4. Are the following statements consistent or inconsistent? Explain your answer and discuss how equilibrium is achieved between the futures and cash markets.
1. Futures markets serve an important function of the global financial markets by giving investors the opportunity to better manage financial risks associated with their underlying business transactions.
2. The futures market is where price discovery takes place.
3. The introduction of futures contracts creates greater price volatility for the underlying commodity or financial asset.
Futures are essentially the right to buy a good in the future. For example, if you were to sell a March 2014 hog commodity future, you could get the designated amount of money in exchange for your hogs in March, 2014. In this way, you could hedge your investment. If you put a lot of money into hogs you would be insuring that your investment would not decline too much. Likewise, if you were betting on the price of pork going down, you could buy a pork commodity future. In general, then, futures are used by hedgers (those producing the commodity) and speculators (those wanting to make money through arbitrage, ...
The solution shows how commodity futures are used to manage financial risk and create profitable trading opportunities.