Liquidity and turnover

Liquidity is a crucial factor in determining the success of a futures market. A futures market must have enough participants with competing price goals (buyers and sellers) to ensure a turnover high enough to permit the buying and selling of contracts at a moment's notice without direct price distortion. Large transaction volumes provide flexibility (liquidity) and enable traders to pick the most appropriate contract month, corresponding to their physical delivery commitments, to hedge the price risks inherent in those physical transactions. More bids to buy and offers to sell in the market at any given time create greater pricing efficiency for the participants seeking a price for the commodity. Currently only the New York and London markets provide this flexibility on an international scale.

Speculators and hedgers competing for price generally means that futures and cash prices move in the same direction over time and as a futures contract approaches delivery the futures price and the cash price will often converge. Futures prices do not always reflect cash market reality though, especially over the very short term when large volumes may be traded for purely speculative reasons. The volume of futures trading and the underlying quantity of physical coffee it represents easily exceed total production of green coffee, or indeed the volume of the physical trade as a whole.

The large volumes on the futures markets not only influence futures prices but inevitably have an influence on the price of physical coffee as well. It is important for those involved in the physical coffee business to be aware of the activity of speculators and derivative traders. For that reason, the futures industry regularly examines and publishes the ratio of speculative and hedging activity in the market.

Speculators are absolutely necessary to the efficient function of a futures market. Speculative activity directly improves liquidity and therefore serves the hedgers' long-term interests. During the last ten years or so, the activity of hedge funds and the development of options on futures markets have both led to an increase in short-term speculative activity.

While options on futures provide another speculative opportunity in the futures market, options also represent an important risk management tool that has become very useful in recent years. See also 09, Hedging and other operations.

Not all options result in actual futures contracts. However, they do represent potential quantities to be traded on the strike dates should the holders decide to exercise their options rather than simply letting them expire. In any event, the large turnover in actual futures demonstrates the impact of the futures markets on the daily trade in physical coffee.

In recent years physical prices have largely been determined by applying a differential to prices in the futures market; that is, the combination of the differential (plus or minus) and the price of the selected futures position gives the price for the physical coffee.

The tables below demonstrate the huge growth in volume of the trade in options and futures:

Annual turnover in futures compared with gross world imports
(millions of tons)        

*Gross imports from all sources.

**Estimated 

Annual turnover in options and futures
(millions of tons)