-
tral purpose of grain futures markets is not to facilitate transfer of
physical grain, we do recognize that as an important ancillary func-
tion. As long as it serves that secondary role, trading in delivery
month contracts increases the efficiency of spot market pricing.

Such a source of improved efficiency would be lost under a cash-
settlement system. In markets where spot transactions prices exhibit
dispersion, a cash-settled futures price would equal the expectation of
some function of the transactions prices, such as the average or
median of some sample of transactions prices. The futures settlement
process would thus not add any valuable information about the supply
and demand for the underlying commodity. A delivery system, on the
other hand, creates an additional market whose prices reveal impor-
tant additional information about the supply and demand for the com-
modity. That is because the spot month futures trading can serve as
an auction market for the deliverable commodity. It is well known
that auction markets efficiently aggregate information about the
demands and supplies of different traders.s3 Moving from a delivery
mechanism to cash settlement would destroy the additional market.
The loss from eliminating the delivery month market depends
upon the nature of spot market trading. In grains the loss may be
large as there is no commercially important, centralized spot-trading
system (other than the spot month futures market), and search,
negotiation and transactions costs in grain markets are potentially
high. The "spot grain market" consists of spatially separated buyers
and sellers who search for trading partners via telephone and fax. It
is well known that prices in such markets will exhibit dispersion; i.e.,
there is no unique equilibrium "market price." Instead there is an
equilibrium distribution of transactions prices, and the transactions
prices may exhibit considerable variability at any moment. The vari-
ability is exacerbated by the transactions heterogeneities discussed
earlier.
Given such variability in transactions prices, to create a unique
settlement price an exchange must establish some way of aggregat-
ing them. It may take an average or median of a certain number of
transactions prices, for instance, as the measure of "market price."
Unfortunately, such a simple rule may not aggregate the prices in an
economically meaningful or efficient way.
An efficient market price for a particular commodity would
simultaneously equate the valuation of the commodity by both the
marginal seller and the marginal buyer, which is the economic
"value" of the good. Such a price would arise in a decentralized spot
market if transactions costs (including search costs) equalled zero,34
or in a competitive auction market. Indeed, one of the primary bene-
fits of centralized exchange is that it performs the crucial function of
aggregating the valuations of disparate buyers and sellers in an effi-
cient manner.
In markets where search and transactions costs are positive,
transactions prices can diverge significantly from economic value.
Averaging (or taking the median of) the prices of transactions negoti-
ated in decentralized "search markets," where search and negotiation
costs are significant, will not aggregate valuations as efficiently as an
auction mechanism for three reasons. First, the average (or median
or any other summary statistic concerning prices) taken from a dis-
tribution of transactions prices may be a biased measure of economic
value. That is because economic value generally does not equal the
mean or median of the distribution of transactions prices, although
this mean or median is almost certainly more informative than any
single price used to derive it. Second, if the settlement price is deter-
mined from a sample (rather than the universe) of transactions
prices (as it almost certainly will be), there will be variability in the
index arising from sampling noise. Third, if transactions used to con-
struct the index are heterogeneous, the index will exhibit additional
variability if the types of the transactions included in the index vary
over time. That is likely in grain transactions that differ by location,
quality, quantity, mode and timing of delivery, and the time at which
transactions were negotiated.
This may be formalized as follows. Consider a cash-settled
futures price that is a weighted average of spot prices at n locations,
where the weight at location i equals wi. The value of grain at i
equals vi, while the observed price at that point equals pi=vi+ei,
where ei is ''noise'' in the spot price that arises from the factors dis-
cussed in the previous paragraphs. The futures price then equals
F=wl(vl +el)+w2(v2+e2)+ ... +wn(vn+en)
Note that if the ei are variable-Le., spot prices are very noisy
measures of value due to search costs, etc.-the futures price may
itself be very noisy even if n is large.
In contrast, the delivery mechanism ensures that the spot month
futures market can serve as a continuous, centralized auction market
for a standardized deliverable commodity, where transactions are
reported synchronously. Due to the lower search and negotiation
costs implicit in an auction mechanism, an auction market will
aggregate the bids and offers of buyers and sellers of spot grain more
efficiently than will a cash-settlement system; i.e., the divergences
between price and value (the noise) in the auction-determined spot
futures price should be very small. The more efficient aggregation, in
turn, should improve the efficiency of prices in the decentralized spot
markets. That is, eliminating the delivery mechanism eliminates a
spot market with desirable transactions cost properties with poten-

tially detrimental effects on the efficiency of all spot trading, not just
the trade executed through the spot future. Thus, the choice between
cash settlement and a delivery mechanism depends upon the contri-
bution to market efficiency of trading in spot month delivery.
The analysis suggests that cash settlement is workable for com-
modities where centralized exchange already exists----e.g., equities35-
or where markets are decentralized and search and negotiation costs
(and consequently price dispersions) are relatively small-e.g.,
Eurodollar time deposits. Similar conditions are not evident in grain
markets. In effect, the existence of an auction market in the spot
month when contracts are settled by physical delivery reduces the
transactions and search costs of determining the market price of the
deliverable commodity. Moving to cash settlement would eliminate
the role of the delivery month futures contract as an auction market
for the deliverable commodity, degrading the efficiency of the futures
market as a mechanism for pricing spot grains.
When futures contracts are cash-settled, the three sources of
variability noted above would also make cash-and-carry arbitrage
risky, to the detriment of pricing efficiency prior to contract expira-
tion. To see why, consider a delivery-settlement mechanism with
only a single deliverable commodity. Under such a system, a termi-
nal operator (knowing the price at which he can buy and sell grain
in the deliverable location and the benefits that he reaps from
holding inventory [Le., convenience yield]) can lock in a riskless
profit if prices diverge from the no-arbitrage values by shorting
futures and holding grain in store. He can always profit by deliver-
ing at expiration and (with some minor variation arising from the
interest earned on daily resettlement) receiving the futures price
that prevails at the time he initiates his position. 36 With cash set-
tlement, such cash-and-carry arbitrage is risky unless the arbi-
trageur knows that he can sell the commodity in store at the
market price at contract expiration and that the futures price will
also equal the market price at that time. In other words, riskless
arbitrage in a cash-settlement regime requires that the arbi-
trageur be a price taker in the spot market, and that the futures
price converge to the price that the arbitrageur takes. Firms are
not price takers in grain markets, but price searchers, which
implies that transactions prices will vary. Moreover, the variations
in settlement price imply that the settlement price at contract
expiration (combined with the idiosyncrasy of transactions prices)
will not necessarily equal the price at which an arbitrageur can
buy or sell the commodity. Thus, cash-and-carry arbitrage is risky

when futures are cash-settled. 37
Unless arbitrageurs are risk-neutral, they will require a risk pre-
mium to engage in arbitrage transactions. Futures prices could
diverge from their arbitrage value by the sum of the risk premium
and the transactions costs of arbitrage. Since one would expect the
transactions costs of arbitrage to differ little between a cash-settle-
ment contract and a delivery-settlement contract for the same com-
modity, any risk premium would reduce the pricing efficiency of the
cash-settled contract relative to the delivery-settled one.
Arbitrage may actually be more costly in a cash-settled market.
To arbitrage a cash-settled contract a trader must execute a spot
trade when he both initiates and terminates his arbitrage position.
To arbitrage a delivery-settled contract, a trader can make or take
delivery rather than make a spot trade at expiration. It is probably
cheaper to make delivery than find and contract with a buyer in
order to unwind a short futures arbitrage position. An arbitrageur
who takes a long futures position may have to pay load-out charges
in order to complete his arbitrage, but he does not have to search for
and negotiate with a seller of the commodity as would an arbitrageur
of a cash-settled contract.
Arbitrage is potentially both costly and risky in a multiple-deliv-
erable system as well. For a contract that allows delivery of several
grades or delivery at multiple locations, the arbitrage is risky unless
the arbitrageur holds inventories in each of the several deliverables
in proportions determined by the likelihood of their becoming cheap-
est-to-deliver, and adjusts that position as the relative prices of the
deliverables change. That is apt to be costlier than simple cash-and-
carry arbitrage in a single delivery point system. It may even be suf-
ficiently costly so that an arbitrageur would choose to hedge
imperfectly and bear the risk instead. Thus, the advantages of deliv-
ery over cash settlement in facilitating arbitrage are reduced in a
multiple-delivery-grade system. In any event, movement to cash set-
tlement would not unambiguously reduce the risk or cost in arbitrag-
ing grain futures markets.
Thus, we conclude that there are some serious disadvantages to
cash settlement in grain futures contracts. Although the terminal
markets are not the dominant grain-trading centers that they once
were, the delivery process still functions well enough to make serious
consideration of cash settlement premature. Moreover, it is possible
that changes in the delivery specifications can revitalize the delivery
auction market. If the major terminal markets become sufficiently
isolated from the commercial mainstream, cash settlement will

become a more desirable option. At the present time it offers no evi-
dence of superiority, and would seem to be inferior to settlement by
delivery.
Summary
This chapter has analyzed a wide range of issues concerning the
role of the delivery process, its recent performance, and prospects for
its future. We conclude that the market has worked well to ensure
convergence of cash and futures in the past half decade, but there are
some indications that the existing system faces some challenges due
to the changing nature of grain markets.
In particular, a continuing decline of Chicago and Toledo as grain
marketing centers (particularly relative to the rise of the Mississippi-
Gulf axis) may make convergence more tenuous. More important,
though, is the effect of this decline in these markets on the price per-
formance of the grain futures contracts: Even if convergence contin-
ues to work as well as in the past, the futures prices may converge to
increasingly irrelevant spot prices.
In markets like grains where transport costs are large relative to
value, basis risk is a fact of life. Regardless of the location of delivery
points, there will be significant numbers of hedgers located away
from these points who must bear the risk of relative price variations.
Given this reality, it is desirable to locate delivery points in the midst
of the most important commercial regions. Chicago and Toledo,
unfortunately, are far less centrally located than was once the case.
We should reemphasize that this does not necessarily imply that
basis risk has increased over the period of this marked shift in grain
market trading patterns. As we noted above, some of the factors that
have greatly contributed to this evolution-particularly the reduction
in transport costs-would also tend to reduce basis risk. Moreover,
the effect of the changed trading patterns on basis risk is not monoto-
nic. Indeed, abstracting from liquidity effects, basis risk will eventu-
ally (if it has not already) decline as the Chicago-Toledo market
becomes progressively less important. It should be noted, however,
that a potential increase in basis risk must be weighed against the
potential for increased manipulation that could occur should small
capacity delivery points be added. This is due to the fact that as a
market becomes a relatively minor demand center, random varia-
tions in demand at that point have little influence on prices outside
that market, and prices in that market must respond to demand and
supply shocks elsewhere in order to ensure that any supplies flow to
it. In the extreme, when a particular market receives few shipments,

spot prices there simply respond to supply and demand forces else-
where, and thus basis risk becomes very small. It should be noted,
however, that liquidity effects could counteract this effect. As a mar-
ket declines, it tends to become less liquid. Prices in illiquid markets
tend to move idiosyncratically, and thus the liquidity effect would
tend to exacerbate basis risk if delivery occurs in a declining market.
Even if basis risk has declined, the number of transactions occur-
ring outside of Chicago, Toledo, and the markets tributary thereto
have increased. That is, more transactions are affected by (a possibly
lower level of) basis risk as a result of the change in trading patterns.
Thus, it is quite plausible that the hedging value of the CBT grain
futures contracts could be enhanced by moving from a delivery sys-
tem that designates Chicago as a primary delivery point to one that
is more compatible with existing trading patterns.
The effects of any such change on basis risk must, of course, be
empirically evaluated prior to implementation. In Chapter 5 we
undertake such an evaluation, and find that under certain assump-
tions a move to an "economic-par" delivery system which allows
delivery at Chicago, Toledo and St. Louis at differentials based on
average price differences would indeed improve hedging performance
in a wide variety of commercially important locations.
Other effects of such changes must also be evaluated. In particu-
lar, although convergence and hedging performance are obviously of
paramount importance, the delivery process must perform other
functions as well. It is thus important that the effect of any changes
in the delivery mechanism on these functions-the merchandising
role of futures contracts and the deterrence of manipulation-be con-
sidered as well. The following two chapters analyze the economics of
these two functions in order to evaluate the effects of possible
changes in the delivery mechanism.
1In the terminology of futures markets, soybeans are treated as a grain, and are the
subject of quantitatively important futures contracts. Other noteworthy contracts
cover the important grains as that term is commonly understood-wheat, corn, oats,
barley, etc. Futures contracts for other agricultural commodities (such as sugar), cer-
tain metals, some energy resources, and particular financial instruments are also
traded on organized exchanges.
2 A spot price is the fee that one must pay to obtain a commodity for immediate deliv-
ery. Hence, it is the price of the commodity for delivery "on the spot," so to speak.
3 Chicago Board of Trade, p. 31.
'Federal Trade Commission, v. V, p. 199.
'For example, an outstanding futures contract for soybeans can be satisfied by a deliv-
ery in either Chicago or Toledo. Hence, the futures price for soybeans is linked to both
the Chicago spot price and the Toledo spot price.
6Garbade and Silber analyze in detail the importance of transactions costs in deter-
mining the degree of convergence.
7 See Telser (1981b); Carlton.
6 There are exceptions. Where the demand for futures trading is high, such as is the
case for stock index futures, several seem to survive simultaneously. But that observa-
tion is misleading; transportation costs are essentially zero for stock index futures, so
the traders in one contract are easily linked to those in another. Consequently, little
liquidity is lost in the stock index futures market by having the trading split into sub-
parts.
Competing wheat futures markets also exist, although the Board is the dominant
wheat market in terms of both volume and open interest. The CBT contract, moreover,
tends to price soft wheat, while the Minneapolis contract prices hard spring and the
Kansas City contract prices hard winter wheat. Thus the wheat futures markets price
distinct commodities.
"A similar argument holds for the time of delivery; there will not be a futures contract
expiring on every business day. Indeed, although the number varies from commodity
to commodity, there are a large number of days during which delivery cannot take
place. In corn and wheat, shorts can deliver on fewer than half of the days in the year.
In soybeans, delivery can occur on somewhat more than half the business days of the
year.
lOIn Chapter 4 we discuss the economics of manipulation in some detail.
11 We quantify the effects of varying the number of deliverable locations on hedging
effectiveness in various locations in Chapter 5.

"There is at least one broker of warehouse receipts in Chicago, but little active trading
or records of transaction prices.
13 Traders who receive warehouse receipts through the delivery process can redeliver
them subsequently. We note in the following chapter that deliveries frequently exceed
the stocks on hand in the delivery market; thus these redeliveries may be quantita-
tively important.
14 For a variety of reasons the nominal capacity of an elevator (which is estimated
according to U.S.D.A. criteria) usually exceeds its economic capacity to store grain. For
instance, different grains and oilseeds cannot be mixed (e.g., corn and wheat cannot be
stored in the same bins at the same time) so remaining space in wheat bins is unus-
able for storing additional corn, even though the corn market may have become abnor-
mally tight. Similarly, it is usually desirable to segregate holdings of different grades

of the same commodity, e.g., #1 and #2 soybeans. Differences in packing and the provi-
sion of oat bins also cause nominal capacity to exceed effective capacity. Market partic-
ipants claim that 80 percent utilization of nominal Chicago capacity is realistically full
capacity operation; the corresponding figure for Toledo is 90 percent.
1& Such divergences would occur for any fixed storage charge (i.e., a charge that did not
vary so as to exactly match the marginal cost of delivery) so a simple change in this
fixed fee would not eliminate them. Since fixed charges for storage are necessary to
allow a delivery mechanism to function (as otherwise an acute opportunism problem
would exist) these divergences between the price warehouses are willing to pay for
grain and the price other traders are willing to pay are endemic to the market.
16The futures price can fall outside the spot low/spot high band for other reasons, such
as a divergence between spot bids and the true spot price, and the bid-ask spread.
17 The convergence is not to within +/- $.06/bu. as the high and the low differ on aver-
age by about $.04/bu.
18 Chicago elevators must provide space for oat storage, for instance, which reduces
space available for corn, wheat, and beans. Several warehousemen indicated that the
age of Chicago elevators also tends to lead to an overstatement of their capacity.
19 Market participants (including some elevator operators) allege that the Chicago and
Toledo warehouses were unable to load out stored grain to reduce marginal storage
costs because they did not own enough of it. Much of the stored grain was owned
instead by Ferruzzi, which had begun to .take substantial deliveries on futures con-
tracts during the previous November. Assuming that they needed the grain to be in
Chicago, that may have been rational behavior on the part of Ferruzzi because the
marginal cost (and thus the price) of storage in other elevators would also have risen,
and hence would have exceeded the pre-established price of storage in regular ware-
houses. In other words, a regular warehouse fixes a storage price in advance in
exchange for the privilege of being a regular warehouse. But since it cannot be varied
in response to short-run variations in capacity utilization, that price will prove to be
too low during periods of unusually high utilization. Hence, it will be bargain storage
for whoever happens to have the space occupied.
20 Redelivery is common in grain futures, meaning that the same physical grain is often
delivered several times within a single delivery month. The ratio of deliveries to total
stocks on hand was smaller than average in the summer of 1988, while deliveries were
numerous. If the futures price was too high (as the difference between Chicago spot
bids and futures prices seems to suggest) then redelivery would have been very prof-
itable. That is, upon receiving a delivery notice, a long trader could have reaped an
arbitrage gain by shorting a contract and then immediately delivering. That such
behavior did not occur in greater than average frequency is consistent with the notion
that the futures prices were an accurate reflection of the spot values of corn and soy-
beans.
21 Safety-valve delivery systems are described in more detail in Chapter 5.
"One grain merchant representative told us that it was unlikely that new Chicago
capacity would be added due to the changed nature of commodity flows and the high
cost of constructing new warehouse capacity.
23We also calculated the average difference between the futures price and the average
high CTD. Since on average this difference is negative (i.e., the cash price exceeds the
futures price) this suggests the bid-ask spread is negative; i.e., the bid price exceeds
prevailing market sales price. This casts doubt upon the relevance of these figures. It
is interesting to note that the wheat cash-futures differential narrows more markedly
than does the corn or soybean when one uses the high CTD as opposed to the average
of the high and low CTD as a measure of the cash price. This is due to the fact that the
spread between high and low bids for wheat tends to be larger than that for corn or
beans.
24 Pirrong (1991) demonstrates that the effects of supply, demand, and transportation
conditions on basis risk are extraordinarily complex and not necessarily stable. A vari-
ety of changes in these conditions either singularly or in combination can lead to a
decline in the size of a market similar to that experienced by Chicago. The analysis in
the 1991 paper demonstrates that in many cases the effect of such an evolution in
trading patterns on basis volatility for out-of-position hedgers often cannot be signed a
priori even if a single change (e.g., a rise in demand at a single point) is responsible for
this shift. When there are multiple causes of such a decline, it is often more difficult to
determine whether the decline in a market is associated with a fall or a rise in the
hedging performance out-of-position hedgers receive. This hedging performance may
vary over time, moreover, due to changes in factors that do not affect market size per
se, such as the volatility of demand at a particular location or the volatility of trans-
port rates. Thus one cannot draw the conclusion that the decline in the Chicago mar-
ket has increased the magnitude of basis risk.
"See the correlation tables in Chapter 5 for evidence of the variability in relative
prices of grain across locations; the correlations are all considerably less than one,
which implies that relative prices are variable. Fundamental economic reasoning
implies that relative prices vary if goods are not perfect substitutes, and that trans-
portation costs make goods imperfectly substitutable.
'" A major opportunity cost of operating the warehouses is the value of the land upon
which they are located. These opportunity costs may rise appreciably in Chicago if the
proposed development of a third airport in the Lake Calumet region (favored by the
current mayoral administration) actually occurs. Several of the major delivery houses
in Chicago are located on or near this area. Although the houses are located adjacent
to, and not on, the proposed airport site, the development of the facility would increase
the value of the land surrounding it. Land around airports has valuable uses, includ-
ing hotels and motels, office and convention complexes, transport-related businesses,
and light manufacturing. The development of the Lake Calumet site would lead these
businesses to bid up the price of land. It is quite possible that at the higher prices the
operators of regular space would find it more profitable to sell their warehouse sites
rather than to continue to operate them.
27In the 1980's the New Orleans Commodity Exchange designed two contracts calling
for delivery by shipping certificate in the Mississippi basin on corn and soybeans. The
Minneapolis Grain Exchange introduced a contract for white wheat calling for delivery
by shipping certificate in the Columbia River District (embracing part of the Columbia
and Willamette Rivers). Those contracts failed, which is unsurprising given the liquid-
ity problem discussed above, and given the existence of competing liquid contracts.
The failure of the contracts does not imply that the replacement of the current con-
tracts with shipping certificate contracts would lead to reduced futures market perfor-
mance.
"See Silber for an analysis of the silver and gold futures examples.
'''This is a form of short manipulation, and is discussed in Chapter 4 below.
"0 For a discussion of cash settlement see Garbade and Silber.
:nThe Chicago Mercantile Exchange's feeder cattle contract has apparently avoided
this problem through the use of its Cattle Fax pricing system. Such a system is costly,
however, and given the other potential problems with cash settlement discussed below,
it might not be worthwhile to incur the expense to create a similar system for grains.
"We do that for corn and soybeans in Chapter 5.

"See Milgrom (1981) for a classic exposition of this idea.
34There may be dispersion in prices even if transactions costs are zero (see Telser
(1978) ch. 8), but the permissible prices would still satisfy the constraint. When search
costs are positive, some prices will exceed and some prices will be less than an efficient
price.
'" Cash settlement in equities may have deficiencies as well. When the unwinding of
arbitrage positions at futures expiration overwhelms the liquidity of the spot market
(as on the New York Stock Exchange and the American Stock Exchange during "triple
witching hours") the spot price is distorted.
3GHe may actually reap more profit, but he is certain that his profit will be no smaller
than he could receive by completing the arbitrage by delivering.
37 Strictly speaking, "risky arbitrage" is an oXYffioron. A more precise statement is that
academic arbitrage is impossible under a cash-settlement system.

3 • Futures Contracts as a Merchandising
Tool: The Role of Delivery as a Means of
Ownership Transfer
As noted above, many futures industry participants believe that

grain futures contracts are not, and should not be, an important mer-
chandising tool. There are three reasons for examining the evidence
for that belief. First, the data upon which the belief is based are mis-
leading. Second, an intention to take delivery is sometimes cited as a
rationale by traders who are long, and who have carried unusually
large positions into the delivery month. Consequently, the enforce-
ment of rules against manipulation requires an understanding of the
rationality of using the futures market for merchandising purposes.'
Third, theoretical work by Jeffrey Williams at Stanford's Food
Research Institute implies that futures markets are a means of bor-
rowing and lending the commodities underlying the futures con-
tracts. Williams argues that hedgers do not use futures contracts to
avoid risk, but instead to obtain or dispose of supplies of the spot
commodity. The delivery process plays a crucial role in his models. It
is the means by which commodity loans implicitly created by combi-
nations of futures and spot positions are repaid. In other words,
according to Williams the delivery process is an important means of
allocating the physical commodity among its high value users just as
bank loans are an important means of allocating supplies of capital.
Thus, his models imply that a substantial fraction of futures con-
tracts should be offset by delivery.2 But that does not appear to hap-
pen in practice.
Williams has created two models of futures market hedging that
do not rely upon risk aversion. In the model presented in his book,
The Economic Function of Futures Markets, the parameters chosen
by Williams predict that delivery will occur more than 67 percent of
the time. But that model is a single period model. Adding additional
periods to the model eliminates the demand to use futures contracts
to hedge inventory, because firms have no reason to borrow invento-
51

ries until the last period. At that time futures contracts represent a
cheap way to dispose of unneeded inventory, but in prior periods
firms choose to carry unused inventories into the next period.
Williams' more sophisticated model appears in the Journal of
Political Economy.3 The parameters he uses there imply that over 50
percent of futures contracts will be closed through delivery.
Williams' models are suspect for reasons other than the empirical
predictions of high frequencies of deliveries. In one model, Williams
(1987) imposes an assumption that firms cannot initiate new futures
positions during the delivery period, but relaxing that implausible
assumption completely changes the model's results.
In Williams' model, firms trade futures prior to the spot month
because spot market trading is expensive. Prior to the delivery
month, some firms anticipate that they will want to reduce their
holdings of grain, while others anticipate that they will want to buy
grain in the future. Rather than simply waiting to trade on the spot
market in the delivery month, firms can initiate futures positions
prior to the delivery month and then stand for delivery. They econo-
mize on transactions costs by doing so because by assumption the
delivery mechanism is more efficient than the spot market. Firms
that anticipate that they have too much grain sell futures. If their
anticipations are correct, they deliver, as it is cheaper to dispose of
grain that way than by spot market sale. If their anticipations are
incorrect, they buy back their futures positions and may even buy on
the spot market. Similarly, firms that anticipate that they will have
too little grain in the future buy futures. If their expectations are ful-
filled, they take delivery. Otherwise they reverse their positions, and
perhaps sell grain on the spot market.
When firms can initiate positions in the spot month, however,
they will always choose to wait to initiate their futures positions
until that time, given that it is cheaper to transfer grain via the
futures delivery process rather than the spot market. That is, if they
have the option to initiate futures positions in the spot month, they
will never do so prior to the spot month, because by the delivery
month firms have precise information about whether they have too
much or too little grain. Prior to the delivery month, they have less
precise information. If a trader initiates a futures position prior to
the spot month, he will sometimes find it efficient to offset some or
all of the position due to unfulfilled anticipations. The reversal is
costly, however. By waiting until the delivery month to initiate his
positions, the trader can avoid the cost. Thus, when one assumes that
firms can initiate new futures positions in the delivery month-in
Futures Contracts as a Merchandising Tool 53
contrast to Williams' assumption-his model leads to a peculiar kind

of "futures" market, one where all trade is intended to facilitate the
immediate transfer of grain.
Despite the flaws of Williams' models, their empirical predictions
deserve empirical scrutiny. If the models are correct, the merchandis-
ing function of futures contracts is an important one. But that, in
turn, would imply that the delivery process should be designed in
order to facilitate the use of futures markets as a means of transfer-
ring ownership and control of the spot commodity, and not just to
ensure convergence. If futures markets do serve as borrowing and
lending conduits rather than risk-shifting tools, for instance, it might
be desirable to increase the number of delivery locations in order to
broaden the commodity loan market. Consequently, an understand-
ing of the extent of use of the grain futures markets as merchandis-
ing tools is essential to the assessment of costs and benefits of
various delivery specifications, and of exchange rules designed to
deter manipulations and market congestion.
An Empirical Analysis of Deliveries In Grain Markets

Analysts commonly cite the small fraction of futures contract vol-
ume offset by delivery as evidence of the unimportance of futures
delivery as a means of acquiring or disposing of supplies of the spot
commodity.· This measure is misleading, however, because it leads to
double counting. A trade occurs both when a trader initiates a posi-
tion and when he closes it through offset. In fact, the total number of
positions open during a contract's life equals (number of positions
closed by offset)+(number of positions closed by delivery), while the
contract's lifetime volume equals 2x(number of positions closed by
offset)+(number of positions closed by delivery). That implies that the
fraction of contracts open during a contract's life offset by deliveries
equals
2 x (number of contracts closed by delivery)

contract volume number of contracts closed by delivery
Thus, measuring the importance of delivery by the ratio of deliv-

eries to volume understates by something less than half the actual
fraction of open contracts offset by delivery.
Table 3-1 reports the number of deliveries as a fraction of open
positions. The number of deliveries relative to open positions is still
small, on the order of 1 percent to 4 percent of the total number of
positions opened during a contract's life. There are still other adjust-
ments that need to be made, however. First, speculators and market

makers have no use for the merchandising capabilities of futures con-
tracts, while the users of spot commodities-commercial traders-
might. Thus, to assess the importance of merchandising capabilities
one should determine the fraction of hedging positions that are closed
through delivery. The figures cited above do not do that; the volume
figures include speculative, scalping, and hedging trades.
Consequently, one would like to adjust the volume figures to reflect
the fraction of futures trades executed by hedgers.
Unfortunately, there are only limited data available to perform
the analysis directly. Some hedgers report their month-end open
interest. Nearly all hedgers must apply for hedge exemptions and are
thus identifiable as such. A few hedgers (such as small country eleva-
tors, for instance) do not need to report their positions. Thus, it is dif-
ficult to assess the use of futures contracts by a potentially important
component of the hedging population.
Moreover, the amount of hedging volume may not match the pro-
portion of month-end reported open hedging interest. If hedgers vary
their positions less often than speculators, for instance, the fraction
of open interest attributable to hedgers may greatly overestimate the
fraction of volume resulting from hedging trades.
The last point deserves emphasis. Heavy volume on the Board is
related to the market-making function of "scalpers." Those individu-
als provide "immediacy," i.e., they stand ready to accommodate the
needs of hedgers and speculators who wish to trade immediately, but
cannot find another hedger or speculator who wishes to take the
opposite side of the trade. Thus, for example, a short hedger may sell
to a scalper, who in turn sells to a long hedger sometime after the ini-
tial trade. Frequently the scalper will offset his initial trade within
minutes of making it. As a result of the scalping process, then, two
positions have been opened. Only one of these is a hedging position,
while the other is only open momentarily. The rapid turnover by
market makers tends to inflate the relevant number of positions open
during a contract's life. Although separating data relating to scalpers
from that relating to speculators is difficult, conversations with
Commodity Futures Trading Commission (CFTC) personnel and
Board analysts suggests that as many of 50 percent of all trades are
scalped. That suggests that the number of positions opened by
hedgers must be significantly less than half of the total volume of
contracts open during the life of the contract. Thus, one should
inflate the fraction of contracts offset by delivery reported in Table 3-
1 by a factor of 2 or more because hedger volume is only a fraction of
total volume. Without knowing the appropriate fraction to use, how-

ever, such an approach cannot be very accurate.
There is, however, an alternative estimate of contracts opened by
hedgers--the number of contracts offset by an exchange-for-physicals
("EFP") transaction. In an EFP, a buyer of cash grain who is long a
futures contract and a seller of cash grain who is short a futures con-
tract agree to exchange grain for cash at a fixed price by exchanging
futures contracts at an agreed-upon price. Thus, the number of con-
tracts offset by EFPs is a subset of the contracts initiated by commer-
cial interests; practically all users of EFPs are commercials, but not
all futures contracts opened by commercials are offset by an EFP.
Superficially, it appears that the EFP is related to the delivery
process, inasmuch as it involves the simultaneous matching of a spot
and a futures trade. Clearly, however, the EFP process differs from
the delivery process. In order to execute an EFP, the parties to the
transaction must negotiate all the terms of the associated spot deal,
such as grade, location, time of delivery, etc. In addition, they negoti-
ate a means of settling offsetting futures positions. Thus, an EFP is
best understood as a combination of a spot transaction and a futures
transaction.
Some deliveries substitute for spot transactions. Instead of find-
ing a counter party and negotiating terms, a short trader who deliv-
ers disposes of supplies through the intermediation of the
clearinghouse. Similarly, the long trader who takes delivery obtains
supplies without engaging in the search and negotiation activities
required to execute a spot transaction.& Thus, delivery is an alterna-
tive to buying/selling via a spot trade, while an EFP is properly con-
sidered a spot trade combined with a futures trade.
If an EFP is different from a delivery, why do firms engage in
such transactions rather than just buying/selling spot and offsetting
futures in the pit? In an EFP firms can fix the futures basis at which
they liquidate their position (i.e., the difference between the liquidat-
ing futures price and the spot price of interest). They cannot do so if
they have to offset in the pit. If the spot trade and the futures trade
are not simultaneous, for example, the hedger is at risk of basis
changes during the interval between the two trades, and it is almost
certain that the basis will move against at least one of the partici-
pants in the transaction. In an EFP the traders negotiate the basis,
not a spot price, and thus protect themselves from such an adverse
move. Since it is an effective means of controlling one type of risk,
but does not affect the transactions costs of negotiating a spot trade,
it is best understood as a manifestation of risk aversion on the part of
the parties to the transaction.

Thus, EFPs are not a form of delivery, and EFP volume is
smaller than the number of open positions held by hedgers. If deliv-
eries are small relative to the number of EFPs, one can infer that
only a small fraction of hedgers use the delivery process for commer-
cial purposes. In other words, the ratio of deliveries to EFPs is an
overestimate of the fraction of hedger positions offset through deliv-
ery.
Table 3-2 reports number of EFPs as a fraction of the number of
deliveries (in thousands of bushels) by year for 1983-89. The largest
ratio of number of deliveries to EFP open interest is 20.75 percent for
Board wheat in 1983. The average ratio is 11.59 percent for Board
wheat, and 8.75 percent for soybeans. The average ratio for corn, the
highest volume contract, is only 2.67 percent. Since EFPs are a sub-
set of all hedging positions, the small ratios suggest that delivery is
not an important merchandising tool for hedgers. That is inconsistent
with the Williams hypothesis, but supports the beliefs of most mar-
ket participants.
The conclusion is strengthened because deliveries appear to be
overstated-Le., the number of reported deliveries seems to be far
greater than the number of deliveries actually "stopped" by a long
trader. In fact, the total number of bushels of corn, wheat and soy-
beans delivered in Chicago and Toledo in a given contract month fre-
quently exceeds the sum of the stocks on hand at the beginning of the
month plus the total receipts during the month. 6 Indeed, during the
1983-89 period on average the number of bushels of corn delivered in
Chicago exceeded the deliverable stocks on hand in the delivery
month by a factor of 2. The figure for soybeans is 2.7 and for wheat
2.5, which implies that the same warehouse receipts are changing
hands several times during the delivery process.
The process of transferring a warehouse receipt received through
the delivery process is commonly called a "redelivery." When a long
trader receives a delivery notice that he does not want to retain
before trading ceases (on the eighth to the last business day of the
delivery month), he can short a contract and then immediately
deliver the warehouse receipt just received. The long trader assigned
delivery by the clearinghouse can do the same. Such a game of musi-
cal chairs can continue until the receipt is delivered to a long trader
who wishes to take possession of the receipt or the grain, or until
some unfortunate long trader receives the notice too late to pass it
along.
The foregoing implies that the number of deliveries reported
exaggerates the quantity of grain transferred from one user to

another through the delivery process. That means that the ratio of
reported deliveries to EFPs is an overestimate of the fraction of com-
mercial positions closed by delivery, and thus exaggerates the impor-
tance of delivery as a merchandising method for two reasons: (1) The
number of deliveries is overstated, and (2) the number of EFPs
understates the number of hedger positions. Given the already small
ratios discovered above, the potential that the ratios are severely
overstated reinforces the contention that the commercial use of the
delivery process is a trivial means of transferring grain ownership.7
Nor are the 1980's anomalous. Observers have commented upon the
low frequency of delivery since the dawn of grain futures trading.
During the 1880's, for instance, market critics cited the low fraction
of contracts offset by delivery as evidence that futures contracts were
gambling agreements. 8
It is difficult to assess the factors that determine the number of
deliveries. Some deliveries may be for commercial reasons, but how
many? Given the quality of the delivery data, it is difficult to tell.
Similarly, some deliveries may occur as a result of arbitrage transac-
tions between the spot and the futures markets, or between different
futures contracts.
That said, an analysis of the delivery data indicates that traders
do use the delivery process to buy and sell grain to a limited extent.
If assuring convergence were the only purpose of the delivery
process, one should observe deliveries only when spot and futures
prices are sufficiently different during the delivery month to justify
incurring the costs of making and taking delivery. Since deliveries
occur in every delivery month, and the evidence provided above indi-
cated few (if any) delivery months where spot and futures prices
diverged significantly, it is difficult to explain the number of deliver-
ies as a response to arbitrage opportunities. That leaves two plausi-
ble explanations for deliveries. First, due to the transactions costs of
dealing on spot markets versus the transactions costs of making and
taking delivery, it is frequently more efficient to acquire or divest the
deliverable commodity via delivery. Second, market participants can
sometimes exploit the delivery process to their own benefit, and as
we show in the following chapter, inefficiently numerous deliveries
occur during the manipulative episodes.
Unfortunately, we are unable to observe the transactions costs
that motivate delivery behavior, and thus we can analyze the number
of deliveries in only a very crude fashion. We do so with a regression
analysis. In this analysis we regress the number of deliveries of corn
58 Grain Futures Contracts: An Economic Appraisal
and soybeans against variables that should be related to this quan-

tity. These variables include: a constant term; a dummy variable
equal to 1.0 if the delivery month is January, March or May and
equal to zero in all other months; a dummy variable equal to one if
the delivery month is September; the quantity of deliverable stocks
on hand in Chicago and Toledo; the basis; the cost of carry; and a
dummy variable equal to 1 in the summer of 1988 and 0 otherwise to
correct for the anomalous behavior in 1988 discussed in Chapter 2.9
It should be noted that these are reduced form regressions. That
is, there is presumably a supply-of-delivery schedule which relates
the number of deliveries shorts would like to provide to the basis, the
cost of carry, the stocks available, and the other marketing opportu-
nities available to him. Similarly, there is a demand for delivery
schedule which relates the number of deliveries longs will take as a
function of these (and perhaps other) variables. The regressions we
run do not estimate these supply and demand functions separately.
They are simply intended to determine whether deliveries vary con-
sistently with observable economic variables. Any systematic relation
suggests that deliveries occur for other reasons than arbitrage: Given
the results of Chapter 2, which showed no apparent pattern in arbi-
trage opportunities, a regression analysis would not reveal any such
patterns in deliveries if the only reason for them was to take advan-
tage of pricing violations.
The regression results are reported in Table 3-3 for soybeans and
3-4 for corn. The amount of the variance in deliveries explained is
modest, particularly for corn. Nonetheless, some patterns emerge.
Controlling for stocks on hand, the cost of carry, and for the summer
of 1988, deliveries are higher in November (for soybeans) and
December (for corn) than in the other contract months, particularly
January, March, and May. September deliveries are lower on aver-
age, controlling for other variables, than deliveries in all other
months for both corn and beans. The larger the carry, given the num-
ber of stocks, the larger the number of deliveries. The more negative
the cash futures basis, the larger the number of deliveries, although
this relation is not statistically significant. Deliveries were, more-
over, abnormally large during the summer of 1988. Finally, the
larger the stocks on hand, given the seasonal dummies and the carry,
the greater the number of deliveries. A 5,000-bushel increase in
stocks leads, however, to less than a 5,000-bushel increase in deliver-
ies, relevant regression coefficient is smaller than one. This is most
pronounced for corn.
Other researchers have concluded from a similar regression
result using a somewhat larger data set that these regressions cast
doubt upon the validity of the cash market data used to measure the
basis. 10 Like us, they find that the explanatory power of the basis is
small, and argue that this suggests that the cash data may be unreli-
able, as a warehouse would presumably like to deliver more, all else
equal, the more negative the basis (cash-futures). Thus the basis
variable coefficient should be negative and significant.
This argument is incorrect. Again, both the Peck-Williams
regressions and those reported here are in reduced form. They are
not structural form estimates of the supply-of-delivery schedule or
the demand for delivery schedule. In efficient markets the spread
and basis variables are equilibrium prices at which the marginal
transaction-i.e., a delivery-occurs between long and shorts. At
these prices, there are no additional mutually beneficial transfers of
the physical commodity from shorts to longs. These marginal prices
may bear little relation to the number of transactions (deliveries)
that are inframarginal at these prices.
This is an example of the well-known identification problem in
econometrics. If the levels of supply and demand for delivery sched-
ules both vary, reduced form regressions will not reliably estimate
the slopes of either schedule. In regards to the basis variable, this
means that in a reduced form regression it is quite plausible that
estimates of its coefficient are either insignificant or of the "wrong"
sign for the slope of the supply or demand schedule. This does not
imply that the basis data are bad, but just that the regression is inca-
pable of identifying the sign of the slope of either schedule because it
is determined by the intersection of these two varying schedules.
Taken together, the models investigated here provide only a dim
understanding of the factors that determine the number of deliveries.
The important finding is that deliveries are systematically related to
observable variables, and these variables are, in turn, likely to be
related to the demand and supply for corn and soybean transactions.
Thus, the reduced form relation estimated here provides evidence
that the delivery process does perform some merchandising function,
and is not solely intended to ensure convergence.
When combined with the previous evidence, this analysis sug-
gests that futures contracts serve a merchandising role, but that this
is an ancillary function as compared to the price discovery and hedg-
ing functions of futures contracts.
Summary
Conventional wisdom holds that futures contract delivery does
not serve a major merchandising function, but instead is a means of

ensuring convergence. Put another way, hedgers use futures markets
to protect themselves against the price risks of cash market transac-
tions rather than as a substitute for such transactions, and the abil-
ity to make delivery ensures that futures prices and the cash prices
of interest to hedgers are closely related. The evidence on grain deliv-
eries in the 1983-89 period that is analyzed in this chapter is broadly
consistent with that belief. Hedgers make and take delivery on only a
small fraction of the positions that they initiate during a contract's
life.
Important policy implications flow from such a finding. Most
importantly, it implies that the futures markets are not an important
way of transferring ownership of the underlying commodity.
According to one market participant, ''There are futures markets and
there are cash markets. Each serves a fundamentally different pur-
pose." Futures markets can function effectively only when they
achieve a sufficient level of standardization. Standardization facili-
tates liquid trading in a centralized exchange. Parties need not hag-
gle over the contract terms, and need to know little about the
characteristics of the counterparties to a trade. Thus, trading can
take place continuously and anonymously through the efficient arti-
fice of open outcry. 11
When a buyer and a seller both wish to transact in the standard-
ized good against which a futures contract is traded, the auction and
delivery processes can efficiently coordinate an exchange between
them. The data presented here imply that for grain markets, the ben-
efits of anonymous, centralized exchange of the physical commodity
via delivery (e.g., liquidity, savings in negotiation and search costs)
are small relative to the benefits of tailored cash transactions, as
only a trivial fraction of all grain bought and sold is transferred in
such a manner.
These results are not surprising given the heterogeneity in grain
markets. The location and quality of the grain transacted and the
timing of the transaction (to name the most prominent) are all of cru-
cial importance to both the buyer and the seller.12 That implies that
the demand for standardized exchanges of grain is low. The factors
that affect demand are beyond the control of a futures exchange, and
there are no obvious means of redesigning the existing com, wheat,
and soybean contracts at the Board to make them more effective mer-
chandising vehicles. In particular, expanding the deliverable set (by
adding a plethora of delivery locations in producing areas, for
instance) in order to allow more traders to participate in the delivery
process would actually impair the ability of the futures market to

coordinate the exchange of grain between buyers and sellers. This is
true because the anonymous delivery mechanism provides no mecha-
nism to reconcile traders' idiosyncratic preferences with respect to
the timing, location, and quality of grain transactions.
At the opposite extreme, one could create several futures con-
tracts for a particular commodity, each specifying delivery at a differ-
ent location or of a different grade in order to facilitate the use of
futures markets to merchandise grain. As noted in Chapter 2, the
fixed costs of operating a liquid futures market make that alternative
unviable.
These considerations suggest that liquid centralized trading of
futures contracts and extensive merchandising use of futures con-
tracts are incompatible when the preferences of traders in regard to
quality, location, etc. are diverse, and when there are fixed costs to
supporting a futures contract. Thus, futures contracts must serve
another purpose-the efficient sharing of risk. The data provided in
this chapter are consistent with that conclusion.
1 Chapter 4 discusses the role of deliveries in manipulation in great detail.

, Pirrong analyzes Williams' theoretical arguments in greater detail.
3 Williams (1987).
• See for instance the Commodity Trading Handbook, p. 31.
, Williams' analysis requires that delivery be cheaper than cash market transactions.
Since an EFP involves all of the costs associated with negotiating a cash trade, it can-
not constitute a delivery as defined by Williams.
6 Receipts and shipment for primary markets data and stocks data supplied by the
Chicago Board of Trade.

7 There are other reasons to believe that the delivery process is not an important com-
mercial tool. For instance, the primary delivery point for Board grain contracts,
Chicago, has undergone a pronounced decline as a grain processing, storing, and trans-
portation center. The same has occurred at the other terminal markets. If ownership
transfer were an important function of futures contracts, the decline in the importance
of the Chicago cash market should have reduced the demand by hedgers to trade
futures contracts. There is no evidence of that. Indeed, grain futures volume picked up
in the early 1970's even though the Chicago cash market continued to decline in
importance during that period. That is inconsistent with the Williams hypothesis. See
Pirrong for details.
6 Federal Trade Commission, v. V, pp. 272-347. Grains are not unusual. Similar data
for other commodities also reveals that only a small fraction of open futures positions
result in delivery.
" Basis is defined as the difference between the cash price and the futures price in the
delivery month. The cost of carry is defined as the annualized average percentage dif-
ference between the expiring and next-to-expire future. The annualization is intended
to correct for differences in the number of days between expiration of different futures
contracts. There are a larger number of days, for instance, between the expiration of a
November and a January future than between a July and an August future.
to Peck and Williams (1990).
uSee Telser (1981b) for a discussion of the role of contract standardization in facilitat-
ing liquid futures trading.
" Even in markets where spatial and quality factors are seemingly unimportant, spe-
cially tailored transactions are becoming more important. Consider the example of
common stock trading. A share of a particular stock seems to be the quintessential
homogeneous product. One share of IBM stock is a perfect substitute for another
share. Thus, stocks appear to be a perfect candidate for centralized exchange.
Nonetheless, since stock traders are becoming more heterogeneous in one essential
characteristic-the size of the share blocks that they wish to buy and sell-the tradi-
tional stock exchanges cannot coordinate transactions as effectively as in the past. As
a result, off-exchange block trading represents a large and growing fraction of equity
transactions.
4 • Maintaining the Integrity of Gtain Futures
Conttacts: The Economics of Manipulation
and Its Prevention
Introduction
Since the birth of grain futures markets, considerable attention has
been paid to the danger of manipulation of futures prices. During the
early years of futures trading, attempts to exploit the delivery process
in order to cause an artificial price change were alleged to be common. 1
Even more recently there have been several allegations of attempted
manipulation, but the allegations have become infrequent with the
refinement of self-regulatory and governmental regulatory techniques. 2
Manipulation is undesirable for several reasons. First, by distort-
ing the relationship between futures and spot prices in an unpre-
dictable fashion, it increases basis risk, and thereby reduces hedging
effectiveness. Second, it might increase the overall variability of
futures prices. An increase in either absolute price risk or basis risk
induces some hedgers and speculators to leave the market, thus reduc-
ing liquidity and increasing execution risk. s Third, it induces economi-
cally excessive numbers of deliveries. Fourth, it leads market
participants to expend real resources or to hold excessive stocks of
deliverables to protect themselves against the potential for manipula-
tion. 4 Fifth, manipulation produces a perception of unfairness among
market participants and causes an erosion of confidence in the mar-
kets. Sixth, and finally, taken together these factors can lead to reduc-
tions in liquidity.
In this chapter we analyze the causes of manipulation and some
ways to deter it. We show that in a market like grains, the transactions
costs of delivery have a major effect upon the profitability of manipula-
tion, and that the design of the delivery process can affect the likeli-
hood of its occurrence. Thus an understanding of these issues is
required to evaluate the delivery process of CBT grain and oilseed
futures contracts.
63

The Economics of Commodity Market Manipulation

It has long been recognized that manipulation is the consequence
of an exercise of market power in futures markets. 5 That is, manipu-
lation by a buyer of futures contracts-a "long manipulation"-is
analogous to the exercise of monopoly in product or input markets.
Similarly, manipulation by the seller of futures contracts-a "short
manipulation"-is analogous to the exercise of monopsony power in
the product or input markets. Consequently, the traditional tools of
price theory can be applied to study the causes of manipulation and
the potential means of deterrence. There have been no previous uni-
fied analyses using those concepts. We present one here.
The theory of monopoly implies that a single seller can increase
price only if he faces a downward sloping demand curve; i.e., monopo-
listic price distortions are possible only if the quantity that the
monopolist's customers wish to purchase varies inversely with the
price quoted by the monopolist. Similarly, a single buyer can depress
prices only if he faces an upwardly sloping supply curve; i.e., monop-
sonistic price distortions are possible only when the quantity that the
monopsonist's suppliers wish to sell varies directly with the price
offered by the monopsonist. Consequently, it is important to evaluate
demand curves faced by various long traders, as well as supply
curves faced by short traders.
When a contract nears expiration, most long traders wish to liq-
uidate their positions, which requires that they sell contracts; most
short traders also wish to liquidate, and so must purchase contracts.
Consequently, the relevant demand curve faced by a long trader is
determined by the futures prices at which short traders are willing to
liquidate to avoid the added costs of delivering. That, in turn, is lim-
ited by the cost to short traders of supplying the contract commodity
at a permitted delivery point. Similarly, the supply curve faced by
the short trader is determined by the futures prices at which long
traders are willing to liquidate rather than take delivery, which, of
course, is limited by the cost to long traders of accepting the commod-
ity.
Ordinarily there are many different long traders and many dif-
ferent short traders holding positions in a given futures contract.
Thus, any given long trader is competing with other longs to liqui-
date at favorable prices, while any given short trader competes with
other shorts. Nonetheless, due to the nature of futures trading the
total number of contracts outstanding to be bought equals the total
number of contracts outstanding to be sold. Consequently, the last
long trader to liquidate is a monopolist with respect to at least one
Maintaining the Integrity of Grain Futures Contracts 65
short trader. He is also at risk, however, to the exercise of monopsony

power by some unliquidated short trader. Competition among long
traders and competition among short traders does affect the
prospects for manipulation near the expiration of a contract, as the
following analysis shows. The potential for manipulation is inherent
in a contract market where participants trade with the intention of
liquidating their positions prior to expiration, rather than making or
taking delivery.
Given that most long and short traders desire to liquidate at con-
tract expiration, what determines the prices at which they are willing
to do so? That is, what determines the shape of the liquidation
demand and supply curves? In order to answer such questions one
must consider the alternatives available to each party (other than
liquidation), since it is their opportunity costs which determine their
reservation prices.
In the case of a short trader, his only alternatives to liquidation
through offset or an EFP transaction are default (which is very
costly) and delivery. Thus, the futures price at which he is willing to
liquidate depends upon the costs of default and delivery. He will not
pay a futures price to liquidate a short position that exceeds the min-
imum of the cost of default and the cost of making delivery. These
costs of making delivery depend upon the price prevailing in the spot
market and transactions costs. 6
If the number of deliveries is less than the uncommitted stocks in
the deliverable location, increasing deliveries marginally should not
significantly increase the marginal cost of making delivery. Once the
threshold is exceeded, however, the costs of making delivery should
rise with the number of deliveries, because price of the commodity
must be bid up in order to divert it from other uses and locations. 7
Thus, the elasticity of the delivery supply curve depends upon the
elasticities of demand of the current holders of the commodity-the
less elastic demand, the more price will have to be bid up in order to
increase deliveries. Thus, commodities for which there are many sub-
stitutes will have a more elastic delivery supply curve than those for
which the substitutes are limited.
When transactions costs and transportation costs are important,
the costs of making deliveries will rise more steeply (i.e., the delivery
supply curve becomes less elastic), ceteris paribus, for several rea-
sons. First consider the role of transport costs. When they are impor-
tant, and the commodity is shipped to or through markets other than
the deliverable point, transport costs isolate markets, thus reducing
the number of viable suppliers to the deliverable one. s Thus, the price
response to a given increase in supplies will be greater, (all else

equal) the higher the transportation costs, as the area tributary to
the delivery point (and hence the number of sellers) declines.
As the price in the delivery market rises, transportation of the
commodity from more distant points becomes economical, and the
delivery point's tributary area increases as the price increases there.
In grains, for example, the marginal value of stocks held in St. Louis
is usually higher than in Chicago (as the price is usually higher
there). In order to draw stocks from St. Louis to Chicago to enhance
deliveries, the price at the latter location must rise by at least the
amount of this premium plus the cost of transport from St. Louis to
Chicago. Thus, the stocks at places like St. Louis will flow to the
delivery market only if the price in Chicago rises sufficiently relative
to that in St. Louis.
N ext consider other sorts of transactions costs, such as the costs
of searching for, and negotiating and contracting with, current hold-
ers of the commodity. If there is a fixed cost of finding a willing seller
and consummating an agreement with him, it is efficient to econo-
mize on the number of such contacts and transactions, i.e., to limit
the number of sellers patronized. A restriction in the number of sell-
ers implies (at least on average) a greater price rise for a given quan-
tity purchased than if all sellers had been canvassed. 9
Such effects will be more pronounced if marginal transportation
costs and transactions costs increase with the number of deliveries
made. There are plausible conditions which lead to such increasing
marginal costs. First, if specialized resources are utilized to execute
transactions, marginal costs should rise with the number of deliver-
ies, because increasing the number of deliveries may increase the
number of transactions made, or because some other transactions
must be foregone in order to arrange supplies for delivery. Unless the
value of the transactional resources in the foregone transactions is
equal for each of them, the marginal cost of deliveries will rise.
Moreover, if there are capacity constraints in transporting the com-
modity to and handling and storing it in the delivery market, mar-
ginal costs of deliveries should increase with their number.Io
Similarly, increasing the number of deliveries may require the bid-
ding away of transportation resources from other uses. Disparities
between different short traders in the transport and transactions
costs paid will also lead to a somewhat inelastic marginal cost of
delivery function.
Such factors are of crucial importance in grain markets, in partic-
ular when compared to other commodities for which futures contracts
are traded. Transport costs are high relative to value, and grain con-
sumption and stocks are geographically dispersed. That implies that
any particular market is isolated, and that the producing and storage
areas tributary to the delivery market are circumscribed. Also, buy-
ing and selling of grain does not take place in centralized markets,
but instead requires traders to search for a transactions partner, and
the negotiation of sales contracts and transportation agreements.
Such activities entail substantial fixed costs, and require specialized
resources. Grain transportation is capacity-constrained, and com-
petes for transportation resources with other commodities. Handling
and storage facilities in the deliverable market are also capacity-con-
strained. All of these factors tend to make the marginal cost of deliv-
eries increase with the number made. l l Moreover, the marginal cost
curve will be steeper, the shorter the time available to make delivery.
Those factors lead to a positive relationship between the mar-
ginal cost of making deliveries and the number made. Hence, the
"liquidation demand curve" (i.e., the locus of prices at which short
traders are willing to liquidate) falls as the number of contracts liqui-
dated rises. The more liquidations, the fewer the number of deliver-
ies, and thus the lower the marginal cost of delivery. Since
liquidating one fewer contract requires one more delivery, the oppor-
tunity cost of liquidating the contract equals the marginal cost of
delivery. Thus, the liquidation demand curve is the mirror image of
the delivery marginal cost (supply) curve. Since the latter is upward
sloping, the former slopes down.
The marginal cost of delivery, and hence the elasticity and level
of the liquidation demand curve, should depend upon a wide variety
of factors. Seasonal ones are likely to be important in grain. As the
crop year progresses, for example, total stocks decline and tend to
congregate at consumption, as opposed to production points. That
tends to make the marginal cost of delivery curve steeper when deliv-
ery points are in producing rather than consuming areas. 12 Moreover,
the demand for grain should be more elastic soon after the crop is
harvested than when a significant portion of the crop year has
elapsed. Late in the crop year most inventories are in the hands of
final consumers and processors, rather than producers and mar-
keters. Processor facilities are typically designed for inbound ship-
ments of grain, not outbound, so it is costlier to move grain from
processor plants than from elevators and other storage facilities
designed for two-way movement. More fundamentally, inventories of
grain are more spatially concentrated late in the crop year. The
analysis of Pirrong (1990b) implies that this reduces the competitive-
ness of the grain market, and thus makes it costlier to acquire sup-
plies of grain for movement to the delivery point.
Secular factors can also affect the costs of making delivery. The
replacement described in Chapter 2 of the East Coast and Great
Lake ports as grain export points by the Gulf, for example, has
reduced the producing area tributary to Chicago and Toledo and
makes it necessary to reverse the direction of commodity flows in
order to enhance deliverable supplies. Such a reversal is wasteful.
These factors increase the steepness of the marginal cost of delivery.
The secular increase in output within the tributary area acts as a
counterbalance.
A long trader must also consider transactions costs when making
optimal liquidation and delivery decisions. A long trader can either
liquidate or accept delivery. The "supply of liquidations" depends
upon the marginal cost of taking delivery. If the marginal cost of tak-
ing delivery rises with the number accepted, the supply curve of liq-
uidations is upward sloping. Some factors may lead to such a positive
relationship between the number of deliveries accepted and the mar-
ginal cost of doing so. If the long trader who takes delivery has no use
for the commodity, he must sell it. If the transactions costs of doing
so are positive and increasing with the number of sales, the liquida-
tion supply curve will slope up. Moreover, if the demand curve in the
delivery market is less than perfectly elastic, and if transport costs
insulate the delivery market from other markets, the long drives
down the price in the delivery market when he sells what is delivered
to him. The greater the amount sold, the more his sales will reduce
the price. This decline in price is a cost of taking large deliveries. It is
sometimes called the cost of ''burying the body." Since this cost rises
with the number of deliveries received, this effect causes the liquida-
tion supply curve to slope up.
Making and taking delivery can also economize on some costs. An
owner of grain who wishes to sell it, for example, need not search to
find a buyer or negotiate the terms of a sale when delivering. Futures
contract standardization and the requirement that some long trader
is required to accept delivery (if tendered) allow a seller to avoid the
costs. Similarly, a long trader need not find a seller, or negotiate an
agreement with him. Standing for delivery is sufficient to obtain the
commodity. Thus, even if the costs of making and taking delivery rise
with the number made, some deliveries may be economical as they
reduce transactions costs. That can also affect the shapes of the liqui-
dation supply and demand curves. Since deliveries according to stan-
dardized specifications are imperfect substitutes for customized
transactions, the opportunity cost of making (taking) more deliveries

should rise as the number made rises. A trader would substitute
standardized delivery transactions for customized spot transactions
only if the price received on the former rises relative to that of the
latter, which makes liquidation supply and demand curves less elas-
tic.
Figure 1 incorporates the foregoing considerations in a supply
and demand diagram of the futures market at contract expiration.
The vertical axis measures the futures price at which holders of open
positions are willing to liquidate. The horizontal axis measures the
number of open positions. Because open interest is finite, both the
demand and supply curves become vertical at a level equal to the
open interest. For the sake of simplicity, the diagram assumes that
all traders enter the market to liquidate their positions simultane-
ously.13 As drawn, the marginal costs of making and taking delivery
rise with the number of deliveries, and hence the liquidation demand
curve slopes down, while the liquidation supply curve slopes up.
Thus, the necessary conditions for a manipulation are satisfied.
As contract expiration approaches, competitively behaving short
traders will be prepared to pay up to their opportunity cost-their
marginal costs of making delivery (or their costs of default if that is
lower)-to liquidate their positions. Competitive long traders will be
prepared to accept offers that do not fall below the net value to them
of taking delivery. In Figure 1, if all traders behave competitively,
the futures price around expiration will be determined by the inter-
section of the liquidation demand and supply curves. In the figure,
the equilibrium price equals P e. At that price, Q, contracts are liqui-
dated, while Qd contracts are settled by delivery. Delivery occurs
because some short traders face transactions costs of making delivery
that are less than the benefits some long traders receive from taking
delivery. Consequently, the long and short traders cannot agree on a
mutually beneficial liquidation price. Instead, they settle by delivery,
which is an efficient, competitive outcome.
Figure 2 illustrates a similar market, with the exception that the
demand curve for short traders is above the supply curve of long
traders for all quantities less than open interest. Consequently, if all
parties behave competitively, all positions will be liquidated, and no
deliveries will occur. The equilibrium price at final liquidation is
indeterminate, but lies within the range PI to Ph."
The forgoing assumes that traders act competitively at expira-
tion. They may not have an incentive to do so, however. In order to
illustrate the potential for non-competitive behavior, assume that all
traders but one have small positions relative to the size of the mar-
ket, and consequently act competitively. The remaining trader has a
large long position, and can choose the price at which he is willing to
liquidate. Presumably he will try to choose the price that maximizes
his profits.
To examine the factors that influence his choice, examine Figure
3. The demand curve for short traders is illustrated by curve D, line
X represents the marginal opportunity costs of trader A, line L is the
supply curve of the remaining long traders, and line S is the sum of
lines Land X.
Assume that all traders other than A act as perfect competitors.
If A does so as well, the equilibrium futures price will equal F*. But
suppose that A offers to liquidate his position only at a price of Fl.
Since all other long traders submit offers of less than F 1> the equilib-
rium price will equal F 1> and Ql short traders will liquidate at that
price. If trader A instead offered to liquidate at F 2> F 1> the equilib-
rium price would equal F 2, and then Q2<Ql short traders would liqui-
date.
The foregoing implies that trader A faces a demand curve to liq-
uidate his positions given by the segment GH of the market demand
curve, which is sometimes called the "residual demand curve"; it is
the portion of the demand curve that remains after the competitive
offers of all other long traders are netted out.
As drawn, the residual demand curve facing trader A slopes
down, implying that A possesses some market power; i.e., he can
influence the liquidation price in the market. The liquidation price
that maximizes A's profits is determined by the intersection of the
marginal revenue curve relevant to GH-line GBI-and trader A's
marginal cost curve-line XS. Because liquidating another contract
requires A to forgo the benefits of taking delivery, the relevant mar-
ginal cost curve is represented by line A, trader A's opportunity cost
curve. Given those conditions, A should be prepared to liquidate at a
price Frn>F*, where he liquidates Qrn positions, and takes delivery on
Qd=OI-Qm contracts.
A similar analysis holds for a short manipulator, except that such
a trader acts as a monopsonist, rather than a monopolist.
There are many implications of our analysis of manipulation:
1. There will be more deliveries when a manipulation occurs than

when all traders act competitively, ceteris paribus. Thus, for a given
demand curve and supply curve, non-competitive behavior leads to
excessive deliveries, which is wasteful, because real resources are
used in the process. The waste is the counterpart to the welfare loss
in traditional monopoly/monopsony analysis, and is represented by
the triangle ABC in Figure 3. The distortion arises because the cost
of making a marginal delivery exceeds its value.
Transactions costs both directly and indirectly determine the
magnitude of the welfare loss. The direct transactions costs of mak-
ing the additional deliveries is an obvious source of loss. The distor-
tion in the supply of the commodity occasioned by the manipulation
also leads to a deadweight loss, and the magnitude of this distortion
depends upon transactions costs.
2. A corollary to the foregoing is that a trader who closes all posi-

tions through delivery has not successfully manipulated; i.e, a manip-
ulator liquidates some futures positions. An inefficient increase in
the number of deliveries depresses the spot price due to the "burying
the body effect." Thus, if a long takes an inefficient number of deliv-
eries and liquidates no contracts, he sells what was delivered to him
at an artificially low price and therefore loses money. In order to
profit from manipulation, therefore, a long must liquidate some con-
tracts at an artificially high price.
A particular long trader (or many of them) might find it optimal
to take delivery on a very large position even if he does intend to
manipulate the market. That would happen if the long trader's trans-
actions costs of buying in the spot market are high, for instance, or if
the futures and spot prices had not properly converged. If the trans-
actions costs of making delivery are high (but lower than the long
trader's opportunity cost of taking delivery), standing for delivery can
lead to a dramatic increase in the futures price at expiration.
Regulators call such a situation "congestion," which, unlike manipu-
lation, suggests no bad intent.
Both the CFTC and the Board consider congestion to be disruptive
and attempt to prevent traders from taking delivery on large positions
in order to prevent substantial movements in futures prices. If traders
indeed act without manipulative intent (Le., "congestion" is truly dis-
tinct from "manipulation"), it is difficult to defend forced liquidations
in such instances. Even if deliveries are expensive, and consequently
the futures price rises (perhaps precipitously), if they are a cheaper
means of obtaining the commodity (including all relevant transactions
costs) than the next best alternative, then it is efficient to allow such
deliveries in the absence of any external effects. That is because at the
margin, the futures price should equal the value of the deliverable
commodity. From such a perspective, congestion means that the deliv-
ery process is serving its function of tying futures prices and spot val-
ues together. When the holders of many long contracts stand for deliv-
ery, one can infer that futures are underpriced relative to spot (when
including all relevant transactions costs), and the rise in futures price
represents convergence, not artificiality.15
In fact, it is likely that the futures price at expiration will be an
artificial one under a forced liquidation ordered in response to con-
gested conditions, because futures traders must discard economic cal-
culation in making their buy and sell decisions, as illustrated by
Figure 2. When ordered to liquidate positions, long traders realize
they must sell, even at low futures prices (or face penalties) while
short traders realize that they must buy, even at high futures prices.
That creates a potentially wide gap between the liquidation bid and
offer curves. The competitive futures price is then indeterminate
because the order to liquidate disconnects it from economic funda-
mentals.
3. A long manipulation will be more profitable, the more inelastic

the liquidation demand curve. Thus, the greater the dispersion in the
transactions costs of short traders, or the greater the impact of trans-
actions costs on the substitutability of stocks at various locations, the
more profitable a long manipulation.
The opportunity costs of short sellers-their delivery costs-are
sensitive to supply conditions. For instance, if supplies eligible for
delivery are abundant, the liquidation demand curve is likely to be
very elastic around the spot market price. If, on the other hand, sup-
plies are tight, short traders may have to pay dearly to obtain the
necessary quantity of grain and transport it to a deliverable location.
The costs of making delivery will rise with the number of deliveries
as short traders bid up prices, go further from the delivery point to
obtain further supplies, buy "fancy" grades, or pay to clean inferior
grades to make them deliverable. Consequently, the liquidation
demand curve is likely to be very inelastic during times of short sup-
ply, making manipulation more profitable then. Similarly, if total
supplies are abundant, but highly dispersed, long manipulation may
be profitable.
The spatial distribution of demand and supply also affects the
elasticity of the liquidation demand curve when transportation is
costly. Pirrong (1990b) shows that if the delivery market is located at
a point removed from the primary flow of the deliverable commodity,
and a relatively small fraction of the commodity is consumed in or
transported through the delivery market, the liquidation demand
curve will be very inelastic. This is true because buyers at the delivery
point (such as shorts attempting to acquire the commodity for deliv-
ery) must bid up the price significantly in order to draw supplies from
their natural markets. This model also implies that the liquidation
demand curve may be relatively inelastic if a delivery point is located
at a relatively low-cost market along the main direction of commodity
movement. Under these conditions shorts desiring to obtain deliver-
able supplies may have to ''backhaul'' the commodity, i.e., reverse the
direction of commodity flows. The transportation costs incurred to
make this backhaul are clearly wasteful. The diversion of the com-
modity from its high value uses is also inefficient. A manipulative
long can induce shorts to liquidate at high prices in order to avoid
paying these costs. Thus, when the delivery point is located at the ori-
gin of major flows of the commodity, rather than at the terminus
thereof, the market is more susceptible to manipulation.
These considerations are worrisome, given the evolution of grain
trading patterns discussed in depth in Chapter 2. Whereas Chicago
was once a primary node in the flow of grain from the country mar-
kets to the final consumption markets (e.g., export markets), and
thus at the terminus of commodity flows, this is no longer the case.
The primary direction of flow is now away from Chicago south
towards the Gulf. Thus, this changed direction of commodity flows
has increased the vulnerability of the CBT grain and oilseed futures
markets to manipulation because ceteris paribus it tends to make the
liquidation demand curve less elastic. 16
It is also well-known that long traders may be able to affect the
transactions costs of short traders by securing control of a large por-
tion of the deliverable supply. Thus, the long trader can control the
elasticity of the liquidation demand curve to some degree.
4. The more inelastic the demand for the commodity in the deliv-
ery market, the less profitable a manipulation.
All else equal, the more inelastic demand makes it costlier to
''bury the body." That is, the less elastic the demand curve for the
commodity in the delivery market, the more a given number of deliv-
eries reduces the price at which the manipulator can sell those units
delivered to him. Thus with a very inelastic demand in the delivery
market, it may be very costly for a manipulator to dispose of the com-
modity he receives via delivery as his sales thereof drastically
depress prices in the delivery market. This will make it costlier to
restrict the number of liquidations in order to elevate the liquidation
price. This implies that a manipulator facing a very inelastic demand
curve for the commodity in the delivery market will liquidate more
contracts than a manipulator facing relatively elastic curve.
Consequently liquidation futures prices will rise less and the manip-
ulator's profit will be lower in the relatively inelastic market, ceteris
paribus.
It is possible, however, that a manipulator can actually exploit
the ''burying the body" effect to his benefit. Specifically, if he initiates
a large short position in a contract that expires after his large long
position, the ''burying the body" effect increases manipulative profits.
This effect depresses the price of the deferred contract, which
enhances the profit of the spreading manipulator. The welfare effects
of this action are also more detrimental than in an ordinary manipu-
lation. The short position reduces the cost of accepting a delivery on
the nearby long position. This induces the manipulator to take even
more deliveries. These additional deliveries distort the distribution of
the commodity even more, and consequently distort prices (including
the spread between nearby and deferred prices) even more than a
simple long manipulation. Thus a large time spreader may be a most
dangerous manipulator.
5. A short manipulation will be more profitable, the more inelas-

tic the liquidation supply curve. Thus, a greater dispersion in the
transactions costs of the long traders, the more profitable a short
manipulation.
Short manipulation is an exercise of monopsony rather than
monopoly power. That is, a large short attempts to drive down the
liquidation price by reducing his purchases of futures contracts at
expiration. He can do so by exploiting the ''burying the body" effect.
By making too many deliveries, or simply bringing the commodity to
the delivery point and selling the excessive quantity on the spot mar-
ket there, he can drive down the spot price in the delivery market.
Longs, recognizing that if they hold out and take delivery that the
price at which they can sell the units tendered to them will be
depressed, willingly sell their futures positions at a depressed price.
The necessary condition for the exercise of monopoly power obtains
here. Since the demand curve in the delivery market slopes down, the
larger the number of deliveries the short makes, the greater the
depression in the spot price, and hence the lower price at which the
longs are willing to liquidate.
The short can also exploit transactions costs to induce favorable
settlement prices by longs. In the grain markets, for instance, it is
often alleged that large shorts (mainly regular warehousemen)
exploit the costs that longs must pay to store, load out, and sell the
grain delivered to depress futures prices around contract expiration.
A pioneering student of grain futures markets, Hoffman, states:
Manipulation, aside from "corners" and "squeezes," may at
times cause the futures market to temporarily move out of
line with the cash market. It sometimes happens that large
elevator interests, who themselves are consistent (short)
hedgers, are the directing force behind the movement. Thus
on the first delivery day of a given future, such as December,
terminal elevator interests may, as sellers of the December
future as a hedge, make delivery on their futures instead of
shifting them to May. Those obliged to take the grain are
very apt to be speculators with no storage facilities aside
from storing in public elevators at unprofitable rates. They
therefore offer down the current future to dispose of their
holdings, and when the "December" has become sufficiently
below the "May" the same terminal elevators buy the
December .... At times only the anticipation of an action of
this kind is sufficient to depress the December sufficient to
make it profitable for the elevator interests to transfer their
hedge to a more distant future. 17
This description is consistent with the analysis presented here.
The large short increases the number of deliveries in order to induce
the remaining longs to settle at favorable prices. Deliveries are exces-
sive, and there is a transfer of wealth from longs to shorts.
The Federal Trade Commission's Report on the Grain Trade
describes a similar process. Discussions with regulators, exchange
officials and market participants suggest that such a practice contin-
ues, and that it is sometimes accompanied by deliveries. IS
Hoffman argues that the "practice is not necessarily manipula-
tive," and it is widely believed that its impact is small. If it is a regu-
lar event, moreover, the effect will be incorporated into the prices at
which long traders are willing to initiate their positions.
Consequently, in the long run the practice seems unlikely to result in
a consistent redistribution of wealth from long to short traders.
If the elasticities of liquidation demand and supply curves change
over time, however, the degree of price distortion will vary. That
would tend to increase the variance of the basis between the futures
and spot prices. 19 The increase in basis risk reduces the value of the
contract as a hedging vehicle, thus reducing contract liquidity.
The most important deterrence to the exercise of monopsony
power is that those most able to exercise it, regular warehousemen,

would be injured by any reduction in hedging effectiveness and liq-
uidity. They rely extensively upon futures markets to manage the
risk of their extensive operations. Consequently, it is not in the inter-
est of those traders to exploit to an excessive degree their latent abil-
ity to disrupt futures pricing by taking excessive advantage of the
delivery mechanism. The latter is probably the most important pro-
tection against serious abuse of the delivery process by warehouse
operators who carry extensive short positions. Inasmuch as they do
not bear the entire cost of the distortion, however, their incentive to
eschew behavior that is undesirable for the market as a whole is not
completely eliminated.
Short manipulations are allegedly rare. 20 They are also quite sub-
tle and difficult to detect, affecting spreads perhaps only 1 or 2 cents.
Still, when and if they occur, they can impose large aggregate costs
on the market and produce large profits to the malfeasors.
The rarity of large short manipulations is not surprising. The
conditions that make long manipulation profitable-rapidly increas-
ing costs of making delivery combined with relatively constant mar-
ginal costs of taking delivery-make short manipulation
unprofitable. Thus, if conditions make long manipulations a recur-
ring threat, short manipulations are unlikely. One form of manipula-
tion should predominate. If long manipUlations are a recurring
problem, then short manipulations should be relatively rare.
6. Large positions facilitate manipulation. Positions that are

large both in absolute size and relative to open interest make manip-
ulation more profitable. Recall from above that the portion of the liq-
uidation demand curve that a long trader faces is that portion from
QI leftward to QI-X, where X is the size of the long trader's position
that optimally should not be liquidated. The larger is X, ceteris
paribus, the larger the dispersion in short transactions costs faced by
the long trader, and hence the higher the price that he can extract. A
similar analysis holds for a short manipulation.
7. Prices may be distorted if several traders with large positions

act in order to maximize profits around expiration. The foregoing
analysis has assumed that all traders but one behave as perfect
competitors (price takers) and submit bids or offers equal to their
opportunity cost. The analysis obviously extends to cases where
some group of traders colludes in order to act as a monopolist or
monopsonist. 21
Even absent collusion, however, the existence of several traders

with large positions can lead to price distortions. To see why, again
consider a long manipulation. Assume now that there are two (as
opposed to one) long traders with large positions; i.e., the market is a
duopoly, rather than a monopoly. The duopolists are competing with
one another by choosing the number of contracts to liquidate (or
equivalently the number of deliveries to accept). It is well known that
quantity-choosing duopolists frequently restrict output below the per-
fectly competitive level. Thus if concentration of traders is high
enough (i.e., there are several large traders, each of whom is too
small to manipulate the market himself), non-cooperative behavior
may result in an artificially inflated futures price.
8. Manipulation is more profitable, the more volatile the spreads

between futures contracts expiring in different months.
The marginal costs of making delivery should rise as the time
remaining until delivery declines, because traders have less flexibil-
ity to prepare to make or take delivery on short notice. Position hold-
ers could minimize the market power of any potential manipulators
by attempting to liquidate their contracts early, then preparing for
delivery if they cannot do so.
There potentially are costs to early liquidation, however, if
futures contracts with different expiration dates are not perfect sub-
stitutes. Several contracts are traded simultaneously for grains,
which indicates that (for instance) May and July contracts are not
perfect substitutes for soybeans, corn, or wheat. The volatility of
spreads between different contract months in a given grain is a fur-
ther indication of the uniqueness of each contract.
Early liquidation would require hedgers to roll their positions
into deferred months (or abstain from trading altogether). If the
spreads between the front and back months are volatile, and the
value of the obligation hedged is more closely correlated with the
front month futures price (in the absence of potential manipulation)
the hedger must live with higher risk if he liquidates early.
Similarly, time spreaders may not be able to trade as effectively, and
speculators with information specific to a particular contract month
will not be able to serve their function of improving price efficiency, if
they are reluctant to hold positions into the delivery period in
response to potential manipulation.
All of these considerations make early liquidation a costly means
of avoiding manipulation. Thus, traders may find it less costly to risk
losses from manipulation than to risk the losses from early liquida-
tion. The losses from the latter are greater, the more volatile the
spreads between different contracts, as the volatility makes the con-
tracts imperfect substitutes. Thus. high spread volatility increases
the slope of the liquidation supply and demand curves prior to the
delivery period, and makes manipulation more profitable.
9. Manipulation can reduce market liquidity and depth. Large

positions facilitate manipulation, and the larger the position a long
creates, ceteris paribus, the higher will be the price at expiration. If
traders cannot observe a would-be manipulator's individual activity
(as is likely, given his ability and incentive to conceal his trading) but
can only observe overall market trading volume, they realize that a
large influx of buy orders may (or may not) be due to the attempt of a
single trader to accumulate a position that will permit him to
squeeze the market. To protect themselves in the face of such a large
flow of buy orders, traders will sell only if they receive a price suffi-
ciently high to compensate them for the possibility of being squeezed
later. This reduces the would-be manipulator's profits to some
degree. Note, however, that large buy orders may occur for reasons
unrelated to a manipulation attempt; for instance, a large hedger
may submit an order for perfectly legitimate reasons, or several spec-
ulators may buy simultaneously. Since other traders may not be able
to determine reliably whether the order imbalance is due to a would-
be manipulator's trade or the activity of buyers with legitimate
motives, they will require the latter to pay the price premium. Thus
the possibility of manipulation makes the market "choppier." That is,
the market is less liquid and less deep. Inasmuch as liquidity is an
important determinant of trading costs, this is an extremely deleteri-
ous consequence.
10. Manipulation increases basis risk in markets for spatial com-

modities like grain. It is possible to show that in a spatial market
(like the grain market) the price of the futures contract rises relative
to the price away from the delivery point. Such a relative price move
is necessary to attract additional supplies to the delivery market.
Therefore, the revelation of a manipulation attempt imposes losses
on a short hedger located away from the delivery point (and benefits
a long hedger so situated). Moreover, since on average the futures
price prior to expiration must compensate shorts for the expected
losses from manipulation (otherwise they would not trade), if the
probability of manipulation is positive the pre-expiration futures
price will exceed the spot price that will prevail in the delivery period
if no manipulation occurs. Thus, given such a positive probability of

manipulation prior to the delivery month, if a manipulation does not
occur the futures price will fall, ceteris paribus, in the delivery period,
and it will fall relative to spot prices away from the delivery point.
This benefits short hedgers and harms long hedgers at non-delivery
location.
An examination of this analysis demonstrates that the potential
for manipulation forces hedgers to bear basis risk. Since prior to expi-
ration whether a manipulation will occur may not be known with cer-
tainty (since manipulation distorts relative prices) and since the
variation in relative prices imposes risks on hedgers, the mere poten-
tial for manipulation will cause idiosyncratic movements in the price
at the delivery point relative to prices elsewhere. That is, the poten-
tial for manipulation creates basis risk.
11. Manipulation injects noise into futures prices. Manipulation

also reduces the incentive of traders to accumulate information about
fundamental supply and demand characteristics. Together these
facts imply that manipulation reduces the informational efficiency of
prices and impairs the price discovery function of futures markets.
As noted in points 9 and 10, manipulation causes unpredictable
price movements that are unrelated to fundamental supply and
demand conditions. Market makers condition their bids and offers on
the order flow in order to protect themselves against the possibility of
a squeeze. Variations in the order flow may occur, however, for rea-
sons unrelated to economic fundamentals. Consequently, if manipu-
lation is possible, prices vary in response to idiosyncratic variations
in the volume of buy and sell orders. The resulting noise reduces the
value of the futures price as a price discovery mechanism.
Moreover, if manipulation can occur, the resulting noise in prices
impairs the ability of those with information about fundamental sup-
ply and demand conditions to predict prices. That is, manipulation
reduces the value of information about fundamentals. Moreover, the
reduction in market liquidity and depth noted in point 9 above
increases the costs of informed trade.
These effects of manipulation have several adverse consequences.
First, those in possession of such information reduce the scale of
their trading activities due to the lower returns and higher costs of
informed trading. Second, traders collect less information because
manipulation reduces the return to knowledge. Together, these two
effects imply that manipulation reduces the amount of information
embedded in futures prices, and thus reduces their reliability and
value as planning tools. Inasmuch as one of the most important roles

of futures markets is to aggregate information in order to improve
the efficiency of resource allocation, the reduction in price efficiency
resulting from manipulation is very costly.
12. Secrecy and information asymmetries are neither necessary

nor sufficient for manipulation to occur or succeed, or for manipula-
tion to harm market performance. The models of Easterbrook and
Kyle emphasize the role of such asymmetries. 22
Although the discussion in points 9 and 10 indicates that secrecy
can make manipulation more profitable, an examination of the model
presented above reveals that it does not involve information asymme-
tries in any way. Once a set of positions has been initiated, the poten-
tial for manipulation exists.
The analysts of manipulation have emphasized the role of infor-
mation asymmetries in order to explain why futures trading can exist
even though manipulations are possible. Traders aware of the likeli-
hood of a manipulation would charge the would-be manipulator a
price to initiate positions that would compensate them for their
expected losses. Since that would deprive the would-be manipulator
of any gains, his incentives to engage in the activity are negligible.
Consequently, people would only trade if they underestimate the
probability of a manipulation. That could occur if there is asymmetric
information; i.e., secrecy.
The analysis implicitly assumes that the only reason a trader
would initiate a position that potentially facilitates a manipulation is
to engage in such behavior. Many traders initiate large positions that
could allow them to extract manipulative gains for perfectly legiti-
mate reasons, however, such as hedging. That large positions exist is
common knowledge. Traders who initiate large positions for hedging
spot market activities or processing activities will often find manipu-
lation profitable (if such behavior is permitted) around the time of
contract expiration. They may do so even if other traders are per-
fectly informed about the size of their positions from the time that
they are initiated, and of the relevant variables that affect the elas-
ticity of supply and demand curves. That is, even if a trader's inten-
tions are pure ex ante he may have an incentive to exploit
transactions cost disparities ex post. Moreover, he may not be able to
effectively precommit himself to eschew such manipulative behavior.
Indeed, although the gains from doing so are negative ex ante even
given complete information (as traders on the opposite side charge
him for their expected losses when initiating positions, and because
some losses are deadweight he does not capture all of them in the
form of private gains), he may still have an incentive to engage in the
activity ex post. Thus, the deadweight losses and excessive variance
associated with manipulation may occur even if all parties are aware
of all the relevant information ex ante. Information asymmetries may
increase the incentive to engage in manipulation, but they are not
necessary for it to occur.
If the real costs of manipulation are sufficiently high, the very
nature of futures trading may preclude the existence of a futures
market if manipulation cannot be checked. That conditions in the
market make it desirable for some traders to engage in a large num-
ber of futures transactions (for hedging purposes, for instance) means
that manipulation is a possibility unless somehow deterred. But a
potential for repeated manipulation could raise the cost of using
futures markets by increasing the absolute price and basis risk, as
well as the deadweight losses from excessive deliveries and delivery
cost reduction. Those costs reduce the gains from futures trading. If
the costs are sufficiently high, liquidity may be significantly
impaired, and the market may even fail.
13. Summary and conclusion. The early history of grain futures

trading at the Board illustrates the potential for manipulation in
grain futures. In its early years the Board strove to prevent the
potentially disastrous impact of manipulation on the market.
The conditions in grain markets are still such that manipulation
could significantly impair futures market performance if unchecked.
Transportation and transactions costs are still significant. Not surpris-
ingly, there have been allegations of manipulation or attempted manipu-
lations of grain futures contracts periodically throughout the last several
decades. Indeed, it is arguable that the decline in the terminal markets
at the deliverable points and the associated changes in grain trading
patterns have made the conditions for grain futures manipulation more
attractive today unless it is somehow deterred, although the improved
efficiency of rail transport arising from the Staggers Act may have offset
the effect of the changed distribution in whole or in part.23 Thus, deter-
rence is potentially more crucial today than ever.
Market participants recognize that, and the self-regulatory effort
has continued. Moreover, since the 1920's it has been augmented by the
oversight of the various government regulatory agencies, the Grain
Futures Administration, the Commodity Futures Administration, and
now the Commodity Futures Trading Commission. The following section
analyzes the methods available to the Exchange and the regulators.
The Deterrence of Manipulation

There are four distinct ways to deter manipulation. First,
explicit, formal rules promulgated by an exchange or governmental
regulatory authority (such as the CFTC) can authorize peremptory
orders directed at a trader thought to be preparing to manipulate a
contract. That we will call ex ante enforcement. Second, manipulators
can be subjected to civil and criminal litigation after a manipulation.
We will call that ex post enforcement. Third, careful contract design
by exchanges can reduce the profitability of manipulation, and hence
its likelihood. Fourth, futures traders can informally signal a willing-
ness to refrain from manipulative behavior, with violations punished
through damage to long-term private relationships with other
traders. We will call that informal enforcement through reputational
loss.
An optimal deterrence system would likely utilize all four meth-
ods. Modern futures contracts overtly utilize the first three, and
knowledgeable observers contend that the fourth is important as
well. In this section we analyze the strengths and weaknesses of each
alternative.
1. Ex Ante Enforcement
Perhaps the most straightforward ex ante enforcement mecha-
nism is the position limit. By preventing traders from amassing
unusually large positions, the CFTC and the exchanges can reduce
the probability of a manipulation. Since some traders have legitimate
reasons to carry large open positions, however, realistic position lim-
its alone are insufficient to deter manipulation, particularly given
implication 3 above; the traders who seem to be most able to manipu-
late profitably are those who require large hedges.
Just as the economics of monopoly (and imperfect competition)
shed light upon the causes and effects of futures market manipula-
tion, they also provide insight into means available for deterring
manipulations by those who necessarily maintain large positions.
Recall that a long trader can profitably manipulate a market if he
restricts the number of contracts that he liquidates. Consequently, a
means of deterring monopolistic behavior is to force a suspected
manipulator to liquidate his position, or a substantial part of it-the
standard method employed by the various exchanges, including the
Board, as well as the CFTC. If a large trader's behavior inspires sus-
picion as contract expiration approaches, the CFTC is empowered to
force a reduction of that trader's position by declaring a market
emergency or revoking a hedge exemption. Under similar circum-
stances, an exchange can declare an emergency action and force an

orderly liquidation of all large positions. Their powers give the
exchanges and regulators leverage to 'Jawbone" large traders before
intervening, and so formal intervention may be a rare event.
Intervention, or even threats to intervene, also imposes costs on
innocent traders whose expectations may be disrupted by sudden reg-
ulatory shocks. Hence, it is inappropriate to intervene regulatorily
merely because manipulation is suspected, or just because manipula-
tion would impose costs on the market. Intervention is ill-advised
unless regulators expect that the benefits would outweigh the costs.
Reliable expectations, of course, require reliable information.
Indeed, an effective ex ante enforcement strategy requires a tremen-
dous amount of information about the suspected manipulator's inten-
tions, his likelihood of success, the magnitude of the cost of a
successful manipulation, and the cost imposed on innocent parties by
regulatory intervention.
One of the more problematic bits of information that the
exchange and the CFTC need pertains to the suspect's intentions.
Consider a suspected long manipulation. A futures contract techni-
cally gives the long trader the ability to stand for delivery against his
entire futures position. Consequently, a long trader can claim to be
maintaining a substantial position into the delivery month because
he plans to take delivery, not because he intends to squeeze the short
traders.
The Board and the CFTC usually discount the statement of
intent to take delivery, because they believe that high transac-
tions costs relative to spot market transactions render the deliv-
ery process unsuitable for efficiently transferring ownership of
large amounts of grain from short to long traders. Because long
traders so seldom take delivery, it is argued, short traders do not
make adequate preparations to deliver. That makes delivery very
costly to a short trader, who consequently will pay a high price to
avoid that eventuality.
Moreover, taking delivery forces a long trader to pay load-out,
storage, and insurance costs, to bear transport charges that may
exceed those applicable on spot market transactions, and to accept
a grade selected by the short trader, which may prove to be unde-
sirable for the long trader's purposes. Hence, it is argued, taking
delivery is also very costly for a long trader. If so, it is argued,
accepting a large delivery is uneconomic, and so a large long posi-
tion that is maintained into the delivery month provides evidence
of manipulative intent.
Those arguments have merit; the evidence from Chapter 3 sug-

gested that deliveries are quantitatively unimportant. It is desirable,
however, to specify the implicit assumptions that underlie them. In
particular, the assertion that the futures market cannot efficiently
coordinate delivery depends upon the price at which short traders
must liquidate at expiration if they fail to prepare to deliver.
Moreover, the argument that taking delivery is always uneconomical
for a long trader assumes that the transactions costs of taking deliv-
ery always exceed the transactions costs of dealing in the spot mar-
ket. We examine the assumptions in turn.
Assume that the cost of making a delivery increases as the period
available to make a delivery decreases. 24 Also assume (counterfactu-
ally for simplicity) that all short traders face the same transactions
costs of making delivery. Given those assumptions, if short traders
fail to make timely preparations, the cost of making delivery will
become very high as the end of trading approaches.
Recall that, as the cessation of trading approaches, the demand
for futures positions depends upon the opportunity costs of the vari-
ous traders with open positions. Also recall that if a long trader's
transaction cost for spot market purchases is higher than the trans-
action cost of taking delivery, his opportunity cost-and hence his liq-
uidation offer-price--will exceed spot market prices. If the offer-price
exceeds a short trader's opportunity cost, the short trader will have
to make a delivery, even at a high cost. Thus, if the long trader finds
it very beneficial to take delivery, the short trader will be forced to
pay the high cost of making delivery-the price for failing to prepare.
But if the long trader's opportunity cost of acquiring the commodity
on the spot market is below the short trader's cost of making deliv-
ery, the traders should be able to find a mutually beneficial liquida-
tion price.
So the effectiveness of a futures market in coordinating deliveries
depends crucially upon the liquidation price. To illustrate, consider
two alternative situations. In the first, liquidation occurs at the short
trader's opportunity cost, which must be higher than the long
trader's for liquidation to occur. In the second, it occurs at the long
trader's opportunity cost.
In the first situation, the short trader realizes that he will be
penalized if he fails to prepare. Regardless of the long trader's reser-
vation price, liquidation is assumed to require the short trader to
bear a price reflecting his own opportunity cost. To avoid that out-
come, the short trader can prepare to deliver, or attempt to liquidate
prior to the last moment at which he can prepare.
To illustrate, assume that if a short trader prepares to deliver

sufficiently far in advance of the last delivery date, he can deliver at
a total cost of pC+t', where pc is the price of spot grain, and tl is the
transactions cost of preparing to make a delivery. If the short trader
delays his preparation, however, he pays a total cost of delivery of
Pc+th, where th>tl is the transactions cost of making a hurried deliv-
ery. Assume that a long hedger (who wishes to obtain grain either in
the spot market or by delivery, depending on which is cheaper) incurs
a transactions cost of TS to deal in the spot market, and a transac-
tions cost ofTD to take delivery.
The short trader's incentives to prepare depend upon the price at
which he anticipates that he will liquidate a contract at expiration
and the probability that he will liquidate (which equals one minus
the probability that he will deliver), which in turn depend upon his
transactions costs and those of the long trader. Assume that the
short trader does not prepare. The long trader (who desires the spot
grain) is willing to liquidate at any price above pc+Ts_TD. If the
futures price is above that level, it will be more profitable for the long
trader to liquidate and buy in the spot market. If the futures price is
lower, the long trader will be better off to accept delivery. Similarly,
the short trader is willing to liquidate at any price below pc+th. Thus,
if pc+Ts_TD<pc+th, the long and the short traders will be able to find
a mutually beneficial liquidation price. If the inequality has the oppo-
site sign, the parties will not liquidate, but instead will offset by
delivery. Thus, if pc+Ts_TD>pc+th, the short trader will pay for his
failure to prepare.
If pc+TS_TD<pc+th, however, the short trader's profit depends
upon the liquidation price. If the short trader always liquidates at
pc+th, he will then have an incentive to prepare, as the following
argument shows. Assume that the last instant has arrived at which
the short trader can prepare to deliver at the transactions cost tl. If
he waits any longer, he must pay tho At that instant he can raise his
bid in the futures market to pc+tLe (where e is one tick: he will not
raise his bid all the way to pc+tl, as then he is indifferent between
bidding and preparing for delivery). If that bid is not accepted by
some long trader, the short trader knows that it is better to prepare
to deliver and incur the cost pc+t1 rather than wait until the last
minute and either liquidate or deliver at a cost of pc+th. Thus, if the
bid is not hit, the short trader always prepares.
Who will hit the bid? The bid will always be hit by any long
trader with pc+Ts_TD<pc+tl, because the long trader knows that if he
does not accept such a bid, the short traders who continue to have
open interests will prepare and make delivery. The long trader's
gains by accepting delivery equal pc+Ts_TD. If he hits the bid, he
earns a revenue of pc+tI-e-(Pc+Ts-TD»O by assumption.
Moreover, it is optimal for a long trader to take delivery only if
the total costs of making and taking delivery, TD_Ts+tI, are less than
O. Thus, only long traders who should not take delivery hit the bid.
All others decline and stand for delivery.
Since short traders prepare if their bid is not hit, the delivery
mechanism efficiently coordinates the activities of long and short
traders if the party that has the option to prepare for delivery-the
short trader-pays a penalty for not doing so. That will occur if the
short trader liquidates at a price that reflects his cost of making
delivery; i.e., pc+th if he does not prepare. Thus, the delivery process
can coordinate the transfer of substantial quantities of grain from
short to long traders. Consequently, it is not obvious that the delivery
process cannot coordinate large transfers; that depends on the price
at which liquidation occurs at the end of futures trading.
The conjecture may be true if, having failed to prepare to make
delivery, the short trader can expect to liquidate at a price of
p*<pc+tl. The short trader incurs a cost pc+t h if pc+Ts_TD>pc+th. If
the opposite inequality holds, however, he may be able to liquidate at
po.
The possibility of liquidating at a low price affects the short
trader's incentive to prepare. He knows that he only pays the high
delivery cost if pc+Ts_TD>pc+th. If that event is sufficiently unlikely,
and P* is sufficiently below pc+tI, then it may be more profitable for
the short trader not to raise his bid to pc+tI. He knows that if he pur-
sues that course he will pay a cost of pc+th only sometimes, but will
be able to liquidate at p' <pc+t1 at other times. If he raises his bid to
pc+tl_e, he knows that the long trader will either hit his bid or stand
for delivery. Thus, by raising his bid, the short trader incurs a cost of
pc+t1 for certain.
Thus, if the probability that pc+Ts_TD>pc+th is sufficiently small;
i.e., the long trader seldom stands for delivery if the short trader has
not prepared, the short trader will not raise his bid and not prepare.
He pays the high cost of having to deliver sometimes, but he liqui-
dates at a beneficial price sufficiently often to make the risk worth
bearing. Then the futures market cannot efficiently coordinate the
transfer of large quantities of grain from short to long traders.
The short trader should prepare to deliver if TD_Ts+tl<O. He will
not have an incentive to do so, however, if the probability that TD-
TS+th<O is small, and he can liquidate at a price below pc+tl. The lat-
ter is more likely when transactions costs of taking delivery are usu-
ally and significantly higher than the cost of a spot market transac-
tion. Thus, the extent to which the futures markets can coordinate
deliveries depends crucially upon liquidation prices at expiration,
which, in turn, depend on the transactions costs incurred by long and
short traders at the end of trading. If they do not rise as delivery costs
increase, then the market may not efficiently coordinate delivery. 25
The analysis here is related to the earlier discussion of conges-
tion. If the price mechanism is not allowed to work when long traders
are willing to pay a substantial premium to receive delivery (Le.,
when the market is congested), short traders may be able to liquidate
at a price that is below the delivered value of the commodity (includ-
ing the relevant transactions costs). That, in turn, will impair their
incentives to prepare optimally. Thus, if traders anticipate that
exchanges or regulatory authorities will sometimes, even in the
absence of manipulation, prevent prices from clearing the market,
the delivery process will work inefficiently.
If large deliveries (i.e., deliveries in excess of stocks on hand in
eligible locations) are rare, short traders will expect usually to liqui-
date at a price reflecting a low transactions cost. If so, prices at liqui-
dation will almost always reflect the low cost of making a delivery
from deliverable stocks, which is lower than the cost of obtaining sup-
plies for delivery from other locations even if there is considerable
time to do so. In that event P' <pc+ti , and thus short traders may not
find it optimal to prepare.
The foregoing argument also reveals why observing that a long
trader's bid price in the spot market is below the futures price plus
the costs of taking delivery is not sufficient to infer that he is manip-
ulating the futures market (although it may be necessary). The effi-
ciency of taking delivery against futures versus dealing in the spot
market depends on the long trader's spot market transactions costs
as well. In order to make inferences about a long trader's intentions,
his spot price should be increased to incorporate any transactions
costs incurred in spot market transactions. Neglecting that cost
assumes that the costs are O. If the costs are high under some condi-
tions, and if it is difficult for a regulator or exchange to determine
them, it will be difficult to use spot bids and futures prices to infer
manipulative intent.
The presumption of regulators and exchange officials is that such
costs are small, although this may not generally be the case. Most
spot bids are "to arrive," and hence include transport expenses. The
regulators and exchange officials we spoke with believe that other
transactions costs, including search and negotiation costs, are trivial

and hence cannot explain substantial deviations between spot bids
and futures prices.
2. Ex Post Enforcement
A supplement to monitoring traders' behavior ex ante is to impose
appropriate penalties on malefactors ex post. A noteworthy advan-
tage of such ex post controls is that they do not require futures
exchanges or public regulators to foresee each and every means that
a crafty trader knows or can invent to manipulate futures trading.
Rather, the events can be observed and analyzed before sanctions
need to be selected.
Indeed, such a distinction is not specific to futures markets, but
concerns the more general and well-studied contrast between the
philosophies that underlie the common law system of Great Britain
and her former colonies, on the one hand, and the civil code systems
that characterize the legal systems of most of the remainder of the
developed world. 26 Common law systems rely heavily on ex post adju-
dication; the legal rules that apply in any factual setting are not
defined until and unless at least one case arises under those facts.
Civil codes, in contrast, attempt to foresee every eventuality, and to
clearly delimit the boundary between permissible and impermissible
behavior before any case has arisen. Hence, civil codes-and any
other ex ante system of controls that is bound by a requirement of
due process-attempt to provide certainty about the law, but require
considerably more information before they can be implemented. 27
There are two distinct tasks that a well-functioning ex post deter-
rence system must perform. The first concerns determinations of lia-
bility for suspected malfeasors; the second the sanctions that are to
be imposed on those who are found liable.
3. Liability
The difficulty with determining liability for manipulative
attempts arises because completely innocent parties sometimes take
actions that look suspicious to observers; some of the accused are not
guilty. If sanctions are imposed too readily, innocent parties will
modify their own behavior in order to reduce the chance that they
will be found liable of violations. Some of those modifications will
entail refraining from socially beneficial behavior; those parties have
been "demoralized."
Because of the potential for demoralization, it is ordinarily unde-
sirable to create a deterrence system that will deter every potential
malfeasor. Stated differently, the optimal number of violations of

trading rules is not O. Penalizing the least skillful and most obvious
manipulators would pose little threat to innocent parties, but trying
to penalize more skillful and subtle ones would necessitate exchange
behavior that would surely entrap some innocent parties as well.
Taking the argument to its conclusion, attempting to penalize the
most skillful and least obvious manipulators would require acquies-
cence in sanctions against a substantial number of innocent parties.
Occasional punishment of the innocent is probably unavoidable if any
sanctions are to be imposed, but as the risk to the innocent grows,
honest people are driven from beneficial trading of futures contracts.
4. Sanctions
Assuming that liability has been established, the sanctions that
are to be imposed also pose a problem. If a sanction is imposed on a
malfeasor, by definition it is a loss to him. That may mean that what
has been lost by the malfeasor is a benefit to some other party. For
instance, if a liable party is fined, the collected funds are received by
someone else. In contrast, if that party is imprisoned, barred from
the exchange, or disabled in some other way, he loses something of
value, but it is not received by anyone else. Indeed, seemingly unin-
volved parties may also be injured, because the liable party is no
longer able to interact with them; voluntary interactions, when not
fraudulent, are expected by the parties to be mutually advantageous.
Those interests of innocent bystanders thus provide one reason to
prefer sanctions that transfer resources from the liable party to a
recipient, rather than those that impose "dead-weight losses" on the
liable party.
Hence, sanctions impose losses on some parties, not all of whom
are guilty or even suspected of a violation of accepted futures trading
practices. But the sanctions may benefit other parties, such as those
who receive the funds collected in fines. For present purposes, the
principal distinction among those sanctions that have benefits con-
cerns the identity of the beneficiaries. We will consider two categories
of potential beneficiary: parties who have been injured by the manip-
ulation; and parties who have been unaffected by it. By analogy,
under the law of torts beneficiaries are of the first sort-if you negli-
gently destroy my automobile, I collect the damages that are imposed
on you; under the criminal law, beneficiaries are of the second-fines
are paid to the state, not to the victims of the criminal activity.28
Beneficiaries should not be selected randomly. Modern scholar-
ship emphasizes a tension between the incentives of potential victims
to protect themselves, on the one hand, and potential opportunism by

the victims, on the other.29 We will consider those factors in turn.
In contrast to activities that are risky, but socially beneficial
nonetheless, inexcusable malfeasance ideally would elicit no caretak-
ing by potential victims. Such offenses have no social value, by defini-
tion, and so they would not occur in a perfect world. Consequently,
potential victims would invest nothing in precautions.
But in our imperfect world inexcusable offenses do occur. In that
case, can potential victims nevertheless be induced to spend no
resources-the optimal amount-on precaution? The answer is that
they can under certain circumstances. If one is able to ascertain the
injury that a victim of manipulation has suffered, then no precau-
tions will be taken if the manipulator is required to pay the victim
compensation that is completely compensatory. In the language of
the law, if a manipulator could always be required to "make the vic-
tim whole," the victim would have no reason to care whether the
manipulation occurred or not, and so would take no costly precau-
tions against it.30 That seems to imply that at least a part of the sanc-
tion against the manipulator should be received by the actual victims
of the manipulation.
Unfortunately, it may be impossible for an observer to accurately
calibrate such losses. In that event, attempting to adequately compen-
sate victims would likely result in overcompensation for some of them.
But then those victims who anticipated that their actual losses would
be less than their apparent losses would actually have an incentive to
increase the risk that they faced. For instance, some might maintain
an uneconomically large open position in futures contracts in order to
increase the likelihood that they would be ''victimized'' by a manipula-
tion, and thus entitled to claim an overcompensatory award from the
manipulator.
Therefore, if foreseeable overcompensation is a significant dan-
ger, awards to victims of manipulation may be made intentionally
undercompensatory-perhaps even nil. Though it induces potential
victims to undertake unfortunate precautions, that may be preferable
to the distortions that result if the victims begin actually to seek
injuries. But in that event, the beneficiary of the sanction must be
the exchange or the government, or else the malfeasor will not be
deterred.
Hence, it may be appropriate to permit the victims of manipula-
tion to sue manipulators ex post. That, as well as the relationship of
award to apparent injury, will depend on the precision with which
the victims' losses can be gauged. If the estimation precision is high,
private suits may provide the only ex post control on futures market
manipulation that is required. If not, however, it will be necessary to
involve the exchanges or governmental entities in both ex ante and ex
post enforcement, with all the potential for undue political interfer-
ence that entails.
5. Contract Design
Ex ante and ex post enforcement strategies are both costly,
requiring exchanges, regulators, and possibly private parties to moni-
tor trader behavior, and possibly requiring traders to employ lawyers
and courts to deter manipulations. One way to limit the employment
of such resources is to design futures contracts that reduce the poten-
tial gains from manipulation, and consequently reduce the incentive
to engage in such behavior.
The analysis above implied that the most effective means of
deterring a long manipulation is to make the liquidation demand
curve as elastic (flat) as possible at expiration. The more elastic the
curve, the lower the monopoly profit available to a long manipulator.
Liberalizing the delivery specification is one means of increasing
elasticity. It is a well-established economic principle that providing
more options to demanders increases the elasticity of their demands.
Consequently, an exchange can enhance the elasticity of the liquida-
tion demand curve by providing short sellers with more delivery
options.
There are four primary ways to increase the options held by short
traders. First, an exchange may expand the number of geographic
locations where short traders can deliver. Second, it can increase the
number of grades that can be delivered. Third, it can increase the
time that the short traders have to make delivery. Fourth, it can
increase the allowable modes of delivery.
The Board has employed each means to expand the deliverable
set. Wheat and soybean deliveries may be made at Chicago and
Toledo; corn at Chicago, Toledo, and St. Louis; oats at Chicago and
Minneapolis. Several grades of each grain are deliverable. 31 Finally,
delivery can take place at any time in the delivery month, including
the last seven business days of the month, during which time trading
in the expiring contract is prohibited.
By providing options, such contractual provisions should increase
the elasticity of the liquidation demand curve, and thereby reduce
the profitability of long manipulation. Consider, for example, the
effect of expanding the number of delivery points. Recall that trans-
portation costs reduce the elasticity of the delivery supply curve (and
hence the liquidation demand curve) at a deliverable location because

they restrict the number of sellers who can economically serve the
delivery point. Increasing the number of delivery points increases the
effective number of suppliers to the delivery market, and hence also
increases the elasticity of the delivery supply curve.
Increasing the number of delivery points may increase liquida-
tion demand curve elasticity in other ways as well. Some firms that
can economically make deliveries (e.g., grain merchants with ware-
house facilities in terminal markets) operate in some markets, but
not in others. Thus, increasing the number of delivery points can
increase the number of firms participating in the delivery process. If
the marginal transactions costs of delivery (e.g., the costs of search
and negotiation) rise at the firm level with the number of deliveries
made, an increase in the number of delivery points will shift the
delivery supply curve out and make it more elastic, thus reducing the
profitability (and hence the threat) of long manipulation.
The effectiveness of adding delivery points as a deterrence to
manipulation depends upon the pricing relationships between the
deliverable points and the delivery differentials imposed by the
exchange, as well as the delivery capacities of each location. Adding
delivery points at areas tributary to existing delivery points will do
little to enhance the relevant elasticities, as price in these markets is
already less than the Chicago price by the cost of transport.
Similarly, adding delivery points at regions not tributary to cur-
rent delivery points, but where prices tend to be higher (e.g., St.
Louis as a soybean delivery point) will not appreciably enhance
deterrence, unless delivery differentials counteract the effect of the
price premium. That is, the manipulation-deterring effect of addi-
tional delivery points at high-price locations is enhanced if deliveries
can be made there at a premium, and is reduced if deliveries can be
made there at a discount. Thus, the Board's current proposal to add
St. Louis as a soybean delivery point at a four cent discount should
have little impact upon that contract's susceptibility to manipulation,
because prices in St. Louis usually exceed those in Chicago by about
two percent. 32
Given St. Louis's position astride the major inland grain trans-
portation route, however, par delivery or especially premium delivery
there should appreciably reduce the elasticity of the liquidation
demand curve. A reduction in the delivery discount for St. Louis corn
delivery would also reduce the vulnerability of that contract to manip-
ulation. The addition of a point such as Minneapolis as a wheat deliv-
ery point for the Board contract would have a similar effect. 33
To attract deliveries of soybeans from St. Louis or Memphis, for

instance, requires shorts to pay the St. Louis price (which is usually
about two percent above the Chicago price due to transport cost dif-
ferentials) plus the cost of transport from St. Louis to Chicago.
Adding St. Louis as a delivery point would lower the cost of accessing
stocks stored in, and continually flowing through, St. Louis by the
cost of transport between Chicago and St. Louis. Allowing St. Louis
delivery at a premium to compensate for the price differential would
further reduce the cost of accessing these stocks, and therefore make
the liquidation demand curve more elastic.
The location of delivery points relative to the direction of com-
modity flows is also a matter of importance. Pirrong (1990b) demon-
strates that manipulation is more profitable when delivery points are
located at the origin of, rather than the terminus of, major move-
ments of the commodity. The intuition behind this result is straight-
forward. Prices at the terminus of major commodity flows (e.g., New
Orleans in grains and oilseeds) tend to exceed the prices in the coun-
try (Le., in tributary regions) by the cost of transportation. Thus
additional supplies can be attracted to the delivery point in response
to small changes in price there if this point is at the terminus of
major commodity flows. In this case, the main frictions a manipulator
can exploit are the capacities of the transportation system connecting
the country and the delivery point, and the storage capacity at the
delivery point. These frictions may allow a large long to artificially
elevate price, but shorts need not attract grain from its normal chan-
nels (at a cost) in order to increase deliveries, and this limits the prof-
itability of manipulation.
If, on the other hand, the delivery point is at the origin of com-
modity flows, to attract additional supplies to the delivery market
shorts must reverse this flow in order to increase deliverable sup-
plies. That is, they must attract grain from increasingly more costly
locations and pay to transport it where it should not go naturally.
These added costs increase manipUlative profit potential. A large
long can also exploit any costs arising from the costs of transporting
and storing unusually large quantities of grain to the delivery point.
Since when the delivery point is at the terminus of commodity flows
only the second friction exists, when the delivery point is at the ori-
gin of such flows the potential for manipulation is more acute. Thus,
the location of the delivery point influences the elasticity of the liqui-
dation demand curve and hence the profitability of manipulation.
The changed nature of grain flows documented earlier has trans-
formed Chicago from a terminal point to an origin point of grain
flows and thus made it more vulnerable to manipulation. This devel-

opment is strongly supportive of adding at least some delivery capac-
ity along the main route of export flows, i.e., a point along the
Mississippi such as St. Louis in order to offset the effect of these
changed patterns on the vulnerability of Chicago as a delivery point.
The benefits from improved long manipulation deterrence due to
increases in the number of delivery points must be weighed against
the other effects of such an action. Such an increase also affects the
basis risk of the futures contract. That is such an important issue
that it is given special attention in the following chapter. Moreover,
although designed to increase the elasticity of the liquidation
demand curve, increasing the number of deliverables also has effects
on the liquidation supply curve. Indeed, it is likely that measures
designed to deter long manipulations will make short manipulations
more likely. The reason is straightforward. Giving options to a short
trader gives him more leverage over the long trader. He can deliver
an unwanted grade at an undesirable location unless the long trader
sells out at a favorable price. Thus, the transactions costs of taking
delivery rise as the number of options available to the short trader
increase, which may permit some short traders to exploit the delivery
process to liquidate at favorable prices.
Although short manipulations are less costly and less frequent
than long ones, it is not necessarily wise to deter one massive long
manipulation through techniques that make short manipulations
more attractive. Moreover, as noted in Chapter 2, the higher the
transactions costs of making or taking delivery, the wider the poten-
tial variation in the futures price around expiration. That is, the
greater the transactions costs, the poorer the convergence. Increasing
the number of options granted to short traders may reduce their
transactions costs but increase those incurred by long traders. Thus,
the net effect on convergence is ambiguous and potentially harmful.
Over the years, the Board has adopted other methods to increase
elasticity as well. In 1915, for example, it adopted a rule allowing
short traders to make deliveries "on track" in rail cars within the
Chicago switching district during the last three business days of the
delivery month. The Federal Trade Commission asserted that the
action appreciably reduced the number of attempts at manipulation."
Although still on the books, the regulation has become non-operative
due to the change in grain transportation markets since the 1973
Staggers Act and the elimination of the grading track in Chicago.
The Board is now considering revitalizing the provision.
On-track delivery can contribute to the deterrence of manipula-
tion when the economic frictions that create a manipulative opportu-

nity are capacity constraints in transport and handling. At one time
these were probably important considerations. Due to the dramatic
gains in the efficiency of transportation and load-in at the regular
houses (primarily because of the development of contract rail car-
riage and unit trains), however, these factors are now of minor
importance. The primary reason for concern about the susceptibility
of the CBT grain and soybean futures contracts to manipulation is,
moreover, the fact that the evolution of grain trading patterns has
marginalized Chicago as a cash market. As noted before, to increase
deliveries in Chicago it is necessary to divert grain and soybeans
from their normal channels, particularly later in the crop year. This
diversion is costly, and a manipulator can potentially exploit this
cost. These conditions can make manipulation profitable even if there
are no important capacity constraints on handling grain in Chicago.
These considerations suggest that the revitalization of on-track
delivery would have little, if any, impact upon the vulnerability of the
CBT contracts to manipulation in the context of the existing Chicago-
Toledo delivery specification. It is not constraints on the speed with
which increased deliverable supplies can be handled in Chicago and
Toledo that create the potential for manipulation; what is worrisome
is that it is so costly to attract these supplies to these points in the
first place. On-track delivery does nothing to address this problem.
Since on-track delivery would require investment in facilities, and
since it is plausible that the transactions costs of taking delivery on-
track are higher than the costs of taking delivery of grain in store
(due, for example, to the delays in receiving the grain: such factors
create opportunities for short manipulation), this proposal is not
attractive. At best it should be considered as an emergency measure
to be employed in the event of a manipulative or congestive episode,
and not an option available to shorts in all delivery months.
6. Informal Enforcement Through Reputational Loss

The reputation of commercial entities is an important asset in
many industries and provides a potential means of deterring manipu-
lation of futures markets as well, thereby maintaining the integrity
of the delivery process. Whenever reputation is valuable, it is a
"hostage" that will be injured or destroyed in the event of bad behav-
ior. 35 Realizing that, a rational individual is inclined to engage in
such behavior only when the expected advantage to him exceeds the
reputational loss that he will suffer as a result. Hence, private
enforcement alone will not deter all manipulation of futures con-
tracts, only those that yield less profit than the value of the reputa-
tion that is to be lost. Nevertheless, the "small" manipulations that
are deterrable privately would also be those that are most difficult
. and costly to detect and sanction through a regulatory apparatus con-
strained by due process requirements.
Remember from implication 12 above that the potential for
manipulation is implicit in any large position around expiration
when the large trader cannot credibly commit to eschew manipula-
tion. If he can credibly do so, however, other agents may be willing to
trade with him. In other words, if there are mechanisms which allow
traders who derive benefits from futures markets (such as risk shift-
ing) to make self-enforcing promises to forego opportunities to manip-
ulate, the need for external antimanipulation enforcement
mechanisms is commensurately reduced.
Informal agreements between large traders are a means of pro-
viding such an enforcement mechanism. When economic agents
interact repeatedly with one another, tacit agreements may be
enforced by threats. 36 If anyone of the cooperating firms defects from
the agreed behavior, the other firms retaliate by withdrawing their
cooperation or engaging in some other sort of behavior that harms
the initial defector. If the punishments are sufficiently costly to the
defector, no firm will "cheat" on the implicit agreement. Though the
argument is most often applied to firms that tacitly agree to raise
prices above the competitive level, its validity is not restricted to
such anticompetitive acts. It is also applicable to cases where firms
can achieve beneficial ends through cooperation.
Many market participants believe that such an informal, implicit
enforcement mechanism exists in the grain futures markets. The
large traders, particularly some grain merchandising and processing
firms, have a vested interest in maintaining market integrity. Any
reduction in the markets' viability impairs their ability to hedge risks
and therefore raises their costs of doing business. Consequently,
although such firms could potentially benefit from engaging in a
manipulation, under normal conditions they understand that in the
long run such behavior is inimical to their interests. Those firms are
consistent participants in the market, and anticipate continued par-
ticipation in the future. That is a necessary condition for informal
agreements to survive. Moreover, because of their size, they should
be able to punish those that fail to "play by the rules of the game."
It is widely perceived among regulators and market participants
that there are such informal "rules," and that in some cases the
major players prefer to enforce such rules through private, informal
channels (i.e., private punishments) than via formal, self- or govern-

ment-regulatory mechanisms. 37 The usefulness of such informal rules
seems to be declining, however, with the increasing internationaliza-
tion of the grain markets. Many firms today trade in the American
marketplace sporadically. Threats to refuse future trade from them
in the event of a violation of the rules become less effective as a
result.
7. The Appropriate Mix of Manipulation Remedies in Grain Futures

Markets.
The preceding analysis clearly demonstrates that there is no
shortage of means available to punish manipulators. There are rea-
sons to believe, moreover, that manipulation is still a major concern
in grain markets. The changed nature of grain flows is one. The evi-
dence of Peck and Williams (1990) concerning the concentration of
the long open interest relative to the deliverable supply is another;
this evidence suggests that even without colluding the four largest
longs in the market just prior to the delivery month could restrict liq-
uidations sufficiently to artificially increase price. Indeed, these two
pieces of information are most worrisome when considered together:
The Peck-Williams evidence suggests that existing deliverable sup-
plies are insufficient to consistently deter price distortions, and the
evidence on grain trading patterns implies that it is very costly to
augment these supplies. Thus, deterrence should be a matter of con-
tinuing interest to the CBT and CFTC. Choosing the appropriate mix
of deterrents is, however, a difficult task.
In principle, the most desirable means of deterring manipulation
is designing a contract that is impervious to manipulation. Such a
contract obviates the need for expensive monitoring of traders, the
costly prosecution of suspected malefactors, and the disconcerting
disruptions of emergency actions.
Although obviously desirable, the nature of grain markets clearly
precludes the attainment of such an ideal. This is not to suggest that
there are no potential improvements to the existing CBT contracts.
The addition of a Mississippi River delivery point such as St. Louis
would enhance the deterrence of long manipulation.
The changed nature of commodity flows documented in Chapter 2
and the analysis above suggests that the creation of significant deliv-
ery capacity on the Mississippi at St. Louis or lower down would
reduce the market's vulnerability to manipulation if sufficient deliv-
ery capacity were available there. The primary flow of wheat, soy-
beans, and com (particularly the first two commodities) in the United
States is from the growing regions to export points in the Gulf.

Chicago and Toledo are near the origin, rather than the terminus, of
major flows of grain and soybeans. as Thus, in the event of an
attempted manipulation, Chicago and Toledo must draw grain out of
its normal commercial channels and can only do so at a cost that a
manipulator can exploit. A middle or lower Mississippi River delivery
point would not be as vulnerable, provided space exists there for
delivery. Thus, contract specification changes which increase delivery
capacity in St. Louis (even on an emergency basis), would apprecia-
bly enhance manipulation deterrence. It would be highly desirable
for the Board and other affected interests to devise such specifica-
tions.
The major concern about the addition of this point is that storage
elevator space is relatively small there. There are two elevators in St.
Louis with capacity of 4.7 million bushels currently regular for corn
delivery. Although the total capacity there equals 15.7 million
bushels (including warehouses that are not currently regular), this is
compared with the 14 elevators with more than 100 million bushel
capacity in Chicago and Toledo. Even if all of the 15.7 million bushels
of capacity in St. Louis become regular, it is probably not viable as a
sole or even a primary delivery point under the existing warehouse
receipt delivery mechanism, since when prices are low there (relative
to Chicago or Toledo) the point is itself vulnerable to manipulative
pressure.
The nature of this vulnerability is, however, much different from
Chicago's and Toledo's. St. Louis is vulnerable to a squeeze on space,
rather than a squeeze on the supplies available in its tributary area.
Chicago and Toledo have large amounts of space, but are vulnerable
to a squeeze on the supplies available in their now circumscribed
tributary areas.
A space squeeze is more readily addressed than a supply squeeze.
In particular, the deficiencies of St. Louis as a delivery point are miti-
gated in the context of a multiple delivery point system where the
Board selects differentials among delivery points to reflect typical
price differences (Le., in what we describe as an "economic-par" deliv-
ery point system) which we describe and analyze in more detail in
Chapter 5. In other words, if Chicago and Toledo are retained as
delivery points the addition of St. Louis at a premium could only help
deter manipulation. Even if St. Louis were the cheapest-to-deliver
location at a particular point in time, a manipulator's ability to
exploit the relatively small amount of storage space there would be
considerably constrained except under extraordinary circumstances
by the ability to deliver in Chicago and Toledo. Thus, the addition of

St. Louis as a delivery point at a premium would make manipulation
of the futures contract less likely when Chicago or Toledo are cheap-
est-to-deliver, but would not appreciably increase the profitability of
manipulation when St. Louis is the cheapest delivery point since it
becomes economic to deliver Toledo and Chicago supplies in response
to a small price distortion in St. Louis.
If the CBT can resolve some of the difficulties with the shipping
receipt mechanism raised in Chapter 2 above, moreover, it could
increase the manipulation deterrence capability of a Mississippi
River delivery point by increasing the potential to deliver there.
Similarly, a provision for emergency barge or rail delivery in St.
Louis could make the liquidation demand curve more elastic and
thereby deter manipulation. Emergency provision for delivery by
shipping certificate at other Mississippi River points might also be
considered. The Board could retain the right to declare emergency
delivery in throughput elevators on a case-by-case basis. It could also
use a variation on the "safety valve" system to induce an automatic
activation of this capacity in the event of a price distortion. The
Board could, for instance, allow delivery by barge, rail, or shipping
certificate at discounts (or reduced premia at a point such as St.
Louis). Deliveries via these alternative means would occur only if
supply space at the delivery point were squeezed significantly. This
could reduce significantly the costs of making very large deliveries,
which would have particularly valuable deterrel.lce effects. It could
also ensure the viability of St. Louis as a pricing point; the following
chapter demonstrates the potential benefits of this.
Beyond these possible changes, there is no obvious means of
altering the terms of the grain futures contracts to reduce the likeli-
hood of long manipulation. In particular, a wholesale multiplication
of delivery points is not justified. More is not always better. Such a
proliferation would (as noted in Chapter 3) disrupt the futures mar-
ket as an ownership transfer mechanism. It would also (as noted in
this chapter) make short manipulation more likely, and (as noted in
the following chapter) increase the cost of arbitraging the futures
market.
In any event, one cannot expect contractual changes alone to
eliminate the possibility of long manipulation in grain futures, par-
ticularly if it is difficult to expand delivery capacity on the middle
and lower Mississippi. Ex post and ex ante measures are necessary,
as well. Of these, ex ante mechanisms are probably preferable. As
noted earlier, ex post measures are superior to the extent that there
is superior information ex post. They are inferior to the extent that ex

post adjudication is expensive.
An examination of the history of manipulation trial and adminis-
trative law suggests that the ex post information advantages are less
than overwhelming and that the legal doctrines concerning manipu-
lation are contradictory and obscure. 39 That is, it does not appear
obvious in practice that the ex post adjudicators have significantly
better information. Alternatively, if they do, they do not employ it in
a manner consistent with the basic economics of manipulation pre-
sented above. For example, the Volkart and the Indiana Farm
Bureau cases suggest that a trader can legitimately exercise market
power at the end of a contract's life as long as he did not initiate the
position with the intent of exercising this power. That is, a long
hedger can legally manipulate according to the logic of these cases.
The ruling in the Cox and Frey case also contradicts the essentials of
the analysis presented above. There the CFTC commissioners
ignored the effects of transportation costs and geographic price differ-
ences when they determined that the relevant deliverable supply for
a CBT wheat contract included all wheat in Kansas City and in tran-
sit by barge on the Missouri and Mississippi Rivers. The analysis
presented above and in Pirrong (1990b) suggests that this argument
is fundamentally flawed.
There is considerable anecdotal evidence, moreover, that ex post
adjudication is extremely expensive. Although one could argue that
the expense and uncertainty of a possible manipulation trial would
make large long traders avoid even the appearance of manipulative
conduct, the uncertainty, expense and time required for determina-
tion of ex post penalties make them a relatively undesirable means of
deterring manipulation.
This is not to suggest that ex ante measures are perfect. In partic-
ular, as we noted earlier, determining the motive of a large trader is
somewhat problematic. Superior data on cash prices and stocks
would certainly improve inferences concerning intent, and the CFTC
and the CBT should attempt to acquire improved data; this would
certainly require the cooperation of the commercials, but it is poten-
tially beneficial to all parties to contribute to the creation of a more
. systematic set of data upon which regulators can rely to monitor
trader behavior.
A more clear-cut articulation of the difference between "conges-
tion" and "manipulation," and regulatory and exchange policies based
on such an articulation, would also enhance the efficiency of ex ante
deterrence. One of the costs of ex ante enforcement is that it is some-
times utilized to counter non-manipulative uses of the delivery

process. In the presence of mispricing, standing for large deliveries
can actually improve market efficiency by ensuring convergence to a
sensible price. Non-intervention in "congestive" episodes could have
other salutary effects as well. As noted above, if shorts realize that
the exchange or regulator will intervene to prevent prices from reach-
ing their equilibrium level around contract expiration, they will not
take efficient preparations to move the commodity to the delivery
market, and they will not employ bidding strategies that allow them
to determine whether the demand for deliveries is high or low. This
behavior can also make manipulation more profitable if shorts are
unable to distinguish between congestive and manipulative episodes,
as shorts do not have the proper incentives to mitigate the costs of
manipulation by making adequate preparations for delivery prior to
the close of the delivery period.
Distinguishing "manipulation" from "congestion" implies at least
some ability to separate these phenomena reliably. If this is true, ex
ante measures should not be employed when manipulation can be
ruled out. If the ability to distinguish manipulation and congestion is
severely limited, regulators and exchanges should discard the dis-
tinction and instead devise ex ante measures that are predictable and
based upon commonly observed variables. For example, the CFTC or
the CBT could establish an explicit policy stating the number of
deliveries a trader could take, or the rate at which each trader must
liquidate positions in the delivery month. This would be predictable
and therefore superior to the existing system of judgement calls.
Moreover, this rule could be made more flexible by allowing an
affected party to apply for waiver of the requirement upon demon-
stration of a legitimate economic need. This would give traders an
incentive to reveal the internal information that an exchange or the
regulator would require to establish intent, which would in turn
assist in eliminating one of the major potential problems confronting
ex ante enforcement.
Summary
The analysis of this chapter emphasizes the important role of
transactions costs in making manipulation profitable. Grain futures
markets are vulnerable to attempted manipulations primarily
because of the importance of transportation costs and the fact that
grain flows to disparate locations. The discussion of Chapter 2 sug-
gests, moreover, that this vulnerability has increased due to the
decline in the terminal grain markets and the concomitant redirec-
tion of grain flows south, away from the existing delivery points on
the Great Lakes. This change tends to reduce the grain supplies held
in areas tributary to Chicagofl'oledo (especially relative to the total
supply, which is more relevant in determining supplies in the tribu-
tary area relative to open interest). It thereby requires shorts to
incur transportation costs and the costs of distorting the distribution
of commodity stocks in order to increase deliveries.
Salutary developments in grain transportation markets, espe-
cially the rise of contract carriage in the wake of the Staggers Act,
have mitigated the severity of the effect of this evolution in grain
trading patterns on the profitability of manipulation. Contract car-
riage has reduced the cost of grain transport, and made the shipment
of grain in large quantities more economical. Each of these effects
would tend to reduce, ceteris paribus, the profitability of manipula-
tion and therefore counteract the effect of the evolution of grain marc
keting patterns. They do not counteract totally, however, the effects
of the evolution in grain trading patterns documented in Chapter 2.
As noted earlier, the conditions that make manipulation profitable
exist when it is necessary to divert grain away from its typical move-
ment patterns in order to increase deliveries substantially.40 The
decline in Chicago and Toledo, and the Great Lakes and East Coast
export markets in general, makes such diversions necessary to
increase deliverable supplies substantially. Thus, continued enforce-
ment efforts, particularly ex ante enforcement, are necessary for CBT
grain and oilseed futures contracts unless and until the Board can
expand delivery capacity on the primary export route.
1See Federal Trade Commission, pp. 167-181; Ferris for discussions of manipulations
in the 1870-1920 period.
2 Two classic examples of alleged manipulative attempts include the Cargill wheat case
of 1963, and the Harper Deal of 1887. More recently, there have been allegations of
manipulation in grain and oilseed markets against the Indiana Farm Bureau (1972),
Cox and Frey (1971), the Hunt brothers (1978), and Ferruzzi S.A. (1989).
3 The decrease in liquidity amplifies the effect of manipulation on volatility.
4 Traders keep larger holdings in deliverable locations, for instance, than they other-
wise would. Moreover, as shown below, deliveries are often too great during a manipu-
lation. Thus, market participants overinvest in the facilities required for making
deliveries, such as elevator capacity, railroad rolling stock, and marketing resources.
See Easterbrook; Edwards and Edwards for discussions of the real costs of manipula-
tion.
, See Easterbrook; Edwards and Edwards for general discussions of the relationship
between market power and manipulation.
6 It should be noted that when discussing manipulation, an EFP is not a substitute for
delivery. What is important is the cost at which a short standing opposite a large long
can avoid purchasing a contract from that long. He can avoid such a purchase by deliv-
ering to the long, or defaulting. Engaging in an EFP transaction with the large long is
equivalent to liquidating at the long's price, as the long would not agree to the transac-
tion unless he profited thereby.
7 There is a subtlety concerning the price effects of increasing deliveries; the prices at
which current holders would be willing to sell the commodity depend upon what they
expect will happen to the stocks thus sold. An implicit assumption of the argument
above is that the incumbent holders expect that the recipient of a delivery intends to
retain possession thereof, or has already arranged a sale to someone who does. If, on
the other hand, sellers expect the delivery recipient to sell the commodity upon the
open market, they might supply the commodity for a small premium above the current
competitive market price, or even at that price, because the current holders expect to
be able to purchase it back at the competitive market price. The premium they would
demand depends upon the time that they expect to lapse prior to the resale by the
deliveree, the rental value of the commodity during that interval, and the transactions
costs incurred in sale and repurchase. If a single trader accepts a large number of
deliveries, he may be able to act as an intertemporally discriminating monopolist (Le.,
a monopolist who price discriminates by selling too little now and too much in the
future), which will lead current holders to demand a greater premium for sale, the
larger the number of deliveries made. We believe that is an unimportant case, how-
ever, so we emphasize the role of transactions costs.
, The delivery point's tributary area has far fewer suppliers than the market as a
whole does.
9 The elasticity of the supply curve faced by those making purchases for delivery is
greater, the greater the number of suppliers from whom purchases can be made. If
increasing the pool of sellers is costly due to search, negotiation, and contracting costs,
buyers will trade off the benefits of a more elastic supply curve against the higher
transactions costs. Thus, the higher the transactions costs, the fewer the sellers
searched, the less elastic the relevant supply curve, and the costlier it will be to
increase the number of deliveries.
10 If the capacity per unit time of transport and handling facilities is constrained, deliv-
eries can be increased by making shipments to the delivery point over a longer period
of time. That requires someone to incur the cost of storage and the opportunity cost of
the capital invested over the time that the commodity is held pending delivery.
11 Transportation technologies that exhibit economies of scale, such as unit trains, may
be a mitigating factor. The marginal cost of transport rises with deliveries until it
becomes economical to use a unit train.
Ii For instance, much of the grain crop produced in northern Illinois is shipped for
export via the Gulf. Thus, supplies tend to migrate away from the delivery point's trib-
utary market as the crop year progresses. See Pirrong (1990b) for a more detailed
analysis of this seasonal effect.
13 Adding the possibility of sequential liquidation complicates the analysis without
appreciably changing its results.

14 As illustrated in Chapter 2, if the transactions costs of making delivery are high, the
futures price may be indeterminate. The greater the transactions costs, the greater the
area of indeterminacy. Then the futures prices at expiration may vary over a wide
range, thereby reducing a contract's hedging effectiveness.
" Hence, a means of distinguishing "congestion" from "manipulation" is suggested: If
many long traders stand for delivery, it is likely that futures are underpriced and that
a sharp price response is justified. Only if the long traders collude (which is unlikely,
given the ability to trade anonymously) could one then infer manipulation.
16 The development of more efficient transportation arising from the Staggers Act and
other innovations has had an offsetting effect, but these are not sufficient to com-
pletely reverse the effect of changed commodity flows.
17 Hoffman, p. 90.
18The operators of regular warehouses frequently have a low (and perhaps negative)
cost of making some deliveries, as they collect storage fees on the grain that remains
in their elevators.
,. The increase in basis risk arises from two sources. First, long traders will demand a
discount in the futures price ex ante that on average will compensate them for the
anticipated losses from short manipulation. The actual price discount at expiration
will differ from that expected ex ante, however, due to unanticipated changes in supply
and demand elasticities. Thus, even if there are no other sources of uncertainty, the
basis will vary. The second source of basis risk arises because manipulations distort
the price of the deliverable grade at the deliverable location relative to the prices of
other grades and locations. Stochastic liquidation supply and demand curves make the
distortion random. Ceteris paribus, that increases basis risk for the non-deliverable
stocks.
'" See Easterbrook; Edwards and Edwards.
21See Ferris, pp. 51-82, and Kolb and Spiller for several examples of collusive manipu-
lation in the early days of futures trading.
22 Easterbrook; Kyle. In Kyle's model a futures contract calls for delivery of one of two
grades, fancy or regular. The fancy grade is more expensive, and the supply of the reg-
ular grade limited. That creates the potential for a downward sloping opportunity cost
for short traders. There are three types of traders: hedgers, uninformed speculators,
and an informed speculator. Hedger demand for short positions is sometimes high,
sometimes low. If their demand is high, the number of open positions exceeds the sup-
ply of the regular grade; if it is low, the supply of the regular grade will cover open
positions. The informed speculator buys contracts when hedging demand is high, and
sells when hedging demand is low. Consequently, he is in a position to manipulate.
23 See Pirrong (1990b) for a model of manipulation, and a discussion of how the nature
of commodity flows can affect the profitability of manipulation.

.. Alchian argues that such a relationship is to be expected in virtually any economic
process. The problem of coordinating numerous deliveries is unimportant unless the
cost of making delivery is higher the shorter the time available to make it .
.. If the cost of making a delivery does not rise as the time remaining to make a deliv-
ery falls, the futures market can efficiently coordinate deliveries. It is plausible, how-
ever, that the cost of making deliveries rises as the time remaining to deliver falls. See
Alchian. Then, once the stocks in warehouses (which are usually small) are exhausted,
short traders must bring supplies from elsewhere, and the cost of doing so would
increase as the speed required to make the delivery increases.
In the early days of grain futures trading, there was a pronounced increase in
futures prices at the end of the delivery month.
26 See, for example, Merryman; Hogue.
27 Indeed, no civil code system exists that has been able to dispense entirely with a
common law-like adjudicatory arm. On the other hand, all modern common law sys-
tems are augmented with code-like statutory law. Perhaps a hybrid system works best.
28 Some violations motivate multiple sanctions, some of the first sort, and some of the
second.
'" See Haddock and McChesney; Haddock, McChesney & Spiegel.
aoIf only some manipulators are detected and made to pay, it would be necessary for
them to pay a multiple of the losses that they had imposed on victims in order for the
expected value of the victims' recovery to be sufficient to make them whole. Hence, the
malfeasor might be liable for "triple damages" if the probability of his compensating for
victim losses was one-third. The multiple could be adjusted to account for risk-aversion.
31In the 19th century, the Board frequently increased the number of eligible delivery
points and grades on an emergency basis during attempted manipulations. The Board
sometimes declared previously irregular (and sometimes substandard) elevators as
regular for delivery, thus increasing the ease with which short traders could deliver.
See Ferris. That was a reasonable option when there was a lot of elevator space in
Chicago, but has become less realistic as the Chicago terminal market, and its associ-
ated storage capacity, has declined.
3' This price premium indicates that St. Louis is not tributary to the Chicago market
despite the fact that they are linked via the Illinois and Mississippi rivers. Whether
one market A is or is not tributary to another market B does not depend upon whether
it is possible to transport goods from A to B. By this definition all markets are tribu-
tary to all other markets. What is important is whether goods flow from A to B or B to
A in actual practice. When the price in market B is higher than the price in market A
it is self-evident that market B cannot be tributary to market A. Thus, the price pre-
mium indicates that St. Louis is not tributary to Chicago. Common knowledge about
the major direction of grain flows down the Illinois and Mississippi (not up) is further
evidence of this fact.
33A potential problem with St. Louis is that most elevators there are throughput facili-
ties, and storage capacity is therefore relatively small. The problem could be rectified
by allowing barge deliveries in St. Louis during special situations. Just as the Board
frequently declared additional elevators or grain in cars regular as an emergency mea-
sure during manipulative episodes in the 19th century, it could make St. Louis barge
deliveries regular on a discretionary basis.
Addition of Minneapolis as a wheat delivery point would obviously be complicated
by the fact that it is a hard spring wheat market, while Chicago is a soft winter wheat
market.
3< Federal Trade Commission, v. V, pp. 175-77. The Board also allowed the board of
directors to declare on-track holdings eligible for delivery in an emergency.

'" See Williamson (explicitly) and Telser (1981a) (implicitly) for extensive analyses of
the use of hostages for enforcing agreements.
W Strictly speaking, at any moment agents must presume that there is a non-trivial
probability that they will again interact with one another in the next period.
'" Some "rules of the game" might be beneficial for the entire market, and that some
might advantage the larger participants at the expense of smaller ones. Any informal
rules against manipulation would fall in the former category.
3S With the corn processing market in Chicago, that city is a more significant terminus
for corn shipments than wheat and soybean shipments. Thus the desirability of a
Mississippi River delivery point is more desirable for soybeans and wheat.
". Klejna and Meyers; Mandel.
40 The soybean market provides a good illustration of this phenomenon. Soybean
receipts in Chicago are largest in November and December, then drop off dramatically
for the remainder of the crop year. According to market participants, soybeans stored
in Chicago are most often loaded out of regular elevators onto barges for shipment to
the Gulf because Chicago serves as a residual storage center for soybeans. Thus, the
primary direction of commodity flow outside of the November-December period is away
from Chicago. In order to increase deliverable supplies to deter manipulation in the
spring and summer, therefore, traders in Chicago must reverse the natural flow of
beans by either loading out fewer of them (which requires them to incur an opportu-
nity cost) or bringing those that would normally flow to the Gulf into Chicago (which
forces them to incur an opportunity cost and the direct costs of transport and excessive
handling). Shorts would be willing to liquidate their delivery obligations at a premium
to avoid bearing these opportunity costs and direct costs. A large long trader can
exploit this willingness to his benefit. Thus, although some transportation market
changes-especially the Staggers Act-have reduced the direct costs of bringing soy-
beans into Chicago, which by itself makes manipulation less profitable, other changes
in transportation markets and grain flows described in Chapter 2 above have created
opportunity costs which also create the conditions for manipulation.
Under these conditions, spectacular efforts of the kind made by legendary figures
such as "King Jack" Sturgess in the late 19th century are no longer necessary to
manipulate the grain market. In that era a significant quantity of United States grain
flowed through Chicago: the transport network made it the focal point of the grain
flow. Only changes in the timing of grain flows, rather than their direction, therefore
were necessary to dramatically increase supplies in the delivery market. Thus, to suc-
cessfully manipulate, a large long trader had to prevent these increased flows. The
manipulators of this era therefore resorted to dramatic measures, such as buying huge
quantities of grain in the country and exporting it at high cost, or tying up transporta-
tion (such as rail cars) to prevent shipments to the delivery market (see Kolb and
Spiller). If they had not taken these actions, they would have been buried in a blizzard
of deliveries as large quantities of grain were ready to move in response to even slight
distortions in price.
5 • The Economic Effect of Potential Grain
Futures Contract Redesign
The preceding chapter noted that an expansion of the deliverable

set can reduce the profitability-and hence the likelihood-of a long
manipulation. An increase in the number of deliverable locations
would also increase available delivery capacity, which would reduce
the likelihood of pricing anomalies due to the exhaustion of regular
space or quality problems. Those are beneficial objectives, but such
an expansion will have other effects as well. An increase in the num-
ber of deliverable grades or delivery locations will, for example,
change the basis risks faced by the hedgers of various grades in vari-
ous locations. As noted in Chapter 2, the costs and benefits of any
such change depend upon the geographic distribution of hedgers.
In this chapter we first analyze some of the theoretical issues
associated with broadly defining the deliverable set. We then use
state-of-the-art models of futures and options pricing and data on
corn and soybean prices to simulate the behavior of the basis at vari-
ous locations under various delivery specifications.
Our primary result is that adding St. Louis as a delivery point for
corn and soybeans would, under the assumptions of the analysis,
lead to significant improvements in hedging effectiveness in Central
Illinois, the Gulf, Central Iowa, Kansas City, Minneapolis, and St.
Louis. This result suggests that such a change in delivery specifica-
tions would reduce basis risk all along the Mississippi and its tribu-
taries. I The reduction in basis risk comes at the cost of higher basis
risk in Chicago. Given the considerable importance of commercial
transactions along the Mississippi system, however, such a trade-off
may be beneficial.
The benefits of retaining two delivery points for soybeans and
corn-Chicago and Toled~but reducing the discount for delivery at
the latter location are less pronounced than the benefits of adding a
third delivery point. For both commodities we find that a reduction in
107

the Toledo discount would lead to substantial increases in Chicago

basis risk, substantial decreases in Toledo basis risk, and moderate
decreases in basis risk at St. Louis, Central Illinois, Central Iowa,
Kansas City, Minneapolis, and the Gulf.
The results imply that expanding the delivery options and reduc-
ing the cost of exercising these options may improve hedging perfor-
mance for large numbers of hedgers. This is especially true if St.
Louis-a Mississippi River point-is made a viable delivery location.
These results should not be particularly surprising, given the chang-
ing export patterns and the evolution of grain markets discussed in
Chapter 2 above. Indeed, they provide some empirical support to the
theoretical argument made there concerning the benefits of a
redesign of the delivery mechanism that ties the delivery month
futures price more closely to the cash prices along the Mississippi
River system. Since such a system would also reduce the profitability
of long manipulations and the likelihood of capacity shortages, its
adoption deserves serious consideration.
Although these results are important, they are not sufficient to
conclude that such an adoption is appropriate. The main potential
costs of moving to such a system are: (1) It might give short traders
advantages that they could exploit around contract expiration; (2) it
might increase the cost of arbitraging the futures contracts; and (3) it
might result in a loss of liquidity (if (1) and (2) are true).
In this chapter we analyze each of these issues in turn. The next
section provides a brief overview of the relevant theoretical issues.
Subsequent sections discuss the relevant empirical analysis and the
implications of an expanded deliverable set for the balance of power
between traders in grain futures markets.
A Theoretical Analysis of the Economics of Delivery Set Design

It has long been recognized that increasing the number of grades
and locations eligible for delivery against a futures contract is an
effective means of deterring long manipulations. Indeed, the Board
has historically favored liberal delivery provisions. As the Federal
Trade Commission noted in its study of grain futures trading:
In establishing what grades of grain shall be good for delivery
on contracts, an exchange has a choice between two alterna-
tive policies. Deliverable grades may be defined broadly so as
to ensure a large available volume of grain for deliveries. Or
it may be defined narrowly with a view to attempting to
secure the delivery of a definite quality and kind of grain, so
The Economic Effect of Contract Redesign 109
that the purchaser of a future contract will know as well

what he is going to get ... as he would if he purchased an arti-
cle of a known identity ... Chicago is quite definitely committed
to a policy of broad and elastic provision of contract varieties
and grades. The Chicago Board has tried to group a number
of related grades and qualities for delivery on contracts, so as
to prevent the possibility of, or at least render improbable, a
corner. 2
To say that an exchange favors a large deliverable set is one
thing; to determine how large it should be is another. Moreover, an
exchange has additional degrees of freedom. It is not necessary that
all eligible grades or locations be deliverable at par; some can be
favored by establishing a set of differentials. That is, for a given
futures price, the receipts of a short trader upon delivery can be
made to depend on the grade of grain that he delivers and where he
delivers it. Discounting a particular grade raises the cost of deliver-
ing that grade. Similarly, applying a premium reduces the cost of
doing so.
Thus, an exchange has many variables to consider when specify-
ing the delivery provisions for a particular contract. The final specifi-
cation will depend upon the objectives that the exchange intends to
achieve.
There are two basic philosophies of delivery system design for
grain futures. 8 The first philosophy is often described as a "safety
valve" system. Under that system, several grades are deliverable at
two or more locations, but one grade and one location are designated
as the par grade. Other grades may be delivered and deliveries may
occur at other locations, but at a discount (or at premia that do not
reflect the higher cost of delivering a particular grade).
Under the safety valve system, which currently prevails with
grain futures contracts traded on the Board, the futures price ordi-
narily converges to the spot price of the par grade and location. But
under abnormal conditions, such as when there is a squeeze or corner
at the par point and/or in the par grade, delivery becomes economical
at the discount locations and/or in the discount grade.
In the safety valve system, the differentials are supposed to be
sufficient to preclude frequent delivery at the discounted locations or
with the discounted grades. Very large discounts would achieve that
objective, but the exchange limits the size of the discounts to limit
the gains from manipulating the par specification. Thus, the greater
the differential, the more profitable a manipulation. That is the
safety valve feature of the system: The alternative deliverables
become relevant mainly when congestive or manipulative pressures

rise sufficiently to trip the safety valve. (The alternate delivery point
may also come into play when relatively large shifts in supply and
demand conditions lead to atypically large increases in the price of
the primary deliverable relative to the safety valve deliverable.)
Thus, there is a tradeoff between maximizing the probability of con-
vergence to the par grade and location and reducing the incentives to
engage in a long manipulation.
The second philosophy does not require the designation of a pri-
mary (par) grade or location. Under the alternative philosophy, the
exchange chooses premia and differentials to ensure that each of the
eligible grades and locations has some non-trivial probability of
becoming the cheapest-to-deliver. In other words, the philosophy does
not intend to ensure convergence to the spot price of one particular
grade or location. At expiration the contract sometimes prices one
grade or location, and sometimes another. ~ It makes each of the sev-
eral deliverables comparable with one another. We refer to it as an
"economic-par" delivery point system.
Under the second philosophy, it may still be necessary to specify
a set of differentials in order to ensure that the grade and location
delivered varies. That is particularly relevant to commodities, such
as the grains, for which transportation costs are important. Then
prices will vary significantly (with a deterministic component) by
location. Markets that are close to production points but distant from
consumption points will usually have lower prices than markets close
to consumption points. When there are no discounts or premia, deliv-
eries will tend to occur at the markets that are relatively distant
from major consumption points and near production points.
Moreover, the futures contract will tend to converge to the spot prices
prevailing at such locations. If it is desirable to ensure that the con-
tract sometimes converges to prices at consumption points, it is nec-
essary to either pay premia for deliveries at those points or to impose
discounts on locations close to production centers.
Although the two philosophies differ, it is in emphasis rather
than essence. Prior to expiration, arbitrage should drive futures
prices to equal a weighted sum of the forward prices relevant for each
location and grade under either system, where the weights roughly
equal the probability that a gradellocation will be the cheapest-to-
deliver at contract expiration. 5 In the safety valve system, the par
variety and location will ordinarily receive a relatively large weight,
but in the alternative economic-par system, each particular grade or
location will have a comparable weight.
When multiple grades are deliverable, the futures price equals a

weighted sum of the forward prices of the deliverable grades. 6 Hence,
in a multiple-grade/multiple-Iocation delivery system the behavior of
the basis by grade and location depends upon the probability that
any particular grade/location becomes cheapest-to-deliver.
To illustrate, compare the behavior of a system that allows deliv-
ery at only one point-say Chicago-and a system that permits deliv-
ery at both Chicago and Toledo. Due to transportation costs and
variations in local supply and demand conditions, the spot prices in
Chicago and Toledo will not be perfectly correlated, nor should the
correlations be expected to remain stable over time. Under the single
delivery point system, the futures price will converge to the Chicago
price. Consequently, the variance of the basis will be lower in
Chicago and areas tributary to it than in Toledo and its tributaries
both at expiration and prior to expiration.
Under the dual delivery point system, the futures price will
sometimes converge to the Chicago price, and sometimes to the
Toledo price. Prior to expiration-when it is uncertain whether the
price will converge to the Chicago or the Toledo price-the futures
price will equal a weighted sum of the Toledo and Chicago forward
prices. Under that system, the Toledo price is explicitly incorporated
into the futures price, which tends to increase the correlation
between the futures price and the Toledo price as compared to the
single point system. Moreover, since the futures price assigns a lower
weight to the Chicago price under the dual delivery point system, the
correlation of the futures price with the Chicago spot price is lower
under the dual point system. Thus, arbitrage implies that the addi-
tion of a point (grade) to the deliverable set tends to raise the correla-
tion between the futures and spot prices at that location (grade) and
reduce the correlation between the futures and spot prices at the pre-
viously deliverable location(s) (grade[s)). As a result, basis risk tends
to fall at the new delivery point (grade) and tends to rise at the old
delivery point (grade).
The addition of a new deliverable point (grade) can actually
reduce the basis risk for an existing point (grade) if the prices for the
new point (grade) are highly correlated with those for the existing
point (grade). The simulations presented below show several exam-
ples of the phenomenon.
Changing the delivery specification may also affect basis risk at
locations where delivery cannot occur. If, for instance, delivery is ini-
tially allowed only at point A, the basis risk incurred by a hedger
located at B depends crucially upon the correlation between spot
prices at A and B. If the exchange now designates point C as a deliv-

ery point in addition to A, basis risk at B will now depend on the cor-
relation between spot prices at Band C as well. If this correlation is
significantly higher than that between A and B, basis risk at the lat-
ter location may fall as a result of the delivery specification revision.
It is also true that adding delivery points or changing differen-
tials can affect the variance of the futures price. In particular, to the
extent that prices of various grades in various locations move idio-
syncratically, averages of several of these prices can reduce futures
price variance due to a diversification effect. This effect may be offset
in whole or in part if very high variance prices are included in the
average. Such changes in variance can also affect basis risk for both
in and out-of-position hedgers.
The foregoing analysis shows that changing the definition of the
deliverable set changes the pattern of basis risk. Similar results fol-
low from changes in the grade and location differentials. Lowering
the discount at a particular location, for example, increases the prob-
ability that location will be cheapest-to-deliver and thus reduces
basis risk there. Basis risk tends to rise at the other deliverable loca-
tions where differentials remain unchanged as the probability that
the futures price will converge to the spot price at those locations
falls.
The change in the pattern of basis risk at various locations and
for various grades may be beneficial. If hedgers are geographically
dispersed (as is the case for grains), the proper objective of a futures
contract should not necessarily be to minimize basis risk at one par-
ticular location. Similarly, if hedgers transact in many different
grades, it is not necessarily optimal to minimize basis risk for one
particular grade.
A possible objective for a futures contract would be to minimize
the weighted sum basis risk by grade and location, where the weights
equal the fraction of hedging performed at a particular location in a
particular grade. That is, an exchange could design a deliverable set
that minimizes the average basis risk faced by hedgers.
Minimizing the average basis risk is a desirable objective and
could probably be achieved by specifying a very broad deliverable set.
That would also have the benefit of reducing the probability of a long
manipulation. Its major drawback is that a very broad deliverable set
may allow the sellers of futures contracts to use the threat of deliver-
ies of unwanted grades or at undesirable locations to induce long
traders to liquidate their positions at low prices. The imposition of
costs on long traders by shorts could reduce market liquidity. We dis-
cuss this issue thoroughly below.

The optimal choice of delivery specification thus depends upon
the tradeoff between changes in basis risk for the various locations
and grades, the deterrence of long manipulation, the deterrence of
short manipulation, and the provision of sufficient delivery space.
The latter considerations are difficult to quantify precisely, but the
effects of a larger deliverable set on basis risk by location can be
quantified with some accuracy. That is the subject of the following
sections.
An Empirical Examination of the Effect of Delivery Options on Corn and

Soybean Futures Pricing
In this section and the one following we employ state-of-the-art
financial pricing models to quantify the relationship between the
number and identity of delivery points,' delivery premia and differen-
tials, and basis risk. The fundamental insight underlying the analy-
sis is that increasing the number of delivery points increases the
options possessed by short sellers of futures contracts. A short trader
can deliver at any of the eligible locations, subject to the relevant pre-
mia and discounts. If he opts to deliver, he will do so at the location
where the sum of spot price, transactions costs, and futures discount
is the lowest. s That is the cheapest-to-deliver location for that partic-
ular short trader.
As noted earlier, the transactions costs of delivery differ between
short traders and over time. Futures prices depend on the transac-
tions costs of arbitrageurs. The section on convergence in Chapter 2
above demonstrated that arbitrageur transactions costs are relatively
small, and that future prices do systematically converge to cheapest-
to-deliver spot prices. Thus, in this section we assume that arbitrage
ensures that at expiration the futures price will equal the lowest sum
of spot price and discount (where a premium is treated as a negative
discount). If the futures price exceeds the cheapest spot price (includ-
ing futures discount/premium) in the delivery month, an arbitrageur
can short a futures contract, buy the cheapest spot, and deliver
immediately in order to reap a riskless profit. 9
Prior to expiration, an option to deliver at the cheapest location
should have value. The option value will reduce the value of the
futures price below the forward price at any deliverable location. The
holder of the short position reaps the benefit of the option and would
be willing to sell a contract at a lower futures price as a result.
Moreover, the option to choose the cheapest-to-deliver implies the
futures price will equal a weighted sum of the forward prices (plus
discounts) at the various deliverable locations. 1o Market participants

could arbitrage deviations of the futures price from the theoretical
value (including the value of the delivery option) by holding a futures
position and a "portfolio of grain" in the deliverable locations; i.e., by
holding grain stocks in particular ratios at the delivery points. The
weights in the portfolio (i.e., the ratios) would correspond to the
weights used on prices in the pricing formula discussed above. The
analysis we perform here assumes that arbitrage is possible, and
that the value of the option thus created is properly incorporated into
the futures price. l l
Recognizing the potential impact that violations of the zero trans-
actions cost assumption and potential data errors could have on our
analysis, we have performed a regression analysis of spot and futures
prices for corn and soybeans in order to validate our assumptions and
data. This analysis tests whether the currently existing option to
deliver at Chicago or Toledo is included in the futures price in the
appropriate fashion, and whether the data is sufficiently precise to
accurately reflect the effect of price differences between Chicago and
Toledo on futures prices.
We find that the delivery option has important explanatory
power for both commodities. Indeed, the estimated spot price coeffi-
cients are quite close to the values that would obtain with costless
spot futures arbitrage. Thus, making this assumption in the simula-
tions we present below is appropriate.
These regression results also provide strong support for use of
the bid data as our proxy for cash prices. In particular, the results
strongly show that these data reflect market price differentials
between Chicago and Toledo in the appropriate way.
In our analysis we assume that the location delivery option is
priced according to the formula derived by Margrabe. This delivery
option formula is:
(5.1) XO=P,JV(dl)-PeN(d~
where: Pc is the Chicago spot price; P t is the Toledo spot price; d 1
and d 2 are functions of Pc, P t and the variance of the ratio of Pc and
P t ; and N(.) is the normal cumulative density function.
The no-arbitrage relation between spot and futures prices is:
(5.2) F=ert[Pc-XOJ
where F is the futures price, t is the time remaining to contract
expiration, and r is the risk-free interest rate. Rewriting (5.1) using
(5.2) implies:
(5.3) F=ertpJI-N(d l)+(Pt / P IN(d:JJ
Taking the natural logarithm of (5.3) implies:
(5.4)
where
Z=[l-N(d1)+(Ptl P cJN(d:z}]
Thus, in a regression of InF on rt, InPe, and InZ or in the first dif-
ferences thereof, the coefficients on each independent variable should
equall.
We ran these regressions in the following way. For each separate
futures contract, we determined the Chicago spot price, the Toledo
spot price, and the futures price for each day during a period begin-
ning 90 calendar days prior to futures contract expiration, and end-
ing on the last trading day of the contract. We used the average of
the high and low terminal bids as our spot price proxy. Market par-
ticipants argue that the high bid is the relevant price, as sellers
would only accept the highest available bid. 12 We find that since both
high and low bids are noisy estimates of the true spot price, however,
averaging the high and low reduces the random deviations between
bid prices and the unobserved ''true'' price. This is reflected in the
fact that correlations between averaged prices are higher than those
between high bids alone or low bids alone. Moreover, variances are
lower for the averaged bids than either the high or low bids. Finally,
regression results are superior for the averaged bids. All of these
findings are consistent with the notion that the averaging process
reduces (although it does not eliminate) the severity of random noise
in the spot price data. After increasing the Toledo spot price by the
relevant discount-$.08/bu for soybeans and $.04/bu for corn-we cal-
culated the delivery option value according to the previously pre-
sented formula.
We run the regressions in first differences, and pool the observa-
tions across years by contract month. For example, all observations
for March soybean contracts for each of the years 1984-89 are com-
bined to form the data set for one regression. Since there are five con-
tract months for corn and seven contract months for soybeans, we
thus estimate five corn regressions and seven soybean regressions;
i.e., one for each contract month. is
The regression results, which are reported in Table 5-0, demon-
strate that the delivery option is an important determinant of futures
prices. For each regression, the coefficient on the delivery option vari-
able is positive and statistically significant at very high confidence
levels. T-statistics for the delivery option variable in the soybean
regressions range between 4.5 and 19.01, and average 9.76. It is
nearly impossible, therefore, that these estimates were the result of
chance. 14 For corn, the relevant t-statistics range between 4.6 and
20.5, and average 12.24. Moreover, the values of the coefficient esti-
mates are often statistically indistinguishable from their theoretical
value of 1. For corn, the only glaring violation is for the December
contract, where the coefficient equals .42. The August soybeans con-
tract is also significantly below 1, but the remaining six contract
month coefficients are not statistically different from their theoretical
no-arbitrage values. Moreover, the average of the coefficients for corn
and soybeans is approximately 1. Thus, the results are consistent
with the hypothesis that spot-futures arbitrage ensures that the
value of the option to deliver at the cheapest location is properly
impounded in the futures price.
The regression results do provide some evidence of an "error in
the variables" problem arising from the use of noisy estimates of spot
prices, as the coefficients on the Chicago spot price are all below 1.
Nonetheless, the downward bias is more severe when only high bids,
rather than averages, are used. As one would expect due to the
higher price of soybeans, the errors-in-variables problem seems to be
somewhat more severe for corn than for beans, although the differ-
ences are not particularly striking; the lowest corn spot price coeffi-
cients are around .6, while the lowest soybean coefficients are around
.8; the largest corn coefficient is .87, while the largest soybean coeffi-
cient is 1.00.
Given this empirical validation of the proposed pricing methodol-
ogy, we now proceed to estimate how the pricing behavior of corn and
soybean futures contracts would change with changes in the deliver-
able set.
Futures Basis Risk Under Different Delivery Specifications: A

Simulation Analysis.
In this section we simulate the behavior of the corn and soybean
futures prices under alternative specifications of the points eligible
for delivery, delivery premia, and delivery discounts. We determine
how changes in the delivery specification can affect basis risk for
both in-position and out-of-position hedgers using the same delivery
option pricing methodology validated empirically in the previous sec-
tion.
This analysis implies that a liberalization of the delivery specifi-
cation for corn and soybeans can appreciably reduce basis risk and
thereby improve hedging effectiveness for a broad spectrum of
hedgers. Most importantly, the simulations suggest that the adoption
of an "economic-par" delivery specification allowing delivery at
Chicago, Toledo, and St. Louis systematically improves hedging effec-
tiveness in all locations studied except Chicago.

In order to derive these results, we rely upon the contingent
claim pricing methodology utilized in the previous section. As noted
earlier, this pricing methodology implies that a futures contract is a
contingent claim upon the deliverable commodities. For a futures
contract with n deliverables, the futures price equals the option to
purchase the minimum of these n deliverables at a strike price of o. If
the prices of the deliverables follow a joint lognormal distribution,
the futures price equals:
(5.5) F=e rt 2:'\=1 PiNn-l{zJ;rJ
where r is the risk free rate of interest, t is the time remaining to
contract expiration, Pi is the spot price of the commodity at deliver-
able location i, and N n -1 (.) is the n-l variate normal cumulative den-
sity. The arguments to the normal cumulative function are:
sit
where sij=var(dln(Pi / Pj)). The correlation vector is given by:
ri ={-rili' -ri2i>··· ,riki>···J
where
and
s,2-rjjSjS,-rjkSiSj+rjkS;Sk
sijBjk
where si=var(dlnPJ and rij=corr(d1nPi>dlnPJ.

In this formula PJ equals the spot price at deliverable location J
plus any applicable discount (or minus any applicable premium).
Note that the weight assigned the price at any particular location in
expression (5.5) (Le., the normal cumulative density associated with
that point) varies inversely with that price, and thus given price
varies inversely with the size of the discount. Thus, relative prices
and discounts determine the weight assigned to any location's price
in the futures price formula just as described above.
In our analysis, we examine this pricing formula for corn and
soybeans under the following three delivery specifications.
The first specification is basically the existing "safety valve" sys-
tern. Delivery may occur at Chicago or Toledo, and delivery at Toledo

is discounted. We use the existing discounts of $.08 for Toledo soy-
bean deliveries and $.04 for Toledo corn deliveries. 16
The second delivery system retains Chicago and Toledo as deliv-
ery points, but eliminates the Toledo discount. That is, under the sec-
ond specification, Toledo corn and soybeans are deliverable at par.
This is a two-point economic-par delivery system, as Chicago and
Toledo prices for corn and soybeans have been on average equal in
price over the 1984-1989 period.
The third specification adds St. Louis as an economic-par deliv-
ery point for both corn and soybeans. Since St. Louis prices tend to
exceed Chicago and Toledo prices by a wide margin, economic-par
delivery at St. Louis requires that delivery there occur at a premium.
We use the average price difference between Chicago and St. Louis
over the 1984-1989 period-$.10 for soybeans and $.10 for corn-as
the premium for St. Louis delivery. IS Thus, under the third specifica-
tion for both corn and soybeans delivery occurs at par in Chicago and
Toledo and at a premium of $.10 in St. Louis.
Given these delivery specifications, formula (5.5), and estimates
of the parameters of the joint distribution of prices across delivery
locations, we simulate the behavior of a series of synthetic futures
contracts and the relations between these synthetic futures prices
and cash prices at various locations. 17 The synthetic futures prices
are determined as follows. On Wednesday of each week from 1984 to
1989 we determine the prices of cash corn and soybeans at Chicago,
Toledo, and St. Louis. Our measure of cash price is the average of the
high and low bids from the USDA price data we have relied upon
throughout. IS Using these prices and formula (5.5) we determine the
price of three futures contracts for both corn and soybeans, each
expiring five weeks from that Wednesday; i.e., we use t=5 / 52 in for-
mula (5.5). The first synthetic futures contract assumes delivery
specification 1, the second assumes delivery specification 2, and the
third assumes delivery specification 3.
We then proceed to the following Wednesday, and determine the
price of these three futures contracts assuming four weeks to con-
tract expiration (i.e., t=4 / 52). The change in each futures price repre-
sents the gain or loss a holder of the respective synthetic futures
contract would have realized over the single-week holding period,
while the logarithm of the ratio of the five-week and four-week syn-
thetic futures prices equals the percentage change in this price over
the weeklong holding period. 19
For each Wednesday-to-Wednesday holding period we also calcu-
late the percentage change in the corn and soybean cash prices at
several commercially important locations. These include Chicago,
Toledo, St. Louis, Central Illinois, the Gulf of Mexico (NOLA),
Central Iowa, Minneapolis, and Kansas City. A viable futures con-
tract will hedge these changes in cash prices at these important com-
mercial locations. That is, the price movements in the futures
contract should closely match the movements of the cash prices so
that hedgers can reduce risk by holding offsetting cash and futures
positions. We estimate the hedging effectiveness of our three syn-
thetic futures contracts by regressing the percentage change in the
cash price at each location against the percentage change in each
synthetic futures price. Formally:
In(P/t) / P/t-l)) =a +bln(F(t) / F(t-l))+e
Since there are three synthetic futures prices, we estimate three
regressions for each location. In order to determine whether a con-
tract's hedging effectiveness varies over time either absolutely or rel-
ative to one of the other synthetic futures, we estimate five sets of
regressions, one set for each of the years 1984-1989.
It is well-known that the R2 of a regression of this form is a mea-
sure of the hedging effectiveness of a futures contract; the higher the
R2, the more effective is a contract as a hedging instrument. 2o
Consequently, the futures contract specification with the highest
fraction of variance explained is the most effective hedging contract. 21
Table 5-1 reports these R2'S for soybeans, while Table 5-2 pre-
sents them for corn. In each table, rows labelled "1," "2," and "3" pre-
sent hedging effectiveness estimates across locations for
specifications 1,2, and 3 respectively.
An examination of these results reveals that hedging effective-
ness outside of Chicago is systematically better under more liberal
delivery specifications for both corn and soybeans. In other words, for
virtually every location for each year for both commodities, R2'S are
higher for specifications 2 and 3 than specification 1. Moreover, for
all locations other than Chicago and Toledo, hedging effectiveness is
almost always largest for specification 3. Indeed, although the gains
in hedging effectiveness resulting from the elimination of the Toledo
discount are frequently modest, the gains resulting from the adoption
of a three-point economic-par delivery system including St. Louis are
often appreciable. Furthermore, this ordering of the hedging effec-
tiveness is very stable over time. The results are not peculiar to one
or two years, but instead (with one or two exceptions) are consistent
across years.
This consistency of superior hedging for specification 3 across
years and locations makes it extremely unlikely that they result from
chance. A simple non-parametric approach demonstrates this clearly.
If true hedging effectiveness for a particular location were equal for
specification 1 and specification 3, but in any finite sample the
observed hedging effectiveness could differ between specifications, in
a large enough sample of regressions the hedging effectiveness of
specification 1 would exceed that of specification 3 about half the
time, while the opposite would happen about half the time as well.
We observe hedging effectiveness for each location in six different
years. Given the null of equal hedging effectiveness under specifica-
tion 1 and 3, the probability that one would observe the hedging
effectiveness of specification 3 exceed that for specification 1 in each
of the six years equals only .015625. Thus, the probability of observ-
ing a higher hedging effectiveness under the economic-par delivery
system than under the safety-valve system in each of the six years by
chance equals only .015625. Since hedging effectiveness is highest
under specification 3 in each of the six years for St. Louis corn and
soybeans, Central Illinois corn and soybeans, Central Iowa corn and
soybeans, Gulf corn, and Minneapolis corn, it is highly unlikely that
we would haVE! observed these results if specifications 1 and 3 indeed
truly provided equal hedging effectiveness. Under the same null
hypothesis of equal hedging effectiveness for specifications 1 and 3,
the probability of observing a higher hedging effectiveness for specifi-
cation 3 than specification 1 in at least five out of six trials equals
about .1094. Since for Gulf and Minneapolis soybeans specification 3
hedging effectiveness is superior in 5 out of 6 years, it is again
unlikely that our results for these locations are due to random sam-
pling error. They instead reflect some underlying economic regular-
ity.
These conclusions become even stronger when one aggregates the
data for each commodity. In total, for all currently out-of-position loca-
tions, the R2 for specification 3 exceeds that for specification 1 in 32
out of 36 observations for soybeans and in 33 out of 36 observations
for corn. Under the null that true hedging effectiveness at a particular
location is equal between specifications 1 and 3, but that observed
hedging effectiveness can vary due to sampling error, the probability
that one would observe a larger hedging effectiveness by random
chance for specification 3 at least 32 out of 36 times equals 1. 6x1O,s,
while the probability that one would observe such a result at least 33
out of 36 trials equals 6.1xlO· 10 • It is therefore extraordinarily
unlikely that we would have found these results if hedging effective-
ness were in fact equal under specifications 1 and 3 for all currently
out-of-position locations. Thus, these results are extremely robust,

and the probability that they are due to statistical chance is nil. 22
Given this uniformity and stability, these results strongly sug-
gest that the adoption of an economic-par delivery system would
improve hedging effectiveness for both corn and soybeans across a
very wide population of hedgers. Hedgers of cash transactions in
Chicago would suffer, but given the size of the Chicago market rela-
tive to the other markets analyzed (in aggregate), it is clear that the
reduction of hedging effectiveness in Chicago is more than offset by
the gains in hedging effectiveness elsewhere.
To some the results may be surprising, yet some of the reasons
are straightforward. First, correlations between Toledo and St. Louis
prices and prices elsewhere tend to be higher than the corresponding
correlations between Chicago prices and prices elsewhere for the
entire period under study. Table 5-3 presents the correlations by
years for soybeans, while Table 5-4 reports them for corn. The ten-
dency for Toledo and St. Louis correlations to exceed the correspond-
ing Chicago correlations is clear.23
Second, a diversification effect is at work here. Under a safety
valve system, the futures price reflects idiosyncratic supply and
demand shocks at the primary delivery point; Le. , supply and
demand shocks that are unique to that location, unrelated to condi-
tions elsewhere. In an economic-par delivery system, on the other
hand, the fact that the futures price is a weighted sum of several spot
prices damps the effect on the futures price of price shocks that are
unique to any of the eligible delivery locations. A demand shock spe-
cific to St. Louis, for example, has an effect on the futures price, but
since in an economic-par delivery system the weight accorded the St.
Louis price in the futures price formula is almost always appreciably
less than 1, this effect is mitigated. As a result of this diversification-
related damping effect, the economic-par futures price is more closely
related to system-wide shocks and less affected by location-specific
ones. This tends to improve hedging effectiveness.
In summary, the simulations in this section suggest that the
movement to an economic-par delivery specification on corn and soy-
bean futures contracts would reduce basis risk for a large number of
commercially important locations. A primary reason for this result is
that an economic-par contract is a broader measure of grain value
than a narrower contract that ensures that most deliveries occur at a
single point. This fact also implies that movement to an economic-par
delivery system would improve the value of the grain and soybean
futures contracts as a price discovery mechanism, as the diversified
economic-par futures price would not be dramatically affected by sup-

ply and demand shocks peculiar to a single point, but would instead
incorporate price information from a representative selection of mar-
kets. Since price discovery is an important economic function of
futures markets, when combined with the hedging effectiveness
results, this provides a very strong argument for the broader delivery
specification.
We next analyze the robustness of the assumptions underlying
this result and the potential side effects of an economic-par system
that could offset, in whole or in part, the beneficial effects quantified
here.
Other Considerations for Delivery Set Design: The Stability of Price

Distributions, the Costs of Arbitrage, and Balance of Power Between
Short and Long Traders
The results presented in this chapter demonstrate that the adop-
tion of an economic-par delivery point philosophy for corn and soy-
beans with delivery points in Chicago, Toledo, and St. Louis (in place
of the current safety valve philosophy) may appreciably improve
hedging performance at several commercially important locations,
including the Gulf, Central Illinois, Central Iowa, St. Louis, Kansas
City, Minneapolis, and Toledo. The results argue for the adoption of
economic-par discounts and premia for soybeans and corn and the
addition of St. Louis as a delivery point. They are not sufficient, how-
ever, to demonstrate that those changes would enhance the perfor-
mance of the soybean futures market. The results are dependent
upon a crucial assumption-namely, that the price distributions used
in the analysis are invariant to changes in the delivery specification.
If these price distributions change as a result of a change in delivery
specification, actual basis risk effects may differ from the results pre-
sented here. Moreover, there are some potentially adverse effects of
the expansion of the delivery set that must be weighed against the
favorable basis risk effects estimated here; an expanded delivery set
could, in principle, increase the transactions costs of arbitraging
futures and make short manipulation more likely. Similarly, as dis-
cussed in Chapter 4, the small amount of space in St. Louis could
make it subject to manipulation when the price there is considerably
below that in Chicago and Toledo.
First, consider the possible relation between delivery specifica-
tion and spot price distributions. Traders may participate in the
delivery process for reasons independent of cash grain market funda-
mentals. Such participation could cause erratic movements in cash
prices at delivery points and thereby affect the price relations

between delivery points and out-of-position locations. As an example,
some market participants relate stories of traders making or taking
large numbers of deliveries of grain or oilseeds as a part of tax avoid-
ance strategies or to circumvent capital controls in foreign countries.
Such behavior can cause erratic supply and demand movements at
the delivery point, which can cause erratic movements in relative
prices. Such idiosyncratic movements reduce correlations between
delivery market prices and prices elsewhere. Thus, the designation of
a new delivery point, or a change in discounts and premia that signif-
icantly increases the likelihood of a point becoming cheapest-to-deliv-
ery could-if this conjecture is correct-reduce the correlation
between that location's spot price and spot prices elsewhere.
In the context of the previous simulation, this effect, when taken
alone, would tend to reduce the hedging effectiveness as estimated by
the regressions, as these regressions assume that the correlations
remain at their previous, higher level. As we note below, however,
one cannot treat anyone market in an economic-par delivery system
in isolation when performing this analysis. One must recognize that
correlations are affected at incumbent delivery points (Le., Chicago)
as well as new ones (Le., St. Louis), and that different markets may
differ in their sensitivity to the effects of delivery on their spot price
dynamics.
Many grain traders argue that this correlation-reducing effect of
delivery is important. Tables 5 and 6 provide some evidence that sup-
ports these arguments. As noted earlier, Chicago correlations tend to
be smaller than Toledo and St. Louis correlations. Although there are
good a priori reasons for St. Louis correlations to exceed Chicago
ones, these considerations are not relevant to Toledo correlations.
The fact that Chicago prices seem less closely related to prices in
the Gulf, Central Illinois, and elsewhere than to St. Louis prices may
be due to the evolution of grain trading patterns discussed in
Chapters 2 and 4 that has led to a decline in the importance of
Chicago as a grain market and the rise of the Mississippi as the
major axis of the export trade. Since prices in two spatially separate
markets are connected only if there are flows of the commodity
between them, the decline of shipments to Chicago and the rise of the
Mississippi as the major export route would lead to an loosening of
the linkages between the Chicago price and prices elsewhere, and the
strengthening of the linkages between prices in major production
locations and points on the Mississippi like St. Louis. This would
tend to make St. Louis correlations higher than Chicago correlations.
Any delivery noise in Chicago would simply reinforce this tendency.

The supplanting by the Gulf of the Great Lakes as a major export
market has, however, affected Toledo as well as Chicago. Toledo is
not directly linked, moreover, to the Gulf (as is Chicago through the
Illinois River waterway and the Mississippi). Consequently, one can-
not explain the higher correlations in Toledo as a manifestation of
the new spatial economics of the grain trade as the factors that have
worked to disconnect Chicago from the major grain flows should have
done the same to Toledo. The fact that Toledo correlations exceed
Chicago correlations is potentially consistent, therefore, with the
hypothesis that the delivery process injects noise into prices at the
primary delivery point.
This raises the question of how delivery-related noise would
affect hedging effectiveness in an economic-par delivery system
including Chicago, Toledo, and St. Louis as the delivery points.
Although it is possible that the introduction of this noise into prices
at St. Louis and Toledo that might occur if they are designated as
economic-par points could reverse the hedging improvements we sim-
ulate here, it is also possible that the redistribution of this "delivery
pressure" that would occur in an economic-par system could actually
lead to greater improvements in hedging effectiveness than we
report. Two reasons are grounds for this belief.
First, in the current "safety valve" delivery system the impact of
any delivery-related noise falls disproportionately on one market--
Chicago. An abnormally high demand for deliveries unrelated to cash
market fundamentals thus requires a supply and price response at
that location alone. For commodities like grains where transport
costs and distance serve to isolate markets, such a shock can cause a
significant increase in the price at the delivery market relative to the
prices in other markets. In an economic-par delivery system, on the
other hand, the effect of such a non-fundamental driven shock is dis-
tributed among several markets. The supplies in three markets are
thus available to accommodate a non-fundamental driven increase in
the demand to take deliveries. If the price in one delivery market
gets too far out of line, the supplies from another market come into
play to mitigate this price effect.2. This is a manifestation of the
diversification effect discussed earlier.
Second, there are reasons to believe that Chicago is especially
vulnerable to delivery pressure, particularly when compared to a
Mississippi River point such as St. Louis. These reasons relate to the
evolution of grain trading patterns discussed earlier. The decline of
receipts in Chicago and the concomitant rise of the Gulf have two
important implications. First, to the extent that order flow and trade
volumes affect market liquidity, this evolution has reduced the liq-
uidity of the Chicago cash grain market and increased that of the
GulflMississippi River cash grain market. Second, the decline of the
Chicago market has made supply of grain in Chicago inelastic rela-
tive to that at points such as St. Louis. Both low liquidity and supply
inelasticity tend to make prices in a market more volatile. These con-
siderations imply that Chicago is more vulnerable to delivery pres-
sure than St. Louis.
The effects of trade volume on liquidity are straightforward, but
the determinants of supply elasticity are somewhat more involved.
Chicago receives grain mainly during the harvest. Receipts are small
throughout the remainder of the year. The primary flow of grain
after the harvest period is, moreover, in a southerly direction away
from Chicago and toward the Gulf of Mexico. Thus, to attract addi-
tional supplies to Chicago at these times it is necessary to reverse the
normal flow of grain. Such a diversion is costly, and makes the sup-
ply of grain to Chicago relatively inelastic; commercial traders state
that grain flows there other than at harvest only at a substantial
price premium.
Put another way, the quantity of grain in store in Chicago is
determined during the harvest period. This quantity depends in part
upon the expected delivery-related demands, as well as demands dri-
ven by grain market fundamentals. After grain flows to the Chicago
warehouses in the autumn (for soybeans and corn) or summer (for
wheat), the supply at any time is essentially fixed and hence inelas-
tic. This inelasticity implies large price movements in response to
delivery-related, idiosyncratic demand movements, as it is well
known that prices are more volatile (ceteris paribus) in markets
where supply is relatively inelastic.
A market like St. Louis, on the other hand, lies directly on the
major export route. Large quantities of grain are stored continuously
in Illinois, Wisconsin, Iowa, Missouri, Ohio, and Minnesota awaiting
shipment down the river. Thus, the price moves required to accom-
modate idiosyncratic demands for delivery at St. Louis should be rel-
atively small. An unexpectedly large demand for delivery at that
point, for instance, is readily accommodated in normal circumstances
by an acceleration of shipments downriver regardless of whether the
demand shock is related to fundamental demand factors or is due to
a trader using the delivery process for reasons unrelated to funda-
mentals. If non-fundamental, delivery-driven demands are abnor-
mally small, as there is no distortion in the rate of flow.
This variation in the rate of shipments occasioned by non-funda-

mental driven variations in demand for delivery at St. Louis will
induce an increase in price in St. Louis relative to prices at tributary
points if it affects grain transport costs (as is likely) and causes a dis-
tortion in where grain is stored. This relative price movement may
impair hedging effectiveness. The relative price response should not
be as large, however, as that required to attract grain in a direction
opposite the normal flow (as is required to bring grain to Chicago).
Thus, supply to St. Louis is likely to be more elastic than supply to
Chicago, and a given delivery-related shock should have a smaller
price impact at the former point.
Since it is quite plausible that the St. Louis market is more liquid
than the Chicago market, and that supply is more elastic at the for-
mer point, the addition of the river point would lead to a transfer of
this delivery pressure/delivery-related noise from a market that is
very sensitive to it (Chicago) to a market that is relatively impervi-
ous to it (St. Louis). This would lead to less noisy prices at Chicago.
Then, even if the addition of St. Louis as a delivery point reduces
price correlations there, it should also increase price correlations in
Chicago. The magnitude of the decline in correlations at the former
point is likely to be smaller, moreover, than the improvement at the
latter due to the greater liquidity and supply elasticity in St. Louis.
This reasoning suggests that the effect of the redistribution of
delivery pressure may well be to strengthen, rather than to weaken,
the simulation results. In other words, even granting that the deliv-
ery process injects noise into prices at delivery points, it does not
then follow that the addition of a delivery point will reverse the esti-
mated improvements in hedging effectiveness. One must consider the
effect of the more liberal delivery specification upon pricing dynamics
at the incumbent delivery points as well as at the new ones. Thus,
the net effect of the redistribution of delivery pressure is quite com-
plicated and could actually reinforce our results. A redirection of
delivery pressure away from a market that is quite vulnerable to it to
a market that can bear it with little distortion actually enhances,
rather than degrades, hedging performance. It is quite possible that
this would occur if St. Louis were added as a corn and soybean deliv-
ery point. This conclusion is strengthened by the fact noted above
that delivery pressure is spread among several markets in an eco-
nomic-par delivery system (rather than on a single market).
It must also be noted that the change in price relations caused by
a change in the delivery specification does not affect the other source
of improved hedging effectiveness under the economic-par delivery
mechanism: the diversification effect. The incorporation of several

spot prices into the futures price through the delivery option reduces
the vulnerability of the futures price to idiosyncratic demand and
supply conditions in a single market. Thus, even if the price correla-
tions between locations change in response to alterations in the deliv-
ery specification, the diversification effect still provides a source of
improved hedging effectiveness under the economic-par delivery
mechanism.
A second factor that may offset the simulated reductions in basis
risk is that arbitrage may become costlier as delivery points are
added. Thus, deviations from the theoretical futures price given by
expression (5.5) may become more variable, the larger the number of
eligible delivery points. This would tend to increase basis risk when
there are more delivery points; if this effect is sufficiently severe, this
increase in risk could offset the reductions quantified here.
In order to arbitrage the futures contract with multiple deliver-
abIes with theoretical value given by expression (5.5), a short arbi-
trageur must hold inventories of each of the deliverables in
proportion to the relevant weights in that expression, while a long
arbitrageur must short cash grain in these proportions. Thus, as rela-
tive prices change, or a contract nears expiration, an arbitrageur
must adjust his holdings of the deliverable spot commodity in order
to hedge his risk.
Note that the arbitrageur should (at least theoretically) make
these adjustments continuously. In a zero-transactions-costs world
(which is what is assumed when deriving the formula) this is possible
and plausible behavior. In a world where transactions costs are posi-
tive-such as the cash grain market-such continuous changes may
be prohibitively costly. Failure to make adjustments to the spot posi-
tions forces the arbitrageur to bear risk, but this risk may be less
costly than the expense incurred to fine-tune the portfolio in response
to each price movement. In any event, attempting to arbitrage the
futures contract is costly; one either incurs transactions costs or one
must live with costly risk.
Under these circumstances, the futures price may randomly
diverge from the theoretical value given by expression (5.5) without
inducing traders to arbitrage the contract. These divergences tend to
increase the variability of the futures price, and if they are truly
orthogonal to spot prices (as is plausible) they tend to increase basis
risk across all locations.
It is possible that these divergences tend to be larger (in absolute
value), the larger the number of deliverable points and grades. This
may be true for several reasons. If, for example, there are economies
of scale in executing cash trades, arbitrage would be less costly when
there are relatively few deliverables (such as two), as under these cir-
cumstances the weight of each in the portfolio is relatively large. This
allows the arbitrageur to take advantage of the scale economies.
Second, if traders have specialized marketing, transportation, or
storage assets in some markets but not in others, extending the
deliverable set to encompass some of these latter markets may raise
some traders' costs to execute arbitrage. 25
If either spot price distributions change when delivery points are
added or deleted, or if arbitrage is more costly with more deliver-
ables, a simulation like that presented above must be interpreted
with some caution. Nonetheless, such simulations provide important
information about how changing the number of delivery points, deliv-
ery differentials, or the number of deliverable grades will affect
hedgers and speculators. This information is of tremendous impor-
tance when determining a futures contract's appropriate delivery
specification.
A third factor that must be considered when analyzing the desir-
ability of moving to an economic-par delivery system is the effect of
such a change on the relative power of long and short traders.
Allowing delivery at each of several locations can reduce the prof-
itability of a long manipulation by increasing the options available to
short futures traders. The addition of these delivery options increases
the elasticity of the demand curve for futures positions that long
traders face at contract expiration, and thereby reduces their ability
to artificially influence the futures price. Unfortunately, this grant-
ing of options to the shorts is not an unmixed blessing, as they can
sometimes exploit these options to the detriment of the holders of
long futures positions as contract expiration approaches. That is, the
granting of options to the shorts can alter the ''balance of power"
between shorts and longs in favor of the former. This added power
may allow large shorts to profitably manipulate the futures price.
In particular, if longs must incur transactions costs in order to
take delivery, and these transactions costs are larger at some loca-
tions than at others for some long traders, large shorts may some-
times exploit these transactions costs in order to induce long traders
to liquidate their futures positions at artificially low prices. In order
to utilize the leverage implicit in these delivery options opportunisti-
cally, moreover, shorts may make too many deliveries, or excessive
deliveries at some locations and too few at others. Thus, profit-maxi-
mizing behavior by some short traders may impose deadweight losses
upon longs. These deadweight losses increase the cost of trading

futures and can adversely impact market liquidity as a result.
Longs may incur a wide variety of transactions costs in order to
take delivery. These can include the cost of storing the delivered com-
modity, loading it out of the delivery warehouse, searching for a firm
to transport it to another location for consumption or sale, paying for
such transport, and searching for and negotiating with a buyer of the
commodity.
A particular long, moreover, may pay higher transactions costs to
take delivery at one location than another. He may have good mar-
keting connections in some areas but poor ones elsewhere. Similarly,
he may face higher transport charges in some markets. He may have
preferential rate rail contracts for shipments from some delivery
markets, but not for others. Furthermore, even if a long can arrange
shipment and sale of the delivered commodity at equal cost from each
of the delivery points, it may require some preparation to minimize
these costs. If uncertain about the location at which he will receive
delivery, he may not be able to make these preparations effectively.
This uncertainty can raise the cost of taking delivery.
The holders of large short positions may be able to exploit prof-
itably these differential transactions costs by making, or threatening
to make, large deliveries at undesirable locations, or by making their
deliveries highly unpredictable. Realizing that if they do not liqui-
date their contracts they may have to take very costly deliveries,
longs will reduce their reservation liquidation prices in order to avoid
these high transactions costs. Thus, shorts who can make enough
inefficient deliveries to affect these reservation prices, or credibly
threaten to make such deliveries, can profitably offset their futures
positions by buying from these longs at the low prices as trading on a
contract nears its end.
Some long grain futures traders have indicated, for example, that
they operate at a disadvantage when they take delivery in Toledo due
to its lack of ready access to the barge market. Grain from Toledo is
almost always shipped by truck, rail, or lake carriers (which do not
operate in the winter when the St. Lawrence is closed). Much grain
from Toledo is sold to feeding operations in the East and Southeast.
Since many firms that have ready access to the barge and Gulf export
markets cannot utilize ship or rail transport or the feeding markets
as effectively, their costs of moving grain out of Toledo exceed those
incurred in Chicago. Indeed, the decline of the Lakes and East Coast
export markets harms Toledo more than Chicago because of the for-
mer's lack of direct connection to the Gulf market. If this representa-
tion is accurate, a reduction in Toledo discounts would increase the

transactions costs of taking delivery for such individuals and firms
and thereby make them more vulnerable to opportunistic behavior by
shorts who can delivery efficiently in Toledo.
Similarly, the addition of a point such as St. Louis as a delivery
point could disadvantage longs, although other delivery points fur-
ther downriver would create greater disadvantages. It is best to be
long at the origin of commodity flows, rather than at the terminus of
these flows. This is true because traders have more flexibility under
these circumstances. That is, they can economically sell to a larger
number of markets when they hold stocks near the origin of commod-
ity flows. If a long owns soybeans in the Gulf, for example, his only
viable option is to sell it into that market or export from there; it
would be uneconomical to send it back upriver, for instance. If a long
owns soybeans in Chicago, however, he can sell into the Gulf market,
to processors in the Southeast or Midwest, or into the Lake market.
This flexibility is valuable to a long, and consequently he would
rather take delivery in a market offering this flexibility.26
A point such as St. Louis is close to major grain-producing
regions, but its major outlet is the Gulf. Consequently, it has some
disadvantages as a delivery point from a long's perspective. Again,
this implies that the addition of a point like St. Louis as a delivery
point can force some longs to incur excessive transactions costs when
taking delivery there. It is likely that the value of any "flexibility
option" should be impounded in the spot prices at each location. That
is, points near the origin of commodity flows should sell at a higher
price (after adjusting for transportation costs) than at the destination
of these flows. If so, the costs arising from this loss of flexibility will
be incorporated in the futures price, and longs and shorts will be
properly compensated at the margin for the units delivered. The
value of the flexibility option may differ among traders, however,
since some may value flexibility more than others.
Dispersions in the transactions costs of taking delivery, and vari-
ations in the valuation of the commodity at different points (due to
differences in the value of the flexibility option, for instance) may
allow large shorts to influence liquidation prices at expiration in
their favor. Longs with low transactions costs or a high valuation of
the flexibility option may willingly accept delivery rather than liqui-
date at unfavorable prices. Those with high transactions costs or low
valuation of the flexibility option, however, would rather liquidate at
unfavorable prices in order to avoid incurring these costs. Thus, at
contract expiration shorts may face an upward-sloping supply curve
for long futures positions (to offset their short positions) due to the
dispersion in transactions costs. Under these circumstances they can
drive down the futures price by making excessive deliveries or mak-
ing deliveries in inefficient locations.
These inefficient deliveries waste resources. Some longs incur
excessive transactions costs to take deliveries at undesirable loca-
tions. Thus, shorts who can make appreciable numbers of deliveries
and thereby affect prices at contract expiration can both enhance
their profits and engage in behavior that wastes real resources. If
these transactions costs are large, the adoption of a mUltiple delivery
point system may therefore result in both a redistribution of wealth
from longs to shorts and a waste of economic resources due to the
opportunistic behavior of large short traders.
Deadweight losses may arise in a multiple delivery point system
even absent such short manipulation. In a multiple delivery point (or
delivery grade) system, longs and shorts cannot effectively coordinate
the transfer of ownership of the deliverable commodity through the
anonymous delivery process. At a particular futures price a long may
wish to take delivery at location x, while a short may find it profitable
at this price to deliver at location y, which the long finds undesirable.
Standing for delivery under these circumstances is very costly for
the long, and this is wasteful. Since the delivery process is anony-
mous, longs and shorts cannot coordinate their activities. This lack of
coordination can reduce the value of the delivery process as a means
of buying and selling the deliverable commodity. This can reduce the
benefits of trading futures contracts. 27
The wealth transfers and deadweight losses implicit in a multiple
delivery point system can have important effects on the pricing and
liquidity of a futures contract. This is best illustrated in a simple sup-
ply and demand framework. For simplicity, assume that all futures
positions are initiated at a single point in time, and that the demand
for long futures positions at this time is downward-sloping, and that
the supply of these long positions (Le., the demand for short posi-
tions) is upward-sloping. 28
If shorts can extract wealth from longs at expiration more readily
in a multiple delivery point system, long-futures-position demand
curve will shift down by the amount of the loss the longs expect to
incur. Similarly, the supply curve for long positions will shift down
by this amount as some traders will be willing to sell futures con-
tracts at lower prices in anticipation of the possibility of artificially
low prices at expiration.
These equal downward shifts in supply and demand curves
resulting from transfers from longs to shorts reduce the futures price
at contract initiation, but have no influence on market liquidity. The
futures price falls, but the number of open positions does not
change. 29
Deadweight losses arising from the adoption of a multiple deliv-
ery point system, on the other hand, impair market liquidity and the
gains from trade in the futures market. Deadweight costs imposed
upon longs drive the demand for long positions down further, while
deadweight costs borne by shorts raise the supply curve for these
positions. As a result of these shifts in the demand and supply sched-
ules, the number of open positions initiated declines. Thus, liquidity
falls, and gains from trade fall. Consequently the addition of delivery
points (or of deliverable grades) can reduce the value of a futures
market. 3D
Put another way, the deadweight losses arising from manipula-
tive behavior by shorts serve as a tax on futures trading. Like all
taxes, this one reduces trading activity, which in turn reduces the
total gains market participants reap from engaging in futures trans-
actions. To the extent that expanding the number of deliverables
makes short manipulation more profitable (and hence more likely),
the movement to an economic-par delivery system can impair mar-
ket efficiency.
The losses arising from the short manipulations facilitated by an
expansion of the number of delivery points must be balanced against
the gains resulting from an improved deterrence of long manipula-
tion. As noted in the introduction, one of the major motives for
allowing delivery of several grades or at several locations is that the
profitability of manipulation by a large long trader is reduced
thereby. Long manipulations also create deadweight losses that
serve as a tax on futures trading. The net effect of liberalizing the
delivery specification thus depends in part upon whether the result-
ing long manipUlation tax exceeds the concomitant short manipula-
tion tax.
Unfortunately, it is difficult to quantify the importance of these
inefficiencies arising from the shift in the balance of power between
shorts and longs implicit in the expansion of the deliverable set with
the same precision as we have quantified the basis risk effects.
Market participants directly affected by any potential change are
best suited to estimate the deadweight costs of the movement to an
economic-par system. Any such losses must be balanced against the
potential gains in hedging effectiveness quantified here.
Summary
This chapter has analyzed the economic effects of moving to an eco-
nomic-par delivery specification for Chicago Board of Trade corn and
soybeans futures contracts. We first demonstrated that the existing
location option-the option of the short to deliver at the market (i.e.,
Chicago or Toledo) where cash prices (including discounts) are lowest-
is impounded in corn and soybean futures settlement prices, and that
despite alleged problems with the cash price data used and the impor-
tance of transactions costs in grain markets, the empirical relation
between futures prices and cash prices is close to the theoretical one.
Second, simulations of the effects of changes in the delivery speci-
fication on basis risk for in-position and out-of-position hedgers
strongly support the replacement of the Board's existing "safety
valve" delivery specification-which allows delivery at Toledo only at
a discount-with an "economic-par" delivery system that allows
delivery at Chicago, Toledo, and St. Louis at differentials that reflect
typical cash price differences. Our simulations strongly suggest that
basis risk would decline substantially for out-of-position hedgers as a
result of a movement to an economic-par system.
Moreover, by producing a broader, more diversified measure of
grain value, an economic-par delivery system would enhance the
effectiveness of the futures contracts as price discovery tools. Since
location-specific supply and demand factors have a far less important
impact on the futures price in the economic-par delivery system, the
adoption of this system will provide producers, consumers, and
processors of grain a more reliable estimate of overall market condi-
tions than the existing safety valve system. This is another major
advantage of an economic-par system.
We recognize that the results of these simulations depend cru-
cially upon our assumption that cash price distributions are indepen-
dent of delivery specification; some argue that the ability to deliver at
a particular location may influence price correlations between prices
there and elsewhere. We also recognize that there are other effects of
a change in the deliverable set that must be considered before imple-
menting such a change. In particular, moving to an economic-par sys-
tem may increase the costs of arbitrage (and therefore the variability
of futures prices), and may alter the balance of power between longs
and shorts in favor of the latter. This altered balance may, in turn,
lead to pricing and delivery inefficiencies. Nonetheless, given the
strong, systematic, and consistent simulation results, the Chicago
Board of Trade should strongly consider the movement to such an
economic-par system. It should give special attention to the addition
:134 Grain Futures Contracts, an Economic Appraisal
of a Mississippi River point, such as St. Louis, as part of this revised

delivery mechanism. This would tie futures pricing more closely to
the existing geography of grain trading, and the simulation results
presented here support the intuitive conjecture made in Chapter 2
above that such a tie would improve hedging effectiveness for a wide
variety of currently out-of-position traders.
1 Verifying such a conjecture requires additional data on prices at various river points.
We could not obtain such data.
, Federal Trade Commission, vol. V, p. 199. Emphasis added.
3 Garbade and Silber discuss similar issues related to delivery set design, as does
Working.
'The Board's Treasury Bond and Note contracts are examples of such a system.
6Gay and Manaster; Margrabe; Johnson. We test this implication explicitly for corn
and soybeans below.
• These forward prices incorporate information about supply and demand at the vari-
ous non-deliverable and deliverable locations.
7An analysis for adding deliverable grades could apply the same approach and
methodology, but due to data limitations we concentrate upon delivery locations here.
• Apremium is merely a negative discount.
" The analysis implicitly assumes transactions costs equal zero. If transactions costs
are positive, the futures price can exceed the cheapest-to-deliver spot price by the cost
of executing an arbitrage transaction. Since a long trader cannot guarantee receiving
delivery, the arbitrage does not necessarily work in the reverse direction. Assuming
that short sellers are rational, however, a long trader who holds a contract to expira-
tion can expect to receive delivery of the cheapest-to-deliver.
It is, of course, true that there is no spot market for grain like that for T-bills or T-
bonds where a short can purchase grain for immediate delivery at a trivial transac-
tions cost. Shorts may have to originate grain in country for delivery to a regular
warehouse and may incur transactions costs as a result. If shorts have stocks in hand
at eligible locations (i.e., they own a warehouse receipt) they can deliver it at an oppor-
tunity cost equal to the cost of replacing the delivered grain, including all transactions
costs.
Although we certainly recognize the importance of transactions costs (note
Chapters 2 and 4 above), the model that we use implicitly assumes they are zero. The
empirical evidence presented below indicates that even given this counterfactual
assumption, the model has significant explanatory power; i.e., it is robust to violations
of the zero transactions cost assumption. Thus, the simplifying assumption is not dam-
aging in this instance.
IJohnson.
. Such an option has been modeled by Boyle; Gay and Manaster; Hemler; and
11 The weights change continuously with changes in the prices at the various delivery
locations. An arbitrageur would thus have to adjust his spot holdings at the various loca-
tions in order to construct a perfect hedge portfolio. That is a cumbersome and poten-
tially expensive process, so transactions costs would again make the continuous
adjustment of the appropriate arbitrage portfolio impractical. Thus, observed futures
prices can diverge from their theoretical values, which would tend to increase basis risk.
However, the important issue for the analysis is whether that would affect some loca-
tions differentially or, instead, affect all similarly. Since delivery capacity is smaller in
St. Louis than in Chicago or Toledo, for instance, and since only two firms operate deliv-
ery capacity in St. Louis, arbitrage may not occur as effectively when St. Louis receives a
high weight in the formula. That could be mitigated in whole or in part by the substan-
tial flows of grain aboard barge through St. Louis. Thus, even though firms may not own
grain in a regular warehouse in St. Louis, they may hold or have ready access to large
quantities afloat with values that are highly correlated with inventories held in regular
warehouses. Those inventories would permit quasi-arbitrage with little risk.
12 Although it is probably true that the highest bidder gets the grain, his bid is not nec-
essarily the best estimate of the "true" market price. He could get the grain because he
overbid (i.e., bid above the market price). The bids of all terminals contain information
about the value of grain, and the averaging process incorporates this information into
our price proxy. A median price would do so as well, but given as we observe at most
two bids, and there are an infinite number of median prices between them, the average
is a useful estimate. This use of the average/median bid simply reflects the fact that
cash prices are not set in an auction market. If there were an auction market for cash
grain, the equilibrium price would reflect the information in all bids, not just the win-
ner's (see Milgrom [1981]). Since we see only two of the bids, we average them in order
to impound the information in each.
" We also estimated separate regressions for each of the 30 corn contracts and each of
the 41 soybean contracts in our sample. The regressions imply that the delivery option
is an important determinant of futures prices, but the pooled regressions are statisti-
cally superior. We pooled by contract month, rather than by year or by time to expira-
tion (the technique adopted by Gay and Manaster) because the data demonstrate that
there are significant similarities across years for a given contract month (e.g.,
September), but that different contracts can behave very differently (e.g., September is
very different from March).
14 T-statistics allow one to determine the likelihood that a particular coefficient differs
from zero by random chance. A t-statistic of 2, for instance, implies that there is only a
five percent probability that a given coefficient is actually equal to 0, but estimated to
be different from 0 due to random chance. Thus, the larger the t-statistic, the higher
the probability that the actual coefficient one is attempting to estimate differs from O.
The t-statistics from the regressions reported here are well above 2. Even the smallest
of them would arise by random chance far less often than once in 100 sample draws.
Thus, they imply that the probability that we have spuriously estimated a non-zero
relationship between the value of the delivery option and the futures price is virtually
nil.
16We recognize that shorts may deliver corn in St. Louis at a $.04 discount. Given the
fact that St. Louis corn prices tend to exceed Chicago and Toledo corn prices by about
$.10 on average, however, it is seldom economical to deliver there. Thus, the existing
corn delivery price is little affected by the ability to deliver in St. Louis, and our model-
ling of the existing corn delivery specification as a two-delivery- point one is conse-
quently realistic. Similarly, the CBT has applied to the CFTC to add St. Louis as a
soybean delivery point, but the discount is so large that it would seldom be the cheap-
est-to-deliver location.
16 It is, of course, true that actual price differences will almost always diverge from
these averages. The important point about the choice of the premiums is that they
should be chosen to ensure that the weight accorded each deliverable is frequently
large. If price relations change over time such that at the existing premiums a single
market begins to dominate, or a particular market is seldom likely to become cheapest-
to-deliver, the premiums should be adjusted to restore the balance. Over the five-year
period examined here the average differential satisfied the criterion quite well.
17 We estimate the relevant parameters as follows. For each year 1984-1989 we deter-
mine the variance of the percentage weekly changes in each deliverable cash price and
the correlations between the percentage weekly changes in these deliverable cash
prices. We also adjust our parameters for the positive correlation between the percent-
age change in price at location i at time t and the percentage change in price at loca-
tionj at time t+1. That is, a rise in the cash price at (say) St. Louis one week tends to
be followed by a rise in the cash price at (say) Chicago the following week. This phe-
nomenon affects the variability of the relative prices across the deliverable locations;
failing to correct for it would lead to an overestimate of the sij in (5.5).
" Again, we use the average bid due to its superior statistical performance; the aver-
ages exhibit lower variance and higher correlations, which is probably due to the
reduction in measurement error due to averaging. See our earlier discussion for a more
detailed discussion of this issue.
,. The results are not dependent in any significant way upon the choice of the time to
expiration of the futures contract .
.. Edderington.
.. Previous draft versions of this report calculated the standard deviation of the basis
between a cash price and the synthetic futures prices. Those results were similar to
those reported here. Basis risk falls under specifications 2 and 3.
Previous draft versions of this report also included simulations of the behavior of a
four-point delivery specification including "Central Illinois" as a delivery point.
22 Whether these gains in hedging effectiveness are large or small in economic rather
than statistical terms depends upon individual preferences toward risk. On the one
hand, an increase in R2 from .9 to .93 represents only a 3.33 percent improvement in
hedging effectiveness. On the other hand, it represents a 30 percent reduction in the
residual risk borne by a hedger; i.e., basis risk falls by 30 percent.
It should be noted that it is not appropriate to apply measures of statistical signifi-
cance to these R2's across specifications for a given year and location, as the relevant
samples are not statistically independent. The regressions are designed to control for
all factors other than the delivery specification, and consequently hedging effective-
ness does not vary between specifications for a given year and location due to sampling
error; statistical significance tests simply determine the likelihood that sampling error
explains differences in results derived from independent samples.
Results for different years are from independent samples and can be compared
using traditional statistical techniques. The non-parametric results reported in this
paragraph and the one preceding demonstrate that the regularity of the superior per-
formance of specification 3 is not due to random sampling error.
Measures of statistical significance cannot substitute for judgment of the economic
significance of these results. Whether an increase in R2 from .9 to .93, or from .6 to .64,
is economically significant depends upon the cost of risk borne by hedgers, which
depends upon their degree of risk aversion. We cannot accurately measure the cost of
this risk, particularly inasmuch as it almost certainly varies extensively between dif-
ferent hedgers. If this cost is large--and the precision with which hedgers attempt to
control basis risk suggests that it is-the improved hedging effectiveness under the
more liberal delivery specifications estimated here would lead to appreciable economic
benefits to hedgers.
'" It should be noted that although simple correlations are important and are partially
responsible for the patterns of hedging effectiveness found here, they are not the only
factors that determine the R2's reported here. This is particularly true for specification 3.
'" The effect on prices of a trader who makes excessive deliveries as part of a tax strat-
egy or other non-fundamental driven reason is the same in a single or a multiple deliv-
ery point system if he delivers in the cheapest market. His actions will depress price in
the CTD market regardless of whether there are other delivery markets or not. The
effect of multiple delivery markets is therefore asymmetric. It mitigates the price
impact of traders who take excessive deliveries for non-fundamental reasons and has
no effect upon the price impact of traders who make excessive deliveries for similar
reasons.
2' It may be possible, of course, to develop these specialized resources. This may be
costly, however. If, moreover, there are diseconomies of scope in dealing in several
markets, the costs of arbitrage will still increase with the introduction of more delivery
points. Conversely, economies of scope would reduce arbitrage costs.

26It is not coincidental that a market at the terminus of commodity flows is less vul-
nerable to manipulation than one at the origin. Manipulation is deterred to the extent
that a long takes possession of the commodity in an undesirable location.
27 Traders can certainly arrange exchange for physical (EFP) transactions (also called
"ex pit" trades) in order to avoid these mix-ups. As noted in Chapter 3, however, such a
transaction is clearly distinct from a delivery; it requires the buyer and seller to find
one another and negotiate a mutually beneficial contract, while a delivery requires
neither search nor negotiation since it is executed via the clearinghouse with neither
party necessarily aware of the identity of the trader on the other side. Thus, delivery
economizes on some transactions costs; multiple delivery points (or grades) can signifi-
cantly reduce the transactions cost savings if traders' preferences for delivery at cer-
tain locations or of certain grades differ significantly.
28That is, the quantity of long positions demanded rises as the futures price falls,
while the quantity of long positions supplied (i.e., short positions demanded) falls as
the futures price falls.
'" Producers (e.g., farmers of corn or soybeans) may believe that this fall in the futures
price reduces their wealth inasmuch as their selling prices are frequently closely
related to futures prices. Since the fall in the futures price is strictly related to the
delivery process, however, such a belief is mistaken. It may increase the basis between
cash market and futures market prices (i.e., cash market prices may rise relative to
futures prices) because the increase in the number of delivery points, the reductions in
discounts, and the increases in premia enhance the value of the delivery option which
is subtracted from the futures price.
30A similar analysis obtains if the adoption of a multiple delivery point system reduces
the likelihood of a long manipulation and the deadweight losses incurred therein. In
that case, the demand and supply curves shift up, but the demand curve shifts up by
more than the supply curve due to the reduction in deadweight losses. This leads to an
increase in market liquidity.
6 • Summary and Conclusions
The delivery process plays a central role in ensuring the effective

performance of futures markets. An efficient delivery mechanism
facilitates the convergence of cash and futures prices. Hedgers rely
upon convergence to guarantee a close relationship between cash and
futures prices. Moreover, the maintenance of a close relationship
between cash and futures prices allows producers and consumers to
make more informed decisions.
The delivery process must do more, however, than simply ensure
convergence. In markets where transportation costs or quality differ-
ences are important, prices will vary between spatially separated
locations and different grades. Under these circumstances conver-
gence alone is insufficient to minimize the risks hedgers bear, or to
maximize the informational value of futures prices. Convergence to
the spot price that prevails at a relatively isolated location, for
instance, or to the spot price of a relatively unimportant commercial
grade may force hedgers at more important, central locations or of
more important grades to bear excessive basis risk. Under these cir-
cumstances, moreover, futures prices may bear less information
about supply and demand at important locations or of vital grades.
Thus, it is important that futures prices converge to the "right" spot
price. This requires that an exchange specify the appropriate deliver-
able locations and grades.
In addition to ensuring convergence to an appropriate spot price,
the delivery process should protect futures markets from attempts of
self-interested traders to manipulate these prices. Manipulation can
distort price relationships and thereby reduce a contract's hedging
effectiveness and informativeness. Moreover, manipulations can dis-
tort the allocation of the stock of the commodity, which imposes a
deadweight loss upon its consumers and producers.
The final major role of the delivery process is to facilitate the
139

transfer of ownership of the deliverable commodity. Transfer via

delivery can, in some circumstances, economize on transactions costs.
In this report we have analyzed the conceptual issues related to
each of these four functions in considerable detail, and evaluated the
delivery process for the Chicago Board of Trade's grain and soybean
futures contracts in light of this analysis. We arrive at several con-
clusions.
First, over the 1984-1989 period the delivery process effectively
ensured convergence. Deviations between cash and futures prices
were relatively small, and well within reasonable estimates of trans-
actions costs and the limitations of the spot price data used as a mea-
sure of the value of grain in store.
Second, it is apparent that ensuring convergence is the primary
role of the delivery process. Although deliveries occur even when
futures and cash prices appear to converge (which is consistent with
the use of the delivery process to facilitate commodity ownership
transfers), there are very few deliveries relative to the number of
grain futures contracts opened by commercial traders. Thus, it is
apparent that ownership transfer is an ancillary function of grain
futures markets. Consequently, effects of changes in delivery specifi-
cation upon the merchandising effectiveness of futures contracts
should receive considerably less emphasis than the effects of such
changes upon the convergence, basis risk, and susceptibility to
manipulation of grain futures contracts.
Third, since transportation costs are large relative to value in
grain markets, and the consumption and production of these com-
modities is geographically dispersed, grain futures markets are vul-
nerable (relative to some futures markets including financials and
metals, for instance) to manipulations. These factors lead, moreover,
to appreciable variations in grain prices across locations; i.e., the rel-
ative price of grain between different producing and consuming areas
varies appreciably. This, in turn, implies that the choice of delivery
locations may significantly affect hedging effectiveness.
These issues are of considerable importance given the evolution
of grain spot markets over the past several decades. During this
period the Chicago-Great Lakes-U.S. East Coast market has declined
markedly in importance relative to the Mississippi-Gulf area.
Although reductions in transportation cost have mitigated the
adverse effects of this development on the vulnerability of grain mar-
kets to manipulation and on the variability of relative prices, it is
nonetheless the case that this evolution of trading patterns has
reduced the benefits of retaining Chicago as the primary delivery
point and of relying upon Toledo as the only alternative point. This
evolution has, moreover, increased the benefits of adding St. Louis or
some other Mississippi River point(s) to the delivery set for corn and
soybeans.
Put another way, the evolution of grain trading patterns has dra-
matically altered the economic geography of grain markets. By eco-
nomic geography we mean the relation between price and location.
There are two salient features of the prevailing economic geography
of grain markets that are directly relevant to delivery specification.
First, Chicago is now a relatively low-priced point, rather than a
high-priced one, because it is at the origin rather than the destina-
tion of major flows of grain and soybeans for most of the year. Thus,
to enhance deliverable supplies in the market in response to an
attempted manipulation it is necessary to reverse the flow of grain
and draw it from higher-value locations. This is costly, and a manip-
ulator can profitably exploit this cost to inflate the futures price arti-
ficially under conditions that recur periodically in grain markets.
Second, the decline in Chicago's tributary area means that more
hedgers must bear basis risk when Chicago is the primary delivery
point.
Both of these conditions would be ameliorated by improving the
alignment of the delivery mechanism with the prevailing economic
geography. This could be accomplished by adding delivery capacity
on the primary route of grain flows in the United States-the
Mississippi-Gulf export route-at a point such as St. Louis.
There are three major advantages in a change in the delivery
specification allowing St. Louis delivery on these commodities in an
economic-par delivery system, i.e., a delivery system where there is
no primary delivery point, and where futures delivery differentials
are established to offset the effect of price differentials between deliv-
ery points. First, given the assumptions of our analysis, an economic-
par system would reduce basis risk for hedgers of corn and soybeans
at many commercially important locations and thereby increase
hedging effectiveness at these sites. Second, by making the futures
price a broader measure of grain value, an economic-par system
increases the value of the contract as a price discovery mechanism.
Third, this system would reduce the vulnerability of these markets to
long manipulation by increasing the elasticity of what we call the
"liquidation demand curve."
The former two effects-the improvement in basis risk and the
improved price discovery-are the most important. The Board and
the CFTC have alternative means available to control manipulation
(such as "emergency actions" that force liquidation of positions that

facilitate a manipulation). Moreover, the storage capacity at St. Louis
is relatively modest. Consequently, unless provisions are made for
emergency barge or rail delivery at St. Louis, or for some means of
ensuring access of throughput elevators in the vicinity of that city to
the delivery process, the enhancement of manipulation deterrence
due to the addition of St. Louis as a delivery point would be modest
as well.
If such capacity could be added, however, the contracts would be
considerably less susceptible to manipulation, as the delivery mecha-
nism would then access the major flow of grain down the Mississippi
in a way that they currently do not. With adequate delivery capacity
in St. Louis it would not be necessary to attract grain from higher-
priced locations to augment deliverable supplies. Grain naturally
flows by St. Louis in large quantities, and large amounts of grain are
stored in country at low-price locations tributary to the Mississippi
River market. Thus, the supply of grain to St. Louis is relatively elas-
tic compared to Chicago, and this reduces the ability of a manipUla-
tor to influence price artificially.
Even in the absence of a dramatic increase in delivery space at
St. Louis, the basis risk improvements and the greater representa-
tiveness of the futures price strongly recommend the movement to an
economic-par delivery system. The primary objections to such a con-
clusion are the effect of this change on the likelihood of "short manip-
ulation" and some uncertainty concerning the validity of the
assumptions upon which it is based.
It is possible that the addition of delivery points can enhance the
power of large short traders with low costs of making delivery-
namely, regular warehouse operators, to artificially influence prices
around contract expiration to their benefit. If the deadweight losses
arising from this behavior are large, futures market liquidity would
fall.
It is unlikely, however, that the relatively modest change in the
delivery specification contemplated here would lead to such large
deadweight losses. Moreover, even if there were such an effect, the
proposed change could also favorably influence liquidity in some
ways. Any enhanced deterrence of long manipulation, reduction in
the likelihood of congestions, or shortages in storage space would
lead to improved liquidity. Moreover, if the improvements in hedging
effectiveness do materialize, this should lead to increased hedging
activity which would also enhance liquidity. Thus, the net effect of
the adoption of the economic-par system with delivery in St. Louis
upon liquidity is ambiguous, and it may indeed be positive.

The validity of the assumptions underlying the basis risk/hedging
effectiveness analysis in Chapter 5 are more problematic. This is not
unique to this study, as any analysis of this type must necessarily
rely upon assumptions. It is important, nonetheless, to carefully eval-
uate the sensitivity of the analysis's conclusions to such assumptions.
Perhaps the most crucial assumption concerns the stability of the
spot price distributions in the face of changes in the delivery specifi-
cation. Some market participants argue that the ability to deliver
against a futures contract at a particular location dramatically
affects the behavior of spot prices in that market. Thus, the ability to
deliver in Chicago, for instance, tends to weaken the relation
between cash market prices in Chicago and those elsewhere due to
what we term "delivery pressure." If this is true, the addition of St.
Louis as an economic-par delivery point would reduce correlations
between St. Louis prices and prices elsewhere, and the reductions in
basis risk that we attribute to the addition would be lower, and per-
haps significantly lower, if the CBT actually made this change.
There is some evidence that is consistent with the notion that
delivery pressure does affect pricing performance. There are some
reasons to believe, however, that adding St. Louis as a delivery point
might have a relatively small effect upon the results we estimate.
Indeed, it is quite possible that the redistribution of delivery pressure
implicit in the adoption of an economic-par delivery system could
actually enhance the improvements we estimate. This is true for sev-
eral reasons.
First, even though the relatively low price correlations in Chicago
may reflect the impact of futures delivery, they are also quite plausi-
bly due to Chicago's decline as a cash market. One would expect
lower correlations for relatively isolated, thin, and inelastically sup-
plied markets. Thus, the correlations might reflect existing cash mar-
ket trading patterns, rather than the deleterious effects of delivery.
Second, given St. Louis's location astride the largest single grain
transport route in the United States, it is also plausible that the cash
market there is significantly thicker and the supply more elastic than
the Chicago cash market in light of the latter's decline. Any effect of
the ability to deliver on price correlations should be lower, the
thicker the cash market and the more elastic the supply to it.
Third, although the adoption of an economic-par delivery system
would increase the importance of delivery at Toledo and St. Louis, it
would also significantly reduce the importance of delivery in Chicago.
Thus, any adverse consequences of increasing delivery pressure on
the former two points would be mitigated, and perhaps completely

offset, by the reduction in this pressure on the Chicago market. In
other words, even if the adoption of an economic-par delivery system
reduces St. Louis and Toledo spot price correlations, it would also
tend to increase the Chicago correlations if the delivery pressure
argument is valid. Even though the former effect would tend to
undercut our results, the latter effect would tend to reinforce them.
Thus, the net effects of the adoption of an economic-par system on
total delivery pressure are ambiguous.
Indeed, given the fact that under the current delivery differen-
tials delivery pressure predominates at one relatively thin, inelasti-
cally supplied cash market-Chic ago-it is quite possible that
spreading this pressure over a larger number of markets would actu-
ally enhance grain futures contract performance. An economic-par
delivery system would have this effect. It is also quite possible that
the addition of a delivery point that is central to the prevailing eco-
nomic geography of the grain trade, a point such as St. Louis, would
lead to reduction of delivery pressure at an inelastically supplied
market on the margin of the existing grain trade (Chicago) and an
increase in pressure at a relatively thick, elastically supplied one at
the center of that trade (St. Louis). Such a redistribution of pressure
would have asymmetric effects. Although one would expect correla-
tions to decline in St. Louis and rise in Chicago, the effect of the
redistribution of delivery pressure should be more pronounced in the
latter market. This would tend to reinforce, rather than weaken, our
estimated improvements in hedging effectiveness.
The other important assumption underlying our empirical results
is that the cost of cash-futures arbitrage is independent of the deliv-
ery specification. In other words, the addition of delivery points does
not affect the cost of arbitraging the futures contract.
Given that arbitrage of a futures contract with multiple deliver-
abIes requires a trader to own varying proportions of each of the
deliverables, it is certainly possible that adding delivery points
increases the costs of arbitraging markets. If true, this would tend to
increase basis risk above what we measure in Chapter 5, as higher
arbitrage costs imply that larger deviations between the theoretical
value of the futures price and the actual futures price are possible.
Again, it is difficult to estimate empirically the effect of the viola-
tion of this assumption. Certainly, the addition of a single delivery
point cannot have too dramatic an effect upon these costs, particu-
larly if the location added has a relatively thick cash market.
Arbitrage transactions costs vary inversely with market liquidity,
and so the addition of a relatively thick market would have more

modest effects on basis risk than would the addition of a thin market.
Given these caveats, however, our evidence strongly supports the
addition of a Mississippi River point such as St. Louis as a delivery
point for the CBT soybean and corn contracts. This represents a rela-
tively modest change to the existing system and helps put the con-
tracts back into the mainstream of the prevailing economic
geography. We believe that this will enhance the hedging perfor-
mance of these contracts and reduce their susceptibility to manipula-
tion and congestion.
A continued growth in the Mississippi River-Gulf axis as an
export route, combined with a continued decline in Chicago and
Toledo, might make even more radical changes in the delivery system
desirable. In particular, movement to a delivery system centered on
the Mississippi and its tributaries, rather than simply including a
single point thereon, may become more viable if current trends con-
tinue. Given the potential costs in completely revamping an existing
set of institutions (which may be considerable considering the large
amounts of human and physical capital devoted to the efficient oper-
ation of the existing system), however, such a shift should be
deferred pending an evaluation of the effects of more modest changes
and an even more pronounced decline in the Chicago-Toledo markets.
Since the proposals advanced here would alter a delivery mecha-
nism that has existed for almost 130 years with only modest changes,
to some they may seem radical. In their essence, however, they are
not. The proposals are motivated by the understanding that economic
geography made Chicago a pre-eminent delivery point for so long, but
that this economic geography has changed, perhaps forever. We rec-
ommend alterations in the existing delivery mechanism in order to
restore the proper relation between this geography and the delivery
mechanism. We therefore consider these recommendations a continu-
ation of the venerable traditions of these markets, rather than a
rejection thereof.
In conclusion, this study has examined the main issues relating
to the delivery process on the Chicago Board of Trade futures con-
tracts, with special emphasis on the choice of delivery points. We find
that the existing system has worked well, but that the adoption of an
economic-par delivery system holds out some significant potential
benefits. We therefore believe that this system deserves full consider-
ation by the Board and all of the varied affected interests.
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TABLE 2-1: CORN
Range of Futures Price in Relation to Cheapest-to-Deliver Cash Price

Showing Extent of Arbitrage Violations between Cash and Futures Prices
Ranges of Futures Row

Prices in cents/bushel Mar. May July Sept. Dec. Totals
All Delivery Months, 1984-9

< CTD- 6 0 0 0 0 1 1
[CTD Low - 6, CTD Low) 5 8 11 0 13 37
[CTD Low, CTD High) 51 57 38 37 44 227
[CTD High, sCTD High + 6) 30 18 20 22 25 115
> CTD High + 6 2 3 16 21 1 43
Column Totals 88 86 85 80 84 423
1984 Delivery Months

< CTD Low - 6 0 0 0 0 1 1
[CTD Low - 6, CTD Low) 1 8 4 0 12 25
[CTD Low, CTD High) 13 6 6 11 0 36
[CTD High, CTD High + 6) 1 0 3 1 0 5
> CTD High + 6 0 1 1 0 0 2
Column Totals 15 15 14 12 13 69

< CTD Low- 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 4 0 7 0 0 11
[CTD Low, CTD High) 8 14 7 10 12 51
[CTD High, CTD High + 6) 2 1 1 3 2 9
> CTD High + 6 0 0 0 0 0 0
Column Totals 14 15 15 13 14 71

< CTD Low - 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 0 0 1 1
[CTD Low, CTD High] 8 11 2 0 11 32
[CTD High, CTD High + 6) 5 2 10 8 3 28
> CTD High + 6 0 1 3 6 0 10
Column Totals 13 14 15 14 15 71

< CTD Low- 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 0 0 0 0
[CTD Low, CTD High) 2 13 11 2 1 29
[CTD High, CTD High + 6] 11 0 4 8 14 37
> CTD High + 6 2 0 0 4 0 6
Column Totals 15 13 15 14 15 72
Tables· Graphs· Figures 153
TABLE 2-1: CORN (continued)


< CTD Low-6 0 0 0 0 0 0
[CTD Low· 6, CTD Low) 0 0 0 0 0 0
[CTD Low, CTD High) 12 0 0 1 8 21
[CTD High, CTD High + 6) 4 13 2 2 5 26
> CTD High + 6 0 1 11 11 1 24
Column Totals 16 14 13 14 14 71

< CTD Low-6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 0 0 0 0
[CTD Low, CTD High) 8 13 12 13 12 58
[CTD High, CTD High + 6) 7 2 0 0 1 10
> CTD High + 6 0 0 1 0 0 1
Column Totals 15 15 13 13 13 69
NOTE: CTD = Cheapest to Deliver.

CTD Low = min [Chicago Low Cash, Toledo Low Cash + 4 cents/bushel).
CTD High = min [Chicago High Cash, Toledo High Cash + 4 cents/bushel).
TABLE 2-2: SOYBEANS

Showing Extent of Arbitrage Violations between Cash and Futures Prices

Prices in cents/bushel Jan. Mar. May July Aug. Sept. Nov. Totals

< CTD Low-6 1 5 3 2 0 2 0 13
[CTD Low - 6, CTD Low) 33 25 15 25 16 6 6 126
[CTD Low, CTD High) 18 51 40 25 50 51 37 272
[CTD High, CTD High + 6) 29 7 27 20 8 9 35 135
> CTD High + 6 4 0 1 13 17 12 2 49
Column Totals 85 88 86 85 91 80 80 595

< CTDLow-6 0 0 3 0 0 1 0 4
[CTD Low - 6, CTD Low) 12 11 12 12 12 2 0 61
[CTD Low, CTD High) 1 4 0 2 4 9 14 34
[CTD High, CTD High + 6) 0 0 0 0 0 0 0 0
> CTD High + 6 1 0 0 0 0 0 0 1
Column Totals 14 15 15 14 16 12 14 100

< CTD Low- 6 1 4 0 0 0 0 0 5
[CTD Low - 6, CTD Low) 14 6 0 10 0 0 1 31
[CTD Low, CTD High) 0 4 15 5 15 12 7 58
[CTD High, CTD High + 6) 0 0 0 0 0 1 5 6
> CTD High + 6 0 0 0 0 0 0 0 0
Column Totals 15 14 15 15 15 13 13 100

< CTDLow-6 0 1 0 2 0 1 0 4
[CTD Low - 6, CTD Low) 7 8 3 2 4 3 0 27
[CTD Low, CTD High) 8 4 11 4 4 7 1 39
[CTD High, CTD High + 6) 0 0 0 6 6 2 11 25
> CTD High + 6 0 0 0 1 0 1 0 2
Column Totals 15 13 14 15 14 14 12 97

< CTD Low - 6 0 0 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 0 0 0 0 0 0
[CTD Low, CTD High) 0 14 0 0 12 11 1 38
[CTD High, CTD High + 6) 13 1 13 14 1 3 11 56
> CTD High + 6 1 0 0 1 1 0 1 4
Column Totals 14 15 13 15 14 14 13 98
Grain Futures Contracts, an Economic Appraisal 155
TABLE 2-2: SOYBEANS (continued)

Prices in cents/bushel Jan. Mar. May July Aug. Sept. Nov. Totals

< CTD Low-6 0 0 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 0 1 0 0 0 1
[CTD Low, CTD High) 0 11 1 2 0 0 5 19
[CTD High, CTD High + 6) 12 5 12 0 0 3 8 40
> CTD High + 6 1 0 1 10 16 11 1 40
Column Totals 13 16 14 13 16 14 14 100

< CTD Low-6 0 0 0 0 0 0 0 0
[CTD Low - 6, CTD Low] 0 0 0 0 0 1 5 6
[CTD Low. CTD High] 9 14 13 12 15 12 9 84
[CTD High, CTD High + 6] 4 1 2 0 1 0 0 8
> CTD High + 6 1 0 0 1 0 0 0 2
Column Totals 14 15 15 13 16 13 14 100

CTD Low = min [Chicago Low Cash, Toledo Low Cash + 8 cents/bushel].
CTD High = min [Chicago High Cash. Toledo High Cash + 8 cents/bushel).
156 Tables· Graphs· Figures Grain Futures Contracts, an Economic Appraisal
TABLE 2-3: WHEAT

Showing Extent of Arbitrage Violations between Cash and Future Prices


< CTD- 6 3 4 0 0 0 7
[CTD Low - 6, CTD Low] 12 8 8 10 3 41
[CTD Low, CTD High] 40 33 44 22 53 192
[CTD High, CTD High + 6) 31 33 20 16 12 112
> CTD High + 6 2 8 13 32 16 71
Column Totals 88 86 85 80 84 423

< CTD- 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 6 10 0 16
[CTD Low, CTD High) 7 7 5 2 13 34
[CTD High, CTD High + 6) 8 7 3 0 0 18
> CTD High + 6 0 1 0 0 0 1
Column Totals 15 15 14 12 13 69

< CTD- 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 2 0 2 4
[CTD Low, CTD High) 11 9 13 7 11 51
[CTD High, CTD High + 6] 1 4 0 6 1 12
> CTD High + 6 2 2 0 0 0 4
Column Totals 14 15 15 13 14 71

< CTD- 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 6 0 0 1 7
[CTD Low, CTD High) 10 7 11 0 1 29
[CTD High, CTD High + 6] 3 0 4 0 5 12
> CTD High + 6 0 1 0 14 8 23
Column Totals 13 14 15 14 15 71

< CTD- 6 3 4 0 0 0 7
[CTD Low - 6, CTD Low) 11 2 0 0 0 13
[CTD Low, CTD High] 1 5 3 0 1 10
[CTD High, CTD High + 6] 0 1 12 10 6 29
> CTD High + 6 0 1 0 4 8 13
Column Totals 15 13 15 14 15 72
Grain Futures Contracts, an Economic Appraisal 157
TABLE 2-3: WHEAT (continued)

Prices in cents/bushel Mar. May Jul. Sep. Dec. Totals

< CTD- 6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 0 0 0 0 0 0
[CTD Low, CTD High) 0 0 0 0 14 14
[CTD High, CTD High + 6) 16 12 0 0 0 28
> CTD High + 6 0 2 13 14 0 29
Column Totals 16 14 13 14 14 71

< CTD-6 0 0 0 0 0 0
[CTD Low - 6, CTD Low) 1 0 0 0 0 1
[CTD Low, CTD High) 11 5 12 13 13 54
[CTD High, CTD High + 6) 3 9 1 0 0 13
> CTD High + 6 0 1 0 0 0 1
Column Totals 15 15 13 13 13 69

CTD Low = min [Chicago Low Cash, Toledo Low Cash + 2 cents/bushel).
CTD High = min [Chicago High Cash, Toledo High Cash + 2 cents/bushel).
TABLE 2-4
SUMMARY STATISTICS BY CONTRACT FOR BASIS DURING THE

DELIVERY MONTH
Average of High and Low Cheapest to Deliver, minus Futures Settle,
in cents per bushel
MEAN
(STANDARD DEVIATION)
CORN
All
YEAR Mar. May July Sept. Dec. Months
1984 1.3 1.5 -3.5 -1.8 6.1 0.7

(2.4) (3.9) (9.6) (1.8) (0.9) (5.8)
1985 2.5 -0.2 2.1 -0.2 -0.5 0.8

(2.1) (1.4) (2.7) (4.9) (1.8) (3.11)
1986 -0.9 -1.3 -11.7 -10.3 -0.6 -5.1

(1.6) (2.1) (15.1) (6.5) (1.7) (9.1)
1987 -5.7 -1.3 -2.4 -6.6 -2.9 -3.8

(1.7) (0.8) (1.1) (3.4) (1.3) (2.7)
1988 -2.0 -2.3 -32.3 -14.2 -2.5 -10.1

(0.7) (1.7) (8.2) (2.6) (2.8) (12.2)
1989 -2.8 -2.8 -1.6 -2.2 0.2 -2.0

(0.8) (1.0) (2.3) (2.7) (0.8) (2.0)
All -1.3 -1.1 -7.9 -2.2 -0.2 -3.3

Years (3.1) (2.6) (13.9) (6.4) (3.4) (7.9)
WHEAT
All
YEAR Mar. May July Sept. Dec. Months
1984 -3.2 -7.2 1.1 2.8 -2.3 -2.0

(2.8) (5.4) (3.2) (0.9) (1.5) (4.8)
1985 -2.9 -7.1 2.1 -5.6 -3.2 -3.3

(6.1) (3.9) (1.0) (1.8) (3.1) (4.8)
TABLE 2-4: (continued)
1986 -2_6 -1.0 -4.4 -30.4 -8.5 -9.4

(4.6) (23.4) (3.1) (2.8) (4.6) (15.3)
1987 10.5 8.0 -2.9 -11.6 -7.6 -0.8

(2.2) (12.3) (1.1) (4.8) (4.1) (10.5)
1988 -7.2 -10.9 -25.6 -22.0 -5.2 -13.8

(0.7) (1.8) (7.4) (0.6) (1.9) (8.7)
1989 -1.1 -6.4 -4.7 -4.2 -0.3 -3.4

(2.5) (3.9) (3.2) (1.8) (1.7) (3.6)
All -1.1 -4.3 -5.4 -12.4 -4.7 -5.5

Years (6.6) (12.6) (9.7) (11.5) (4.2) (10.1)
SOYBEANS
All
YEAR Jan. Mar. May July Aug. Sept. Nov. Months
1984 3.1 2.6 6.6 9.6 10.6 3.8 -1.0 5.2

(5.4) (0.7) (1.4) (2.1) (5.3) (4.2) (1.8) (5.2)
1985 7.4 5.8 1.2 3.3 2.2 -0.4 -2.4 2.6

(2.5) (2.8) (1.5) (1.0) (1.0) (2.5) (3.4) (3.8)
1986 2.2 4.3 1.5 -3.4 -2.1 1.2 -6.6 -0.3

(1.0) (1.8) (2.5) (5.6) (6.4) (13.7) (2.2) (7.2)
1987 -5.3 -1.8 -5.1 -10.8 -13.0 -7.3 -8.1 -7.3

(0.9) (1.6) (2.4) (3.9) (8.5) (1.9) (3.0) (5.3)
1988 -3.9 -2.3 -4.1 -24.4 -24.9 -18.6 -5.0 -11.9

(1.9) (1.8) (4.7) (16.3) (2.3) (2.7) (3.2) (11.5)
1989 -9.4 -.7 -5.7 -5.2 -5.7 0.9 2.3 -3.4

(4.0) (1.7) (4.0) (3.7) (4.0) (0.2) (0.7) (5.0)
All -0.8 1.1 -0.8 -4.9 -5.5 -3.7 -3.4 -2.5

Years (6.5) (3.6) (5.4) (12.8) (12.6) (9.9) (4.3) (9.0)
TABLE 2-5
RECEIPTS AT PRIMARY MARKETS AS A FRACTION OF U.S. OUTPUT
WHEAT
YEARS AVERAGE AV~, RE!:;EIPTS
RECEIPTS AVG. OUTPUT
55-59 468 .427
60-64 444 .363
65-69 425 .298
70-74 418 .261
75-79 327 .160
80-82 219 .083
83-85 189 .082
86-88 200 .099
CORN
YEARS AVERAGE AY..~. BE!:;EI~IS
RECEIPTS AVG.OUTPUT
55-59 360 .109
60-64 449 .121
65-69 389 .087
70-74 369 .072
75-79 273 .040
80-82 344 .044
83-85 252 .037
86-88 204 .030
SOYBEANS
YEARS AVERAGE AV~. BE!:;EIPTS
RECEIPTS AVG. OUTPUT
55-59 77 .159
60-64 86 .130
65-69 95 .097
70-74 96 .077
75-79 54 .031
80-82 90 .045
83-85 75 .040
86-88 62 .034
RECEIPTS IN MILLIONS OF BUSHELS
SOURCE: 1955-1982 AB. Paul ''The Role of Cash Settlement in Futures Contract
Specification" in Futures Markets: Regulatory Issues. Anne Peck, ed.
1983-1988 Receipts and shipment dats supplied by the CBT. Production data from
CRB Commodity Handbook.
TABLE 2-6
RECEIPTS AT CHICAGO AS A FRACTION OF U.S. OUTPUT
WHEAT
YEARS AVERAGE AVG, B~EI~TS
RECEIPTS AVG.OUTPUT
55-59 27.0 .025
6().64 28.4 .023
65-69 27.5 .019
70-74 17.9 .011
75-79 16.3 .008
80-82 12.7 .005
83-85 8.1 .003
CORN
YEARS AVERAGE AYJiA, BECEleIS
RECEIPTS AVG.OUTPUT
55-59 117.5 .036
6().64 135.9 .037
65-69 129.4 .029
70-74 95.9 .019
75-79 112.1 .016
80-82 83.6 .011
83-85 89.8 .013
SOYBEANS
YEARS AVERAGE AYJiA, BECEleIS
RECEIPTS AVG.OUTPUT
55-59 34.7 .072
6().64 34.8 .053
65-69 38.5 .039
70-74 44.8 .036
75-79 26.7 .015
80-82 19.2 .009
83-85 22.6 .012
RECEIPTS IN MILLIONS OF BUSHELS

SOURCE: Chicago Board of Trade Statistical Annual 1969-1985.
TABLE 2-7
CHICAGO, TOLEDO AND ST. LOUIS RECEIPTS
AS A FRACTION OF RECEIPTS AT ALL TERMINAL MARKETS
YEAR CORN SOYBEANS WHEAT

84 .6377 .7023 .0671
85 .7115 .7631 .1873
86 .7591 .7677 .1455
87 .7186 .8312 .0988
88 ~ ~ ...Qa!Z
AVERAGE .7121 .7806 .1167
SOURCE: Receipt and Shipment data, CBT.
TABLE 3·1
DELIVERIES AS A FRACTION OF OPEN POSITIONS

1980·1989
2x Deliveries
CONTRACT Volume + Deliveries
CBTWHEAT .0189
CBTCORN .0123
CBT SOYBEANS .0195
KCBTWHEAT .0215
MGEWHEAT .0433
MACE WHEAT .0149
MACE CORN .0131
MACE SOYBEANS .0109

TABLE 3-2
DELIVERIES AS A FRACTION OF EFPs + DELIVERIES

1983-1989
WHEAT CORN SOYBEANS
1983 .2075 .0211 .1699
1984 .0503 .0133 .1103
1985 .1071 .0089 .0506
1986 .0320 .0320 .0483
1987 .1156 .0449 .0541
1988 .2060 .0547 .1038
1989 .0930 .0117 .0754
Average .1159 .0267 .0875

TABLE 3-3
TOTAL SOYBEAN DELIVERY REGRESSION RESULTS

T-Statistics in Parentheses
Variable Coefficient
Constant 16113
(3.14)
D1 ·9943
(-2.26)
DU ·15730
(-2.77)
Total Stock .502

(2.77)
SUMDUM 24212
(2.74)
CARRY 351.7
(2.77)
BASIS -179.9
(-.53)
B2 .659
Degrees of freedom 30
Dw 2.20
D1 = 1 in January, March, and May; D1 = 0 otherwise.
DU = 1 in September; DU = 0 otherwise.
SUMDUM = in July, August, and September 1988; SUMDUM = 0 otherwise.
TABLE 3-4
TOTAL CORN DELIVERY REGRESSION RESULTS

T-Statistics in Parentheses
Variable Coefficient
Constant 38285.75
(2.38)
01 -22592
(-1.86)
OU -40999
(-2.61)
Total Stocks .33

(.88)
SUMOUM 38421
(1.78)
CARRY 397.5
(1.76)
BASIS -670
(-.50)
B2 .403
Degrees of freedom 21
Ow 1.90
01 = 1 in March and May; 01 = 0 otherwise
OU = 1 in September; OU = 0 otherwise.
SUMOUM = 1 in July and September 1988; SUMOUM = 0 otherwise.
TABLE 5-0
DELIVERY OPTION REGRESSION RESULTS
DEPENDENT VARIABLE = PERCENTAGE CHANGE
IN FUTURES PRICE
T-STATISTICS IN PARENTHESES
CORN
CONTRACT SPOT PRICE DELIVERY OPTION R>
COEFFICIENT COEFFICIENT
MAR. .86 .96 .855

(43.63) (15.82)
MAY .87 1.24 .812

(39.06) (20.54)
JULY .59 .92 .548

(21.08) (4.66)
SEPT. .60 1.36 .598

(23.39) (13.16)
DEC. .78 .41 .777

(35.02) (6.99)
SOYBEANS
CONTRACT SPOT PRICE DELIVERY OPTION R2
COEFFICIENT COEFFICIENT
JAN. .85 .81 .871

(43.37) (5.54)
MAR. .89 .79 .895

(53.97) (7.18)
MAY .97 1.39 .946

(81.22) (12.34)
JULY 1.00 1.28 .950

(83.50) (19.01)
AUG. .88 .43 .879

(51.84) (4.58)
SEPT. .77 .81 .739

(32.34) (7.70)
NOV. .79 1.01 .784

(36.30) (11.96)
TABLE 5-1
SOYBEAN HEDGING EFFECTIVENESS UNDER ALTERNATIVE

DELIVERY SPECIFICATIONS
Delivery
Specification 1984
CHI TOl Sl Cil GULF MN CIA KC
1 .986 .977 .941 .949 .951 .952 .957 .966

2 .906 .991 .935 .948 .940 .942 .958 .963
3 .899 .977 .971 .971 .940 .934 .974 .943
1985
1 .965 .956 .899 .875 .865 .734 .871 .758

2 .918 .990 .910 .883 .881 .750 .883 .769
3 .898 .982 .945 .905 .890 .750 .901 .777
1986
1 .896 .890 .775 .855 .803 .640 .694 .644

2 .833 .943 .789 .861 .814 .658 .693 .638
3 .788 .953 .860 .883 .841 .673 .740 .643
1987
1 .915 .875 .769 .838 .857 .709 .893 .862

2 .901 .911 .770 .849 .870 .709 .904 .875
3 .899 .869 .903 .890 .911 832 .920 .873
1988
1 .993 .982 .964 .922 .959 .921 .974 .958

2 .985 .986 .964 .923 .961 .923 .976 .961
3 .977 .965 .992 .959 .976 .959 .989 .976
Tables' Graphs· Figures 169
TABLE 5-1: SOYBEAN HEDGING EFFECTIVENESS (continued)

Delivery
Specification 1989
CHI TOL SL CIL GULF MN CIA KC
1 .957 .943 .939 .952 .930 .931 .944 .891

2 .931 .961 .941 .954 .920 .932 .951 .904
3 .918 .949 .975 .965 .958 .953 .959 .883
CHI= CHICAGO
TOL= TOLEDO
SL= ST. LOUIS
CIL = CENTRAL ILLINOIS
GULF= GULF OF MEXICO (NOLA)
MN= MINNEAPOLIS
CIA = CENTRAL IOWA
KC = KANSAS CITY
TABLE 5-2
CORN HEDGING EFFECTIVENESS UNDER ALTERNATIVE

DELIVERY SPECIFICATIONS
Delivery
Specification 1984
1 .975 .603 .458 .518 .448 .510 .493 .431

2 .946 .663 .485 .551 .479 .527 .514 .471
3 .901 .655 .639 .656 .622 .625 .560 .558
1985
1 .756 .627 .637 .487 .563 .550 .401 .446

2 .616 .747 .620 .509 .603 .577 .479 .523
3 .637 .736 .782 .502 .707 .697 .531 .637
1986
1 .961 .850 .669 .722 .711 .646 .580 .536

2 .930 .894 .678 .730 .727 .665 .581 .548
3 .720 .774 .960 .919 .892 .823 .643 .563
1987
1 .968 .900 .723 .809 .750 .628 .716 .874

2 .927 .948 .737 .828 .757 .646 .736 .880
3 .877 .932 .822 .878 .796 .688 .736 .870
1988
1 .998 .960 .911 .959 .892 .935 .947 .891

2 .994 .968 .913 .963 .896 .937 .951 .896
3 .982 .967 .962 .975 .901 .955 .966 .890
TABLE 5-2: CORN HEDGING EFFECTIVENESS (continued)
Delivery
Specification 1989
1 .993 .824 .827 .837 .877 .673 .889 .879

2 .983 .853 .831 .849 .884 .680 .898 .890
3 .942 .878 .945 .907 .908 .725 .932 .909
CHI= CHICAGO
TOl = TOLEDO
Sl = ST. LOUIS
CIL = CENTRAL ILLINOIS
GULF = GULF OF MEXICO (NOLA)
MN = MINNEAPOLIS
CIA = CENTRAL IOWA
KC= KANSAS CITY
TABLE 5-3
SOYBEAN PERCENTAGE PRICE CHANGE CORRELATIONS

1984
Sl Cil GULF MN CIA KC

CHI .882 .888 .962 .961 .927 .949
TOl .942 .953 .918 .950 .947 .950
Sl 1.000 .951 .919 .884 .952 .884
1985

CHI .867 .843 .825 .608 .829 .687
TOl .882 .857 .882 .606 .886 .776
Sl 1.000 .883 .882 .586 .869 .697
1986

CHI .770 .717 .616 .528 .608 .523
TOl .636 .813 .792 .662 .647 .503
Sl 1.000 .835 .817 .617 .785 .491
1987

CHI .789 .757 .846 .782 .881 .851
TOl .897 .795 .882 .777 .894 .855
Sl 1.000 .784 .905 .832 .897 .800
1988

CHI .901 .927 .954 .811 .965 .951
TOl .933 .955 .967 .860 .960 .962
Sl 1.000 .965 .972 .890 .982 .967
1989
Sl Cil GULF MN CIAKC

CHI .813 .831 .923 .710 .928 .767
TOl .848 .910 .900 .794 .929 .820
Sl 1.000 .919 .967 .834 .941 .735
TABLE 5-4
CORN PERCENTAGE PRICE CHANGE CORRELATIONS
1984

CHI .380 .411 .437 .537 .328 .403
TOl .446 .506 .463 .485 .423 .505
Sl 1.000 .819 .885 .726 .463 .630
1985

CHI .565 .428 .417 .430 .502 .398
TOl .575 .531 .646 .603 .626 .542
Sl 1.000 .567 .744 .637 .563 .579
1986

CHI .632 .691 .645 .607 .552 .529
TOl .594 .660 .685 .670 .669 .607
Sl 1.000 .921 .888 .809 .631 .563
1987

CHI .672 .758 .713 .567 .668 .817
TOl .715 .820 .722 .640 .764 .825
Sl 1.000 .916 .791 .772 .665 .737
1988

CHI .905 .952 .886 .930 .939 .883
TOl .929 .979 .928 .929 .971 .911
Sl 1.000 .958 .897 .942 .955 .850
1989

CHI .815 .816 .858 .658 .872 .860
TOl .815 .886 .835 .688 .890 .900
Sl 1.000 .877 .860 .693 .878 .832
SOYBEANS BASIS: Contracts for March Delivery by Year"
______"'_ of High and Low Cheapest to Deliver minus Futures; in cents/bushel. I~
80
60
A
v
e
a
9
e
Gt
C 0
T 5"
D ~
B -20
a-~
III
a
s ~
i ~
S I»
~
g>
I»
::s
t."J
8
5
8
n"
-90 -70 -50 -30 -10
~
Days to Maturity
For Each Year: o 1984 o 1985 x 1986 + 1987 /:;. 1988 v 1989 II
SOYBEANS BASIS: Contracts for September Delivery by Year.
Average of High and Low Cheapest to Deliver minus Futures; in cents/bushel.
I;;?f
80
~
60 iOJ
"'l
A 40 1·
v OJ
e
r
a 20
9
e
C 0
T
D
B -20
a
s
i
s -40
-60-4 },
-80 I I I I I
-90 -70 -50 -30 -10
Days to Maturity
~
For Each Year: (> 1984 o 1985 x 1986 + 1987 !'l 1988 \1 1989 en
CORN BASIS: Contracts for March Delivery by Year. ~
en
60 - -
50
40
A 30
v
e 20
r
a
9 10
e
-=.A =- !it
C 0 'X"""'"' """"=
~
T ~
~lqi ~ 5·
D
10 v "'
B ~.~
III
a
s ·20
f
i
s ·30
40
.f
~
t."l
8
50 5
E!
I'i"
60 I
-90 -70 -50 -30 -10
Days to Maturity
For Each Year: 0 1984 0 1985 x 1986 + 1987 ~ 1988 v 1989
f.!.
CORN BASIS: Contracts for September Delivery by Year.
Average of High and Low Cheapest to Deliver minus Futures; in cents/bushel. ~
(;)
60
'"
50 G(
i
40 '"
'"Z.l
~.
A 30
v al
e 20
'"
r
a
9 10
e
C 0
T
D
-10
B
a -20
s
i
s -30
-40
-50
-60 I I
-30 -10
Days to Maturity
For Each Year: 0 1984 o 1985 x 1986 T 1987 r:, 1988 'V 1989 '-..a-..a"'
WHEAT BASIS: Contracts for March Delivery by Year. .......
Average of High and Low Cheapest to Deliver minus Futures; in cents/bushel. 00
80
60
A 40
v
e
r
a 20
9
e
G(
C 0 e.
T ::s
D ~
B -20 [
OJ
a
s
i
s -40
f
~
t:.l
-60
8
~
(i.
-80 t t t I I
-90 -70 -50 -30 -10
~
Days to Maturity ~iii·
For Each Year: <> 1984 0 1985 x 1986 + 1987 b. 1988 'V 1989 e:.
WHEAT BASIS: Contracts for July Delivery by Year. t-:3
I
Average of High and Low Cheapest to Deliver minus Futures; in cents/bushel. ~
80
Gt
60 i
'"
A 40
v i
e '"
r
a 20
g
e
C 0
T
D
B -20
a
s
i
s -40
-60~----------------------------------------------------
-80 I I I I I
-90 -70 -50 -30 -10
Days to Maturity
For Each Year: 0 1984 o 1985 x 1986 + 1987 f:, 1988 "V 1989 !:::
CD
~ a
~
(/)
p;j
~
~«
~
I:l ::E
:=
~ ~
~
::l
::;
g
~
i
0
u
0
.-<
~
8~
a:l
:l
0
S
0
~
~
~
[2
N ~
e:s
rZ S
~
~
!=:
~
~
~
0
U
~
~
z
0
z
~
0
z
Figure 3
~
N
FUTURES CONTRACf MANIPULATION BY A LARGE TRADER
$ x
F2
FM
Fl
!it
5"
F* ~
H
[
'"
~
I
~
t.o:J
I
n"
~
UQUIDATIONS I
l!.
Index
Alchian, 105 Corn, 1, 3-4, 12, 14-15, 18-28, 36-37,

Basis risk, 13, 28, 30-35, 45-46, 49, 47-50, 56-60, 77, 91-92, 98, 106-
63, 75, 78-79, 81, 94, 104, 107- 107, 113-122, 125-126, 133, 135-
108, 111-113, 116, 121-122, 127, 136, 138, 141, 145
132-133, 135, 137, 139-145 Delivery option(s), 10, 91, 108, 113-
Carlton, 47 116,127-128 136,138
Cash settlement, 35, 39-41, 43-45, Delivery pressure, 124-126, 143-144
49-50 Delivery, 1-3, 4-6, 1, 10-25, 27-49,
CBT (see Chicago Board of Trade) 51-79, 81, 83-87, 91-95, 97-99,
101-145
CFTC (see Commodity Futures
Trading Commission) Easterbrook, 80,103-104
Chicago Board of Trade (Board, Economic geography, 141, 144-145
CBT), 1-2, 4, 6, 10-11, 13, 15, 21, Economic-par, 1, 3, 46, 98, 110, 116,
25, 35-37,46-47, 54, 56, 60, 62-63, 118-124, 126-128, 132-133, 141-
71, 73, 81, 83, 91-95, 97-102, 105- 145,
106, 108-109, 133, 135-136, 140- EFP (see Exchange for Physicals)
141, 143, 145
Ex ante deterrence, 101
Chicago, 1-2, 4-6, 11-16, 19-22, 24-
36, 45-49, 56, 58, 62, 66, 68, 73, Ex post deterrence, 88
91-95, 98-99, 102, 105-109, 111, Exchange for Physicals (EFP), 55-56,
114-119, 121-126, 129-130, 133, 62,65,103,138
135-136, 140-145 Futures price(s), 1-2, 4-6, 11-13, 15-
Commodity Futures Trading 28, 31, 36, 40-45, 47-48, 55, 57,
Commission (CFTC), 54, 71, 82- 60,63-65" 69-72, 74-70, 77-79, 85,
83,97,100-101,136,141 87-88, 94, 104-105, 108-119, 121-
Congestion, 27, 53, 71, 87, 101, 104, 122, 127-128, 130-133, 135-142,
145 144
Convergence, 1-2, 10-13, 15-16, 18- Garbade, 47, 49, 135
22, 24-28, 30, 34, 45-48, 53, 57, Gay, 135-136
59-60, 72, 94, 101, 110, 113, 139- Grossman, 7
140
Gulf of Mexico (NOLA), 119, 125
Hedging, 1-6, 13-15, 32, 35, 40, 46- St. Louis, 3, 5, 27, 32-34, 36, 38, 46,
47, 49, 51, 54, 56, 59, 63, 75-76, 66, 91-94, 97-99, 105, 107-108,
80-81, 104, 107-108, 112, 116, 118-126, 130, 133-136, 141·145
119-124, 126-127, 132, 134, 137, Telser, 47, 50, 62, 106
139-145
Toledo, 1·2, 15·16, 19·22, 24-36, 45-
Hedging effectiveness, 1-3, 14-15,47, 48, 56, 58, 68, 91, 95, 98-99, 102,
63, 76, 104, 107, 116, 119-124, 107·108, 111, 114-115, 118·119,
126-127,132,134,137,139-144 121-124, 129-130, 133, 135-136,
Information, 5-6, 11, 16, 23, 26, 41, 141, 143·145
52, 77, 79-81, 83, 88, 97, 100-101, Transactions costs, 3·4, 12·14, 16·17,
122, 128, 135-136, 139 19, 30, 34, 40·42, 44, 47, 50, 52,
Kyle, 80, 104 55,57,63,65-66,68-69,71-74,76,
Manaster, 135-136 81, 83·85, 87·88, 92, 94·95, 101,
103-104, 113, 122, 127-131, 133,
Manipulation deterrence, 94, 98-99, 135,138,140,144
142
U.S.D.A. (see United States
Manipulation, 2-3, 6, 11, 13-15,30,35- Department of Agriculture)
36, 38-40, 45-47, 49, 51, 62-65, 69-
83, 87, 89-107, 109-110, 112-113, United States Department of
122,128,131-132,138-142,145 Agriculture (U.S.D.A.), 16, 18, 22,
47
Margrabe, 114, 135
Wheat, 1, 11, 18·19, 23·26, 28, 37,
Milgrom, 50, 136 47-49, 56, 60, 77, 91, 93, 98, 100,
NOLA (see Gulf of Mexico), 103, 105·106, 125
Oats, 28, 47,91 Williams, 51-53, 56, 62, 97
Options, 2, 3, 91, 94,107-108,113,128
Pirrong, 7, 31, 49, 62, 72, 93, 100,
104-105
Price discovery, 5-6, 11, 59, 79, 121-
122, 133, 141
Redelivery, 48,56
Regular elevator, 33
Regular warehO\~se, 24, 28, 48, 135,
142
Regular warehouseman, 18
Short manipulation, 15,49,64,74,76,
95,99,104,113,122,131-132,142
Silber, 47, 49, 135
Soybeans, 2, 3, 5, 14, 16, 18-26, 28,
36, 47-50, 56, 58, 77, 93, 95, 98,
106-107, 114-122, 125, 130, 133,
135, 138, 141
Spot price(s), 3, 10-16, 17-28, 35, 42,
45-48,50,55,63,71,74-75,78-79,
110-117, 122-123, 127-128, 130,
135, 139-140, 143-144

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GRAIN

A MIDAMERICA Institute Research Project

Grain futures contracts : an economic appraisal / by S. Craig Pirrong,

Copyright © 1993 by Springer Science+Business Media New York

Printed an acid-free paper.

The Grain Futures Delivery Process: An Overview xi

Tables • Graphs • Figures

TABLE 2-1: Corn

This study is an independent scholarly analysis of the economics

The grain futures markets of the Chicago Board of Trade (Board

a delivery point on the Mississippi River in addition to the existing

the chapter. We provide new empirical evidence that indicates that

Although the Board of Trade was chartered in 1848, futures trad-

'Williams (1986); Williams (1987).

To evaluate properly the function of the delivery process, and

Forward and Futures Markets

S. Craig Pirrong et al., Grain Futures Contracts:An Economic Appraisal

can only contract to deliver integer multiples of a standard lot size; a

In this chapter, we discuss the economic value of forward con-

The Economic Function of Futures Markets

negotiating a tailored forward contract. To execute a forward con-

'See Grossman (1977).

'See Pirrong (1992).

The delivery terms of futures contracts specify the types and

S. Craig Pirrong et al., Grain Futures Contracts:An Economic Appraisal

realize that only low-quality widgets will be delivered. But, by

Convergence and the Delivery Process: An Overview

markets are not intended-and have never been intended-as a way

prices is a desirable characteristic of futures markets. In order to

risk of hedging Peoria spot transactions through the use of Board

by transportation and transactions costs. First, the reliability of a

curtail manipulation can also penalize, and hence discourage, pro-

The Convergence of Spot and Futures Prices: An Empirical Analysis of

ity; i.e., it should reflect the value of grain in store. There is no

completely unrelated to spot-futures arbitrage considerations.

reflect the marginal cost of grain storage. l5

plus $.06/bu. This $.06 figure is a rough estimate of transactions

First consider the corn and soybean contracts. Taken as a whole,

philosophy;21 additional capacity came on line when it was exhausted

narily more volatile markets. Perhaps more importantly, many

Since a larger spread is indicative of a less liquid market, this sug-

Basis Patterns Prior to the Delivery Month

last trading day. Basis is defined as the difference between the

An examination of the spot and futures data underlying the fig-

Chicago, in order to satisfy a demand for delivery that could have

Both measures reflect the redirection of grain flows away from

relative size, so that a smaller percentage of transactions occur there,

level and price sensitivity of demand curves, the level of transport

ket, and it is in large part an adverse consequence of the volume of

tive decline in cash markets at the existing delivery points, Chicago

Changing or Adding Delivery Points

A Delivery Mechanism Tied to Current Commodity Rows

in the nature of spot markets is to devise a completely different deliv-

they make it costlier to arrange for delivery, particularly (as must

Cash Settlement of Grain Futures Contracts

synchronous). Although the index could attempt to control for that, it

month contracts increases the efficiency of spot market pricing.

spot market with desirable transactions cost properties with poten-

buy or sell the commodity. Thus, cash-and-carry arbitrage is risky

isolated from the commercial mainstream, cash settlement will

it. In the extreme, when a particular market receives few shipments,

effectiveness in various locations in Chapter 5.

mally tight. Similarly, it is usually desirable to segregate holdings of different grades