Can you help explain how commodity exchanges and “commodity futures” and “index futures” work?

BY busadmin  June 24, 2008 at 4:16 PM EST

Question/Comment: Can you help explain how commodity exchanges and “commodity futures” and “index futures” work? Apparently both some members of Congress, and the Commodities Futures Trading Commission, are looking into how speculators affect oil and food prices. As the typical layman, I have no idea how the futures markets work, much less how “index” markets work, much less how there can be many more “contracts” afloat than actual commodities.

Paul Solman: I’m a feed corn farmer and you’re a rancher whose cattle feed on corn. I have to pay for the seed, fertilizer and such today, but my crop won’t come up for six months, when the price could be much higher – or much lower, maybe so low it wouldn’t cover my costs. How do I decide whether to plant?

That’s the justification for the futures market. The farmer can lock in a price in the future today by making a side-bet with the rancher, or anyone else willing to take it.

But once there’s a market for these “instruments,” I, a non-farmer if ever there was one, can make the same bet with you. And so can any other two parties on earth. No matter if there were only one corn farmer, one crop. The amount of the bets is only limited by the amount of wealth in the world. That is, if I had a quadrillion dollars and so did you, we could make a quadrillion-dollar side bet on the price of corn – or oil, or whatever – at some point in the future.

Hey, go to InTrade.com and you can make a $34 bet that will pay you $100 if John McCain wins on Nov. 4. You can put up as much money as there will be willing bettors on the other side.