Instructors love teachable moments — headlines or events that shed light on an important concept in the classroom. Convergence problems in futures markets, particularly in the Chicago wheat market, provide a great teachable moment on two fronts: the importance of convergence and the situation needed for a new futures contract to emerge.
Convergence of cash and futures prices is an observable fact with a simple description: In the delivery month and at the delivery point, cash and futures prices converge because of the privilege to make or take delivery of futures contracts.
Would you like that in English? When the December 2009 corn futures contract expires in mid-December, the price of the contract should be the same as the cash price quoted at delivery points along the Illinois River. If cash prices are lower than the futures price, some savvy merchandiser will buy low (the cash corn market) and sell high (the futures market) and make an easy profit. This sort of arbitrage should force convergence of prices.
THE CHALLENGE WITH convergence is explaining how bloody important this simple occurrence is to the confidence of every participant in the cash and futures markets. Convergence is what makes basis — the relationship between cash and futures prices — more predictable. A predictable basis, in turn, gives confidence to every player who uses the futures market to hedge price risks, including elevators, exporters, processors and producers.
About five years ago, poor convergence in the CBOT wheat, corn and soybean contracts started to emerge as an issue in the markets. (Scott Irwin and his colleagues at the University of Illinois have written several insightful papers on the issue.)
In corn and soybeans, the problem was intermittent, and a tweaking of storage rates in the contract terms appears to solve the problem. To address the issue in wheat, the CBOT changed delivery from warehouse receipts to shipping certificates (starting with the July 2008 contract), and dramatically increased storage rates (July 2009 contract).
Problem solved? Hardly. A quick review of Chicago and Toledo delivery points in early July shows cash wheat prices trading at a 60-80¢ discount to the expiring July contract.
Recent changes in the CBOT wheat contract do not address a deeper issue: The Chicago and Toledo delivery points are nearly irrelevant to today's commercial flow of wheat. Solution? A cash-settle contract, like the soft red winter wheat index (SWRI) at the Minneapolis Grain Exchange (MGEX).
Introduced late in 2004, the SWRI contract sat idle for nearly five years. Then late in September, trading activity began and in six weeks there were 2,400 contracts open. This figure is still tiny compared to Chicago, and cash-settle contracts have their own challenges, but you can bet on a direct relationship between convergence issues in the CBOT contract and renewed interest in the MGEX cash-settle alternative. Stay tuned.
Ed Usset is a grain marketing specialist for the University of Minnesota Center for Farm Financial Management (CFFM). He can be reached at email@example.com.