Random Yield, Forward Market and Price Formation
40 Pages Posted: 27 Jul 2018
Date Written: June 1, 2018
Many agricultural commodities are traded in both forward and spot markets. Yet, at the time of signing forward contracts, firms (i.e., agricultural producers) face significant yield risk. This paper studies the interplay of random yield and forward market in a market with spot and forward transactions. Specifically, we examine two main questions: (a) how yield uncertainty affects the equilibrium outcome in such a hybrid market; and (b) how yield uncertainty mediates the role of forward market. It is found that as yield risk increases, firms sell less in the forward market, and counterintuitively, higher yield risk may benefit firms and make the spot price less volatile. The existence of a forward market leads to greater spot price volatility; that is, a forward market destabilizes spot price. There is a mitigating effect of yield uncertainty on the role of the forward market. Finally, the forward ratio can be influenced by yield risk in multiple directions.
Keywords: random yield, forward market, spot market, price formation, market equilibrium
JEL Classification: L
Suggested Citation: Suggested Citation