Knowledge @Wharton
The new paper follows on Gorton and Rouwenhorst's earlier work, which found that, over long periods, commodity returns are as high as those of stocks, while experts had long thought them to be lower. That work, described in a paper titled "Facts and Fantasies About Commodities Futures," also concluded, surprisingly, that commodities are not as risky as stocks. "Part of what we're doing is trying to understand the determinant of those returns," Gorton says about the follow-up study. "We get much more specific ... [to] see if we can explain what moves that risk premium around through time and on individual commodities."
Insurance Against Price Declines The work comes as commodities markets are booming. Rapid economic growth in China, India and other countries has spurred demand for oil, metals and many other commodities, as has use of grain for ethanol, a gasoline alternative. The action has attracted more investors. New commodities exchanges are being established and older ones are expanding and converting to for-profit models searching for new products to trade, such as futures contracts. Heavy demand means that many commodity inventories are especially low. That makes prices more volatile because commodities buyers are less certain of future supplies. Commodities producers are thus drawn to the futures markets, which provide insurance against price declines by locking in tomorrow's prices today. Investors are eager to earn the premiums that come from providing that insurance through futures contracts. As a result of all this, futures contracts have become more liquid, or easy to trade, Gorton says. "The whole futures industry is expanding by an amazing amount." A futures contract is an agreement for the seller to deliver a specified quantity of a commodity on a certain date for a price agreed upon in the present. Once created, a standardized contract can be traded in the secondary market. In practice, only about 2% of contracts are used to affect an actual delivery of the commodity. In most cases, the parties simply buy or sell other contracts to offset the obligations incurred earlier. Their profits or losses are determined by the differences in prices between the two contracts. A corn futures contract traded at the Chicago Board of Trade, for example, provides for delivery of 5,000 bushels of corn. Recently, contracts for delivery in March 2008 traded at a price of about $3.90 per bushel. The holder of the contract, therefore, is obligated to pay $19,500 to buy 5,000 bushels next March. A producer, such as a corn farmer, might write, or sell, such a contract to lock in a price for a sale at a later date. That way, the farmer is insured against the risk that the market, or spot, price falls. On the other side of the deal, the investor or speculator is providing the insurance and hopes the price will rise. If the price next March is $4 a bushel, the investor will make 10 cents a bushel, or $500 per contract, using the contract to buy -- for $3.90 -- corn that can be sold for $4. The farmer would, in effect, have paid, or given up, 10 cents a bushel to avoid the risk of getting less than $3.90. If the price falls to $3.80, the contract holder would lose 10 cents a bushel, or $500 per contract, and the farmer would avoid a $500 loss.
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