Commodities Forward Contracts and the Commodity
What are forward contracts.
When the Chicago Board of Trade, Chicago Mercantile Exchange, and New York
Mercantile Exchange were set up, they facilitated trading between farmers who
produced agricultural products and the merchants (distributors, food producers and
wholesalers) who needed those products.
This improved economic activity in this area, but wasn't enough to eliminate risks.
Farmers and Merchants Negotiated Private Forward Contracts
Therefore, farmers and merchants began negotiating what are called forward contracts.
For instance, in May a farmer who has just planted one thousand acres of corn might
enter into a contract with a corn bread bakery to deliver 100,000 bushels of corn after it's
harvested in October.
Let's say the farmer has calculated he needs to receive at least 50 cents per bushel to
repay a bank loan, buy a new horse and buy his kids new shoes. Not to mention buy the
few food staples he doesn't raise himself and must get at the general store.
The corn bread bakery has calculated it cannot afford to pay any more than 60 cents per
share. If it does, it will have to raise store prices on its corn bread, and consumers will
buy the corn bread made by its competitors.
So when the farmer and the bakery speak together in May, they agree the bakery will
pay the farmer 55 cents per acre for those 100,000 bushels he will deliver after the
The Agreed Upon Price Eliminates Some Risk to Both Parties
Both sides are happy. The farmer knows he will get more than enough money to make a
profit. The bakery knows it will get the corn it needs at a price low enough to compete in
So if all goes as planned, the farmer raises his crop during the summer, then harvests at
least 100,000 in October, delivers it to the bakery's warehouses, and receives a check for
However, this system did not always work.
Some Farmers and Merchants Defaulted on Their Contracts
Suppose there was a tremendous summer drought t