Futures, Prices and Production

0:00Okay, so I'm going to talk about futures. My goal here is to recall basically what the required conditions for futures to emerge in the first place are and to explain which role they can have in the social fabric from the point of view of economic theory. I will I will particularly concentrate on the second part, since some of you already heard about the conditions of emergence, especially my German advisor who is here, and we French people are expecting me to bring something new. We French people tend to comply with the German occupier.

0:54So as far as the conditions for the emergence of derivatives are concerned, I will particularly stress the importance of uncertainty and entrepreneurship, as Ludwig von Mises understood them. And it will lead me straight to their social function, namely how the use of futures or forwards and improve the overall division of labor via the transfer of uncertainty bearing. So let me first take a simple example of a future, which will allow me to define what this kind of thing is. So let's say we have two persons, A and B. They sign a future or forward contract today, Which means A is, for example, the buyer and B is the seller of some quantity of, say, corn for a certain futures price.

2:01That is, they both agree today on doing a transaction in the future at a predefined price and the transaction will actually occur, the two sides of the transactions will occur at this future date. So three things of interest for us can happen. Either the spot price, that is, either the spot price in the future, in the regular spot market is the same than the future price, or it is higher, or it is lower. Meaning what happens because of the difference if it exists in these two prices, one partner in the exchange will have made a speculative gain and the other the equivalent loss.

2:55Now the question is why would these two people engage in such a transaction in the first place? The typical textbook answer is that we have here, we may have here someone who is a hedger and someone who is a speculator, that is, the hedger wants to protect himself against the possibility that, say, in my example, it would be the corn producer, he wants to protect himself against the possibility that the price of corn will fall in the future and the speculator, his partner, might think this price will actually rise And if I can get it, if we can decide on the price today for the transaction to occur in the future, which will be lower than the spot price in the future, then I will make a gain.

3:57So if such conditions happen, there is room for ex-ante beneficially, mutually beneficial future transaction. Now, what does this presuppose? That's the important thing from the point of view of pure economic theory. At the very least, in my example, it presupposes that the futures price is unknown. Which means more generally that for a future transaction or actually any derivative transaction to occur, A and B or any partner must live in a world of uncertainty. The whole demand and supply schedules for these contracts are based on some expectation of the future spot prices.

4:51These schedules are fundamentally based or derived from the expected exchange value of the underlying products in this example column. So we have this fundamental condition of uncertainty because we cannot even think of speculation and these kind of activities without uncertainty, of course. To be more specific, we have to realize that we are talking about uncertainty in the Misesian sense as separated from what Mises and Knight called risk, which belongs to the realm of frequency distribution, class probability.

5:43I will not go into details here and just assume you're familiar with it. What is the importance of this? The importance is that if we don't make the difference between the two kinds of uncertainties, and typically this is what neoclassical people might be tempted to do, we will falsely characterize derivatives as insurance products. If you remember Mises' night exposition on the difference between uncertainty and risk, one implication is that insurance is possible with events which belong to a class of homogeneous events. So it's the realm of class probability.

6:31Since here we are talking about speculating on future prices, we are talking about social events. First, prices are social events which cannot belong to a class of homogeneous events. Therefore, it's not insurance, properly speaking, partners are dealing with. Now, the other conditions for the emergence of futures, we need uncertainty but we also also need divergent expectations of future prices, as was suggested in my example, or at the very least, differences regarding preferences toward uncertainty bearing.

7:26Someone has to be more comfortable somehow than the other. Another condition which is of interest is the question we have to wonder if capital is required because that's the intriguing feature of the forward transaction I presented before. No resource is transferred when the two people commit to the exchange. So we might think, hey, is this not an example where we don't actually have capital involved? Well, the reason is that these are purely exchange of future goods versus future goods as opposed to traditional investments which are exchange of present versus future goods.

8:16Does this really mean that no capital is required? That it is conceivable to engage in such transactions without capital at inception of the contract, not having to spend money in these transactions, Transactions does not change the fact that for, A, in my example, the buyer of the forward, the money he spends at maturity on corn is an investment for which capital is then required. This speculator entrepreneur, whatever he does, selling the corn maybe the next day or the same day on the spot market or using it in some production process maybe to sell product later, is spending some money in order to obtain an income later, this is investment.

9:06Plus viewed from the point of view of the whole process of production, both the buyer and seller are investors in an implicit partnership, unless the buyer is himself a consumer. This does not contradict, by the way, the Rothbardian idea that there is no such thing I think as a resource-less speculator or entrepreneur, which you could think, since A, the speculator, in my example, is, as we will see, a specialist in uncertainty-bearing. But, the thing is, incomes of entrepreneurs or speculators, negative or positive, profits or losses, must be residuals of at least two transactions, one consisting in buying and the other in selling later.

10:08And this is not really different in this case. Buying in this context is capital investment, and investment, however short the period separating both acts can be. Plus, as a contingent requirement, participants will be all the more eager to engage in such deals to the extent that their partners is thought as credible and to be credible you might need to show that you have some capital that could be used to pay for a loss, for example. Okay, so I'm late, unfortunately, for the second part, but now we are interested in consequences of the emergence of futures.

11:07So, the obvious is that we will have a different distribution of income, but the essential feature of the whole process I want to stress is that we had in this operation a further degree of specialization in uncertainty bearing. The relevant quote in Mises' Human Action is this one, quote, The futures market can relieve an entrepreneur of a part of his entrepreneurial function. As far as an entrepreneur has insured himself, and he puts square quotes for insured, through suitable forwards transaction against losses he may possibly suffer, he ceases to be an entrepreneur and the entrepreneurial function devolves on the other party to the contract.

12:03The cotton spinner who, when buying raw cotton for his meal sales, the same quantity forward has abandoned a part of his entrepreneurial function. He will neither profit nor lose from changes in the cotton price occurring in the period concerned. Now, it is tempting to say, let's just apply the law, the Ricardian law of association here. The forward, we could say the forward contract by placing the risk on those who want to bury it, makes possible for corn producers, in my example, to concentrate on what they do best and spend resources in acquiring relevant knowledge on possible future prices. And this is the specialty of the speculator who could not exert his talents to the same extent to some extent, if he also had to care about the specific knowledge required to produce gold.

12:52And all this should lead to a more productive economy and higher overall output. However, it's more complicated. The reason is that we have to think for a moment of the Ricardian law of association. It tells us that when each person specializes into the production for which he has relative, if not absolute, advantage, advantageous subsequent exchanges can occur. In other words, in isolation, one might be able to produce a quantity X of something or a quantity Y of something else so that he has an internal exchange ratio of X divided by Y. With specialization and exchange, each one can obtain a better ratio of exchange.

13:44That's the idea. However, this whole thing presupposes you can express the contribution in terms of a physical productivity schedule, which is X and Y in my example. But if we If we take seriously Mises and the entrepreneur, this will not do, so the relationship between the uncertainty bearer and his partner, the hedger or maybe the laborer in other cases than with derivatives, cannot be characterized this way. So we are in a conundrum which, well I will not have to explain in detail, but I think Frederic Bastiat provided a solution talking about associations purely in terms of difference of taste in uncertainty bearing and insisting on the general distaste and discomfort that uncertainty brings.

14:48So, just to conclude, the two laws can go actually together. We have to think of the relationship between the hedger and the speculator, under what I would call Bastiat's law. And you have pairs of exchangers where this law applies and this is still connected to the Ricardian Law of Association since the entrepreneur or speculator makes possible, relieves the labourer or hedger, whatever, the one who gets rid of uncertainty bearing, relieves him from this burden which means he can push forward And further is specialty which is expressible in physical terms, therefore the overall division of labor between these specialists is enhanced and overall productivity can be higher. Thank you very much.