Given a choice between liquidity and basis risk, futures markets tend to choose institutional arrangements that favor liquidity. My question is ---- who is most impacted by this...and why would maximizing liquidity be more important than minimizing basis risk? ...thanks
Hey Larry, I would argue that the actual producers are the most affected by this. Speculators provide tremendous liquidity to these markets which really we need. What good is 8.00 corn if b/a was a buck wide?
The maximized liquidity is made the number one priority because of the sheer number of participants involved. Specs to hedgers is what maybe 10-1? I have no idea on the figure so please don't chide me if I'm wrong, but the concepts are the same no matter what the number of specs to hedgers is. In producer dominated markets (wool, milk etc etc) The emphasis is more on the risk than liquidity but those markets are followers not leaders.
Basis risk is certainly a major reason why grain options trade much higher volume relative to their underlying volume than options on heavier traded financial products like currencies. I never thought it through before but there's almost a correlation between basis risk and options volume across the spectrum. Eurodollars for example also have HUGE basis risk hence huge options activity. One only wants to be hedged in a very general sense vs. a benchmark that may become inapplicable. Basis risk has ALWAYS been a problem in ag markets. As R-T said any move away from standardization hurts liquidity and subjects a market to manipulation. I've seen weather accidents impact yield differentials between Iowa farms virtually next to each other. Which begs the question, how many different Corn contracts would you need to see listed to reasonably mitigate basis risk?
And to add: Even if each county in America had their very own personalized Corn contract it STILL wouldn't protect a grower who shorted futures in May against a crop that later burns up in the field in July. Hence-PUTS.
liquidity is MUCH more important because basis is so regional. For instance, where I am at, we are basis positive on corn, whereas in the Midwest they are basis negative. Basis is moreso affected by region, given demand (feedyards, ADM ect.) and transport issues (Mississippi river for Midwest) so basis is much more manageable from a producer standpoint, through basis only contracts that are available from many end users. Liquidity is much more important, because producers cannot control this as much, and one only needs to trade in illiquid contracts (livestock options) to realize how important liquidity is to effictively apply your hedging strategy.
Good points fellas, I didn't think of the options K. Tex accept my damned yahoo friend request man lol. I got a new comp and had to get a new yahoo call.
thanks for the replies guys ---- any additional perspectives on this topic would be greatly appreciated --- thanks once again