One of the difficulties in explaining about futures and options is that they can seem detached from reality--just games that rich people play with money.
However, the farm sector offers some extremely practical examples of how these tools are used. Daniel Prager, Christopher Burns, Sarah Tulman, and James MacDonald explain in "Farm Use of Futures, Options, and Marketing Contracts" (US Department of Agriculture, Economic Information Bulletin Number 219, October 2020).
I'll walk through a few of their examples, but of course most of us aren't farmers. Thus, I'll raise a question of greater relevance to many of us: Why can't homeowners (and banks and mortgage-lenders) use futures and options to hedge against the risk of large shifts in housing prices, like what occurred in the lead-up to the Great Recession of 2008? Frank J. Fabozzi, Robert J. Shiller, and Radu S. Tunaru tackle this question of why such financial instruments barely exist in . "A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?" (Journal of Economic Perspectives, Fall 2020, 34: 4, pp. 121-45).
As the USDA economists point out, farmers face a problem that they can't know in advance what prices they will receive for their crop after it is harvested. What options to farmers have to protect themselves against a fall in crop prices?
Farmers may use on-farm strategies, such as commodity diversification, to manage such risks, and they may also draw on Federal risk management support programs, including commodity support programs, Federal crop and livestock insurance, and disaster assistance. Market mechanisms are also available to farmers who can use agricultural derivatives—such as futures and options contracts—and marketing contracts to protect against price fluctuations. These tools can help guarantee producers an established price before harvest.
The USDA report goes into some detail on how farmers use these different approaches. For those who are a little rusty on just what the financial terms mean:
• A futures contract is an agreement to buy or sell a commodity or an asset at a predetermined price at a specific date in the future. Futures contracts are traded on organized exchanges and are standardized by quantity, delivery date, and location. Organized futures trading is often used for major agricultural commodities, where traders can opt for futures trading as a way of hedging against price risks for a commodity. ...
• Options. Options offer the right (but do not carry the obligation) to purchase or sell an instrument at a set price, regardless of the market price at the time of sale. ...
• Marketing contracts. Marketing contracts are agreements to exchange a specified asset for a certain price on a future date. They are neither standardized nor tradeable, as futures and options are, but are customized to the needs of specific buyers and sellers. They often include features such as price adjustments for quality, and they sometimes include commodity-specific features. Marketing contracts also reduce market risk by securing a buyer and a delivery window for the farmer’s output.
• Production contracts. Production contracts are agreements under which a farmer agrees to raise livestock or crops for a contractor, which may or may not be another farm. The farmer is paid a fee for growing services, while the contractor provides key inputs and markets the product. Most input and output price risks are transferred to the contractor.
It turns out that "[s]ince the mid-1990s, between 33 and 40 percent of U.S. agricultural production has been produced under contract ..." Meanwhile, larger farms tended to be the ones who use futures and options contracts: "Among corn and soybean producers, 17 percent of midsize farms and 27 percent of large farms used futures contracts. ... Those corn and soybean farms that used futures or options hedged a substantial share of their production through such instruments. For example, while only 10 percent of all corn producers hedged using futures contracts, those that did hedged 41 percent of their corn production in 2016."
It's also important to note that that there are a number of parties who want protection against farm prices unexpectedly rising higher than expected: for example, companies that buy crops for animal feed, or to produce human food, or to produce other products using agricultural inputs, all have reason to use futures and options to protect themselves against large rises in the price of such products.
So why can those worried about fluctuations in farm prices use financial tools to protect themselves, but those worried about fluctuations in home prices cannot easily do so? Fabozzi, Shiller, and Tunaru point out that there is a 30-year history of trying to create financial contracts based on housing prices. What are some of the issues that come up?
One is that any contract based on what the price will be in the future must specify that price very clearly. With farm products, for example, contracts are quite specific about exactly what type of corn or soybeans are involved, and there are active markets setting prices at all times. But what would an index of housing prices, adjusted for quality, look like? The answer that has emerged is to use a "repeat-sales" approach, which relies on price data from houses that have been sold more than once--and in that way offers some adjustment for the quality of the houses being sold. But creating such indexes in a way that can serve as a basis for futures and options contracts isn't a simple task: "The first lasting house price futures contract finally arrived on May 22, 2006, when the Chicago Mercantile Exchange (CME) started trading house futures contracts and options based on the family of S&P/Case-Shiller® Home Price Indices, which covered both a national composite index and 10 major cities."
Another problem that has bedeviled these markets is that lots of parties (homeowners and financial institutions) would like protection against a fall in the price of housing, but for the market to work, it needs another side--that is, it needs parties who will agreed to contracts where they will lose money if the price of housing falls. The hope here is that a broader group of economic actors who want to be fully diversified against risk, and who could look at participation in a housing prices market as part of their overall portfolio. Such players might include "mutual funds, insurance companies, pension funds and other managers of large pools of funds who desire to be fully diversified who take the other side of the real estate risk on derivatives."
A related problem is that if these big players are going to invest in financial derivatives based on housing prices, they need a somewhat reliable way of characterizing the likely returns and risks of such an investment and how that translates into current prices of the financial instruments. To understand part of this problem, consider options or futures contracts that are based on the stock market. The value of those options and futures contracts are governed by the fact that someone can easily and quickly buy a fund that represents the actual stock market--which then governs the prices in the derivatives market. But an investor who owns financial derivatives based on housing prices cannot easily and quickly buy or sell a representative portfolio of real estate holdings, and so the rules for valuing options and futures in the context of the stock market cannot be applied directly to financial derivatives based on housing prices.
In short, creating a market for futures and options based on housing prices has been a stop-and-start process with only limited success. There are lots of challenges here both for real-world market participants and academics. But the average homeowner has reason to root for these challenges to be resolved. There are a lot of people who might be willing to buy "down-payment insurance," which would guarantee that no matter how housing prices change in the next few years, you won't lose the amount of your down-payment. Financial arrangements like "reverse mortgages" would be much more widespread if it was possible to hedge against falls in housing prices. Many financial crises around the world in the last few decades--including the Great Recession in the US--are linked to fluctuations in housing prices. A well-functioning futures and options market based on home prices could help both to address personal financial risk and to limit a cause of macroeconomic instability.
Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.