A "derivative" is an asset whose value is based on some other asset. For example a futures contract for oil has a value that depends on the actual price for oil at some point in the future. Derivatives can be used to speculate on future prices and hedge the risk of price changes. But can they be used to forecast? We've seen in this section that prices contain information and so maybe derivative prices contain information about the future. Let's see.

• First, read this shortreport from two economists at the Federal ReserveLinks to an external site.

The Futures Market is an Imperfect Forecasting Tool | St. Louis Fed (stlouisfed.org)

• Now do a bit of research on your own. Pick an industry that you think might benefit from being able to forecast prices or something similar (like the weather) and find describe what speculative markets you might look at to forecast.

The Futures Market as Forecasting Tool: An Imperfect Crystal Ball William R. Elnmons , 11motl1y J. Yeager Many commodities are traded in both spot and fumes markets. The spotrnarket is for trading today, whereas the futures market is for future delivery. Press reports sometimes imply that futures prices provide a good forecast of future spot prices. Does the futures market really provide us with a crystal bail? The short answer is yes am no: Futures markets sometimes forecast future spot prices. but sometimes they do not. When. new and why do tutures markets provide reliable forecasts? To answer these questions, we must rst understand the concepts of tomard contracting, hedging and speculation. Forward Contracting Can Decrease or Increase Risk Aforwertf contract is a firm legoi commitment made by a seller to deliver a rare-specified amount at an agreed time at a particular price. Contract detaiis are agreed at the outset, but no mor'ey or commodities are exdianged until the settl'emenl' (defraery) date. A standardized forward contract that is traded on an organized exchange sud'i as the Chicago Board of Trade tCBOT} is a futures contract. Agricultural futures contracts were first traded in Chicago during the mid-18005. later, futures contracts on industrial commodities, precious metals. stock indexes. currencies and interest rate instruments were added. and other exchanges were opened. Forward contracting is used for hedging a preexisting risk and for speculating on price movements. A farmer with a com crop in the ground is exposed to the risk that com prices in the spot market will below when his crop actually is harvested and sent to market. To hedge this risk. the farmer could sell a com futures contract for delivery at harvest time This contract locks in a price today forcom that will be deiiuered in the future, so. the price risk is hedged arrow Aspeculetor, on the other hand. boys or sells com futures with no other risk exposure to the price ofcom.A com futures buyer prots when the price rises but loses when it falls. When Do Futures Markets Forecast Spot Prices? Prices in futures markets sometimes function well as forecasts of spot prices. In other cases, they do not For example, the federal funds futures market can be used to calculate market forecasts of Federal Open Market Committee tFOMCt interest rate changes. A bank loan otcer, however, should not use soybean futures prices alone to forecaslfuturespot prices when making a soybean production loan. To complicate matters further, a tirm that needs to forecast oil prices six months from today sometimes can look tott'ie futures market for a reliable forecast but sometimes cannot do so. To aooount for these dierent scenarios. we need to separate commodities into three catagones. nonistorable commodities, stumble commodities with large inventory 'cwerhangs" and storable commodities with modest inventories. Non-storeble Commodities Futures prices Of \"On-We We embody only met expectations of future SLIDDIY and demand conditions. These commodities are the only ones forwhich futures prices serve as perfectly straightforward forecasting tools. Non-storable commodities are perishableslhings whose quantity or quality characteristics change rapidly Eggs, for ample, are considered non-storahle bemuse they spoiiquickly, a fresh egg is quite different from a I'l'lOl'IIf'ivOid 999. Futures prioesof mnstorable oommodilies can deviate signicantly li'orn spot prices because of anticipated changes in supply or demand. Suppose the women expected a reduced supply or eggs three months from now The three- month futures price would be driven higher than the current spot price. Scot prices would not be affected because vendors cannot store the eggs {take them eulof the spot market) to sell in the future. They must sell today's eggs based on today's market conditions. Conversely, if the market expected egg production to increase in three months. the futures price would be driven lower than the unchanged spot price. A futures market also exists for federal funds, the interbank meme! tor reeenres {deposit balances held by centre at the Federal Reserve}. These instruments are nonstorable because a bank cannot hold reserves today to satisfy future reserve requirements. One can use federal funds nilures prices to infer rnarltetexpectalions orthe FOMC's future interest rate changes 2 Current conditions in the federal funds market are irrelevantfor future conditions and woe verse. Storeble Commodities with Large Inventories For stumble commodities with large inventory eveningssay, several months' worth of consumption of the commodity-futures prices simply reflect the current spot price plus carrying posts. Carrying costs are the interest and storage coatsihat would be incurred between the currentdate and the maturity date ofttie futures contract ii are held the commodity in inventory. For example, the Nov. 1, 2001, 5901 price for soybeans was $4.26 per bushel: the January 2002 futures quote on Nov 1 was 54 34.3 The difference of 8 cents represents the persoushel carrying costs of soybears for approximately two months. Why must spot and futures prices be linked by carrying costs? If the soybean futures pnoe exceeded the spot price by more than marrying costs, than art arbitrageur could earn a sure prot by selling a soybean futures contract, purchasing the soybeans in the spot mancetwilh borrowed funds and delivering the soybeansto the buyer dflhe futures contract on the settlement date. Because the difference between the futures price received and the spot price paid would more than cover carrying costs' a risk-free prolit would be guaranteed. Conversely, if the natures price fell