xvEPA
United States
Environmental Protection
Agency
Municipal Environmental Research
Laboratory
Cincinnati OH 45268
EPA 6OO 8-78O19
December 1978
Research and Development
An Analysis of Scrap
Futures Markets for
Stimulating Resource
Recovery
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RESEARCH REPORTING SERIES
Research reports of the Office of Research and Development, U.S. Environmental
Protection Agency, have been grouped into nine series. These nine broad cate-
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The nine series are:
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4 Environmental Monitoring
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6 Scientific and Technical Assessment Reports (STAR)
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9. Miscellaneous Reports
This report has been assigned to the "SPECIAL" REPORTS series. This series is
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COVER PHOTOGRAPH - Courtesy of Phoenix Quarterly, a publication
of the Institute of Scrap Iron and Steel, Inc.
This document is available to the public through the National Technical Informa-
tion Service, Springfield, Virginia 22161.
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EPA-600/8-78-019
December 1978
AN ANALYSIS OF SCRAP FUTURES
MARKETS FOR STIMULATING
RESOURCE RECOVERY
by
Robert C. Anderson
Roger C. Dower
Environmental Law Institute
Washington, B.C. 20036
Grant No. R804309-01
Project Officer
Oscar Albrecht
Solid and Hazardous Waste Research Division
Municipal Environmental Research Laboratory
Cincinnati, Ohio 45268
MUNICIPAL ENVIRONMENTAL RESEARCH LABORATORY
OFFICE OF RESEARCH AND DEVELOPMENT
U.S. ENVIRONMENTAL PROTECTION AGENCY
CINCINNATI, OHIO 45268
For «ale by the Superintendent of Document*. U.S. Government
Printing Office, Washington, D.C. 20402
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DISCLAIMER
This report has been reviewed by the Municipal Environmental
Research Laboratory, U.S. Environmental Protection Agency, and
approved for publication. Approval does not signify that the
contents necessarily reflect the views and policies of the U.S.
Environmental Protection Agency, nor does mention of trade names
or commercial products constitute endorsement or recommendation
for use.
11
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FOREWORD
The Environmental Protection Agency was created because of
increasing public and government concern about the dangers of
pollution to the health and welfare of the American people.
Noxious air, foul water, and spoiled land are tragic testimony
to the deterioration of our natural environment. The complexity
of that environment and the interplay between its components
require a concentrated and integrated attack on the problem.
Research and development is that necessary first step in
problem solution and it involves defining the problem, measuring
its impact, and searching for solutions. The Municipal
Environmental Research Laboratory develops new and improved
technology and systems for the prevention, treatment, and
management of wastewater and solid and hazardous waste pollutant
discharges from municipal and community sources, for the preser-
vation and treatment of public drinking water supplies, and to
minimize the adverse economic, social, health, and aesthetic
effects of pollution. This publication is one of the products
of that research; a most vital communications link between the
researcher and the user community.
A substantial proportion of the materials from the solid
waste stream is not recycled. The rate of recycling, for some
materials, as a percentage of total available tonnage, is
actually declining. This report examines the feasibility of
futures markets as an economic policy for increasing the rate
of recycling.
Francis T. Mayo, Director
Municipal Environmental Research
Laboratory
111
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ABSTRACT
The unusual price volatility of secondary material markets
introduces risk into planning decisions based on the use of re-
cycled materials. The price volatility creates uncertainty over
future prices and thus acts as a barrier to the use of secondary
materials in production processes. This study assesses the
feasibility of initiating futures markets in certain secondary
materials as a mechanism for the transfer of price risk and for
decreasing uncertainty over future prices.
Conversations with commodity exchange officials and a re-
view of pertinent literature reveals that to be successfully
traded on futures markets commodities must have certain charac-
teristics in common. Wastepaper and scrap steel are analyzed
as to whether they have these same characteristics. Given
certain caveats, it is argued that futures contracts in these
commodities would be feasible. Furthermore, it is shown that
the availability of these contracts would lessen the impact of
uncertainty on production decisions concerning secondary mate-
rials.
Because of a possible divergence between social and private
returns from listing a scrap futures contract, the government
has a potential role in sponsoring the design, initiation, and
inspection of such a contract.
This report was submitted in fulfillment of Grant No.
R804309-01 by the Environmental Lav/ Institute under sponsorship
of the U.S. Environmental Protection Agency. This report covers
the period June 15, 1976 to January 15, 1978, and work was com-
pleted as of January 15, 1978.
IV
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CONTENTS
Foreword iii
Abstract iv
Figures vi
Tables vii
Acknowledgments viii
1. Introduction 1
2. Summary and Conclusions 3
3. Uncertainty and Resource Allocation
in Secondary Materials Markets 5
4. Futures Markets and Their Economic
Impact on the Cash Market 14
5. Futures Trading in Secondary Materials 26
6. Impacts of Futures Trading on Markets
for Secondary Materials 45
7. Private and Social Returns from Listing
Commodities for Futures Trading 48
References 52
Bibliography 57
Appendices
A. Prediction of Secondary and Primary
Materials Prices 61
B. Correlation Analysis of Wastepaper
and Ferrous Scrap Prices by Grade 63
C. Correlation Analysis of Wastepaper
and Ferrous Scrap Prices by Grade
and by City 64
D. The 1954 Scrap Iron and Steel Futures
Contract 69
E. Impact of Futures Trading on Softwood
Plywood Supply Response 70
F. Scrap Copper Dealer Interview 76
G. Comparison of Supply Elasticities 78
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FIGURES
Number Page
1 Variation in market prices 5
2 Demand shifts for scrap inputs 8
3 Time profile of two hypothetical price series .... 11
4 Copper prices: futures, wirebar and #2 scrap .... 22
5 Locations of paper stock dealer and broker
concentrations and major paperstock users 34
6 Interregional and intraregional rail movements
of wastepaper 35
7 Locations of iron and steel scrap dealers and
broker concentrations and electric steel-making
furnaces 36
8 Locations of iron and steel scrap dealers and
broker concentrations, open hearth or basic
oxygen steel-making furnaces and integrated
blast and open hearth or basic oxygen steel-
making furnaces 37
9 Interregional and intraregional rail movements
of scrap iron and steel - 1969 38
E-l Supply response before (S^) and after futures
trading (82) 76
VI
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TABLES
Number Page
1 Supply and Demand Elasticities for
Secondary Materials 6
2 Coefficient of Variation of Monthly
Wholesale Prices for Selected Com-
modities, 1971-1975 10
3 Selected List of Newly Introduced
Non-agricultural futures contracts 15
4 Copper Futures Price Quotations 16
5 Example of a Buying Hedge 23
6 Example of a Selling Hedge 24
7 Concentration Ratios for Selected
Sectors of the Pulp and Paper,
and Steel Industries (4-Firm Ratios) 29
A-l Estimated Price Forecasting Equations
for Primary and Secondary Materials 62
A-2 Theil's U-Values for Primary and
Secondary Price Prediction 63
B-l Correlation Matrix of Wastepaper
Prices by Grade 64
B-2 Correlation Matrix of Ferrous Scrap
Prices by Grade 64
C-l Correlation Matrix of Ferrous Scrap
Prices by Grade by City 65
C-2 Correlation Matrix of Wastepaper
Prices by Grade for New York and
Chicago 67
C-3 Correlation Matrix of Prices for
Hard White Envelope Cuttings
by Grade 68
C-4 Correlation Matrix of Prices for
Old Corrugated Boxes by City 68
C-5 Correlation Matrix of Wastepaper
Prices by Grade within Wew York
and Chicago 69
E-l Expected Signs for Regression
Coefficients 72
F-l Copper Scrap Dealer Questions and
Responses 77
VI1
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ACKNOWLEDGMENTS
This report was prepared by members of the staff of the
Environmental Law Institute. The project director was Robert
Anderson, and his associate was Roger Dower. Several other
members of the ELI staff contributed to the report, including:
Esther Tepper, who edited and prepared the report for
publication;
Deborah Webb, who assisted with the data collection and
performed the telephone interviews; and
Robert Collinge, who also assisted in data collection
and the statistical analysis.
Many other individuals provided helpful comments and cri-
ticisms which were deeply appreciated. In particular, we ac-
knowledge the remarks of Oscar Albrecht, the project officer;
Professor Thomas Hieronymus of the University of Illinois;
J. R. McAlpin of Armco Steel Corporation; and Erving Kaplan" of
Copperweld Steel.
Although it is impossible to individually thank all the
scrap industry members and commodity exchange officials who
answered our many questions and participated in interviews,
we would like to acknowledge the valuable insights provided
by Gary Fishman, formally of Commodity Exchange, Inc.; Charles
Rasher of McMahon Iron and Steel; David Jordan of Media General;
Alan Abrams of the New York Mercantile Exchange; Herschel
Cutler of the Institute of Scrap Iron and Steel; and Jerry
Scharf of the National Association of Recycling Industries.
Vlll
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SECTION I
INTRODUCTION
Scrap markets are characterized by unusual price volatili-
ty. By all accounts, this price variability hinders investment
in the secondary materials industry and adversely affects re-
cycling levels. This study investigates the feasibility of
futures markets in scrap materials as a mechanism for reducing
the adverse impact of variable prices.
The rationale for studying a futures market in secondary
materials will be presented on Section 3. In essence, it will
be argued that the price volatility in the scrap markets intro-
duces a large degree of risk into planning decisions based on
scrap inputs and outputs because of uncertainty over future
prices for these materials.* The inability of industry to cope
with this price risk biases input use away from secondary
materials and toward primary materials.
In light of the discussion in Section 3, this study will
focus on two of the several functions of a futures market:
(1) providing a market to transfer future price risk; and (2)
upgrading the quantity and quality of market information con-
cerning future prices. Section 4 contains a brief introduction
to futures markets and futures trading, as well as a discussion
of potential and empirically verified impacts of futures trad-
ing on the cash market for a commodity.**
Having established this background information, two funda-
mental questions will be addressed. First, can scrap materials
be successfully traded on a futures market? In order to answer
*Throughout the remainder of this paper, "risk" will be defined
as variance in income.
**For the purposes of this report, the term "cash" will refer
to market transactions not involving futurity. In part, for-
ward contracting agreements are distinguished from transactions
on futures markets in that they do not take place on an organ-
ized exchange (the different characteristics of futures mar-
kets and forward contracting agreements are discussed more
fully in the beginning of Section 4).
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this question, it will first be necessary to determine whether
secondary materials share certain basic characteristics with
commodities currently traded on futures markets. Second, if a
futures market in a scrap material (e.g., ferrous scrap) were
established, how would it be used by industry members to achieve
the desired results. Sections 5 and 6 investigate these issues.
The discussions in Sections 5 and 6 raise one last set of
questions. If a futures market in secondary materials is, as
will be agrued, a good idea, why isn't a futures contract in
wastepaper or ferrous scrap being traded right now? Parts of
the answer will surface in all the sections, but Section 7 con-
tains a formal answer. In short, the listing of a scrap fu-
tures contract may prove less beneficial to the listing ex-
change than to society as a whole. Section 7 suggests some
possible solutions to this divergence between private and social
benefits.
This study focuses on two specific materials as candidates
for futures trading: wastepaper and ferrous scrap. These two
commodities are particularly affected by price volatility and,
therefore, future price uncertainty. In addition, forward nar-
kets for their respective primary substitutes do not exist as
they do for several other scrap materials (i.e., copper, zinc,
lead, and tin). These forward markets for primary materials,
as will be shown later, can be, and currently are, used to
transfer future price risk for the scrap product.
The conclusions reached are clear. Provided that care is
taken in the design and initiation of each contract, a scrap
futures market is feasible. It will confer direct benefits on
the scrap industry members who trade in the futures market as
well as those who do not. Furthermore, a scrap futures market
should benefit society as a whole through a more efficient allo-
cation of capital and labor in the production and processing
of primary and secondary materials.
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SECTION 2
SUMMARY AND CONCLUSIONS
With only minor qualifications, futures trading in ferrous
scrap and wastepaper is feasible. The qualifications, in order
of importance, are: (1) a private exchange or government agen-
cy must educate industry members as to the benefits and useful-
ness of futures trading so that a hedging demand for a scrap
futures contract can be established; and (2) a standard contract
grade that is acceptable to industry members must be defined.
A particular qualification, specific to wastepaper, is that un-
less it can be shown that prices for different grades of waste-
paper are highly correlated, contrary to the results presented
in this report, a contract in one grade of wastepaper may not
be useful for other potential hedgers who deal in grades dif-
ferent from the contract grade.
It should not be difficult to convince industry members
that risk management, income stabilization, and the resulting
easier credit terms from lending institutions are tangible
benefits from futures trading. A futures market is a business
tool to be used in conjunction with normal cash market trans-
actions. Except for the concept of futurity, for which many
industry members concede a need, a properly designed futures
market would represent transaction terms that are familiar to
industry members and thus easily incorporated into their busi-
ness decision-making process.
Problems relating to contract grade specification, as well
as other aspects of contract specification, are discussed later
and will not be presented here. Resolution of these issues must
come from discussions between an exchange and industry members.
In addition, this report suggests a potential governmental role
in this process.
Although the impact of a wastepaper or ferrous scrap fu-
tures contract on the recycling rates in those industries is
impossible to quantify because of the hypothetical nature of
this study, qualitative projections can be made. Scrap buyers
and sellers would be less hesitant to rely on scrap inputs or
to invest in secondary processing facilities because of (1) the
ability to transfer the risk of future price changes through
hedging; (2) increased market information flows; and (3) im-
proved financing terms. There would follow a corresponding
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increase in the amount of scrap materials used in production
processes and, therefore, an increase in relative recycling
rates. Furthermore, there is the possibility that a scrap
futures contract would indirectly reduce the impact of other
market imperfections on recycling levels. For example, a scrap
futures market might give a sense of legitimacy to the sellers'
side of the market and make it more amenable to vertical inte-
gration by user mills.
One, if not the major, theme of this report is the need
for extensive industry participation in the design and initia-
tion of a scrap futures contract. Without such participation,
it is doubtful that the aforementioned conditions vital to a
successful contract could be met.
As a first step, it is recommended that formal presenta-
tions on futures markets and their use be made to industry
members. Besides acting to disseminate information on futures
markets, these presentations would provide a forum for elicit-
ing industry responses, comments, and ideas. To generate and
hold interest, the presentations should be directed, as much as
possible, to the particular concerns of the scrap industry.
Accordingly, the group responsible for the presentations should
be familiar with both futures markets and scrap markets. Repre-
sentatives of a commodity exchange would be desirable as dis-
cussants, since they have experience in such matters. But be-
cause exchange officials may have higher priorities, government-
sponsored presentations may be needed.
A further role for the government, as suggested in Section
7, is to conduct in-depth studies on the specific aspects of
scrap market transactions that need to be standardized for a
successful futures contract—in particular, contract grade
specification, delivery requirements, pricing terms, and in-
spection procedures. To be done properly, these studies would
require extensive interviews with industry members and close
cooperation with an interested commodity exchange. Here again,
a commodity exchange is the most likely candidate for conduct-
ing such research, but government sponsorship may be required.
A scrap futures contract should provide significant bene-
fits to the scrap industry and society as a whole. Industry
acceptance poses the principal obstacle to successful scrap
futures contracts. An effort to secure this acceptance might
be well rewarded.
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SECTION 3
UNCERTAINTY AND RESOURCE ALLOCATION
IN SECONDARY MATERIALS MARKETS
This section will attempt to establish two basic proposi-
tions: (1) that secondary materials markets are characterized
by an unusually high degree of price uncertainty; and (2) that
uncertainty in the markets for secondary materials has deterred
new investment in scrap processing facilities. Discussion of
these propositions will be prefaced with a brief review of the
underlying causes of price uncertainty for secondary materials.
CAUSES OF PRICE UNCERTAINTY FOR SECONDARY MATERIALS
The familiar economic constructs of supply and demand func-
tions are a useful point of departure for the discussion of
price uncertainty. Prices for a commodity are considered un-
certain when they are difficult to predict. A common proxy for
predictive difficulty and uncertainty is the observed variation
in past prices. In terms of supply and demand, prices are more
variable when supply and demand functions are unresponsive to
price and when either function is subject to large shifts.
Figure 1, below, depicts two fundamentally different situations.
In Panel A, the supply function is elastic—it is responsive to
price signals. The large shifts in demand from D to Dl do not
result in significant changes in market price. In Panel B, by
contrast, both the supply and demand functions are inelastic.
Relatively small shifts in either demand or supply lead to
large changes in market price.
Price
Panel A
Price
, D
__ Quantity
Panel B
Quantity
Figure 1. Variation in market prices.
5
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In an earlier report to the Environmental Protection Agen-
cy, the Environmental Law Institute estimated the supply and
demand elasticities for wastepaper, scrap steel, and secondary
lead. In addition, earlier estimates by others for secondary
copper were tabulated. These elasticity estimates are repro-
duced in Table 1.
All of these elasticities are low, particularly in compari-
son with the primary material supply elasticities. For example,
the price elasticity of supply for primary lead was estimated
at 1.0, and for copper at 1.7, whereas the respective secondary
supply price elasticities were 0.48 and 0.32. These figures
illustrate one of the underlying causes of price variation in
secondary material markets—the low supply and demand elastici-
ties for many scrap materials.
Economic theory demonstrates that the elasticity of demand
for an input to production process depends upon: (1) the number
and availability of substitute materials; and (2) the cost of
the input relative to the selling price of the final output. If
there are many substitutes in the production process or if the
input price is high relative to the value of output produced, a
comparatively small change in the price of the input may cause
substantial changes in the quantity demanded, and an elastic
demand schedule will result. To a certain extent, both of these
considerations apply to secondary materials. In general, scrap
materials compete with primary materials as inputs to production
processes, although the range of substitution possibilities of
secondary inputs for primary inputs depends on a host of fac-
tors, including the grade of scrap to be used, the production
process, and the type of output. For example, most copper scrap
TABLE 1. SUPPLY AND DEMAND ELASTICITIES FOR SECONDARY MATERIALS*
Material
Wastepaper
Scrap steel
Secondary lead
Scrap copper
Supply Elasticity
0.40
1.12
0.48
0.32
Demand Elasticity**
0.08
0.64
0.21
0.87
* Sources: for wastepaper and scrap steel, see reference [3];
for secondary lead, see reference [2]; and for scrap copper, see
reference [13].
**For secondary lead and scrap copper, the demand elasticity re-
fers to the industry demand curve for primary and secondary in-
puts combined.
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substitutes perfectly for primary copper, whereas the degree of
substitution for aluminum scrap and primary aluminum will depend
on the output being produced; scrap aluminum substitutes per-
fectly in the production of castings, but not at all in the pro-
duction of sheet aluminum [42, p. 15].
It is more difficult to generalize about the impact of the
cost of scrap relative to the final product on the elasticity
of demand for scrap materials. This relationship depends not
only on factors influencing substitution possibilities between
secondary and primary materials, but also on the elasticity of
demand for the final product. For example, if demand for the
output of an electric furnace is inelastic, a small change in
the price of scrap would have little effect on the quantity of
ferrous scrap demanded for this use, even though scrap costs
might represent over one half of the cost of producing steel.*
Similarly, because the cost of tetraethyl lead made from scrap
lead is very small relative to the value of leaded gasoline,
and because demand for gasoline is fairly inelastic, a change
in the price of scrap lead would have little impact on the
quantity of scrap lead demanded for the purpose of making
tetraethyl lead additives.
The total impact of the standard economic effects of sub-
stitution, relative costs, and demand elasticity for the final
product on the elasticity of demand for secondary materials is
indeterminate. At best, it can be said that these factors
alone cannot account for the low elasticities of demand for
secondary materials; other forces must also act to reduce
demand elasticities.
The low demand elasticities for secondary materials may
arise in part from the backward integration into primary
material supply sources by many users of both primary and
secondary inputs. The reasons for this backward integration
have not been fully explored, but appear to include the users'
desire for: (1) insurance against uncertainty in input availa-
bility and protection against possible cartelization of primary
material supplies [28]; and (2) favorable tax treatment of pri-
mary production which can be enhanced even further in a ver-
tically integrated operation.** By owning and operating primary
* A study for the Environmental Protection Agency estimated the
total per net ton costs of producing molten steel from an elec-
tric furnace to be $53.04; scrap costs were estimated at $31.10
of that total [34, p. 262].
** For a more complete discussion of vertical integration in
the secondary materials user industries and its impact on re-
source recovery, see [8],
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supply sources, user firms accept a certain level of sunk costs
which provide an incentive to those firms to rely upon primary
inputs in preference to secondary materials.
Furthermore, demand for wastepaper and ferrous scrap ap-
pears to be tied to the capacity cycles in the paper and steel
industries. Increased demand for paper and steel products
strains the capacity of these industries to produce woodpulp
and pig iron, their respective primary inputs. An outward shift
in the demand for secondary inputs results as firms are forced
to rely on scrap materials as substitutes for pulp and pig iron
in their production processes. A decline in the demand for
paper and steel products shifts the demand for secondary materi-
als back to more normal levels. Figure 2 depicts this process.
During normal capacity utilization levels, demand for scrap in-
puts is represented by D-^. An increase in the demand for final
products shifts the demand for scrap inputs to 02, with a cor-
responding increase in short-run supply, Q^ — Q2» and price,
P! — ?2« As demand for the final products decline, demand for
scrap shifts back to D]_, and price decreases to ?2- This two-
level demand structure for secondary materials and the vertical
integration of user mills imply that the demand for secondary
materials will be less elastic and subject to larger fluctua-
tions than would be the case for primary materials.
The supply elasticities for secondary materials are low for
an entirely different set of reasons. In the first place, ris-
ing costs are encountered as the more marginal supplies are
brought to market. In addition, most of the prompt industrial
scrap is brought to market irrespective of the price of scrap,
since receipt of any positive price for industrial scrap is
normally preferred to paying for its disposal in a landfill.
Another factor leading to low supply elasticities for
secondary materials, particularly wastepaper and ferrous scrap,
is the low level of inventory holdings by user mills and scrap
Price
Q2
Quantity
Figure 2
Demand shifts for scrap inputs.
8
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dealers.* Most paper and steel mills keep inventories of scrap
from which they may draw as the need arises. But because of the
high cost of storing scrap inventories, due to low value per
unit volume, inventories may represent only a month or two of
expected needs. Wastepaper is an extreme case where low value
per unit volume and perishability act in concert to restrict
normal inventories to not more than one month's needs.
During periods of high demand, as described earlier, mills'
inventories are depleted and they must buy scrap in the cash
market. Like the mills, scrap dealers and processors cannot
afford to hold large inventories, and as these inventories are
depleted, the price of scrap begins to rise without, at least
initially, a corresponsing increase in supply. The lack of
supply response results from the lag time required for the
dealer to generate new sources of scrap and for new members to
enter the industry. For this and other reasons, the supply of
scrap is price inelastic in the short run.
THE DEGREE OF UNCERTAINTY
The net result of inelastic supply and demand functions,
small industry inventories, and fluctuating demand is a widely
varying price for most secondary materials. Table 2 reports
the coefficient of variation for selected primary and secondary
materials.** The price series used for each commodity was the
monthly wholesale price for the period 1971-1975. Wastepaper
and ferrous scrap show the largest price variation. In general,
the secondary materials exhibit a larger degree of variation in
short-run prices than do the corresponding primary materials.***
As mentioned earlier, price variation is only a proxy for
predictive difficulty and uncertainty. It is possible to
* A description of the interaction between demand fluctuation
and low inventory holdings to produce price variability for
wastepaper can be found in [40, pp. 148-51].
** The coefficient of variation is a parameter that measures the
variance in a data series and through standardization allows
for the comparison of the variances of different series. Spe-
cifically, it is computed by dividing the standard deviation by
the mean. A value of zero indicates that individual observa-
tions in the data series never move away from the mean; the
larger the value, the more variation.
***The coefficient of variation for primary tin prices relative
to secondary tin is one exception to this observation. The
authors know of no reasonable explanation for this discrepancy.
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TABLE 2. COEFFICIENT OF VARIATION OF
MONTHLY WHOLESALE PRICES FOR SELECTED COMMODITIES, 1971-75*
Commodity C.V.
All industrial commodities 0.143
Refined petroleum products 0.393
Woodpulp (all grades) 0.425
Wastepaper (all grades) 0.440
Paperboard products 0.219
Iron ore 0.175
Iron and steel scrap (all grades) 0.458
Iron and steel products 0.229
Copper wirebar (domestic origin) 0.169
Copper scrap (base) 0.286
Aluminum scrap (base) 0.361
Primary aluminum ingot 0.218
Lead pig (common) 0.210
Scrap lead (battery plates) 0.289
Nickel cathode sheets 0.175
Scrap nickel anodes 0.223
Tin pig, grade A 0.367
Black tin pipe scrap 0.250
Zinc slab (prime western) 0.044
Old zinc, New York 0.236
*A11 prices from U.S. Department of Labor, Bureau of Labor
Statistics, Wholesale Prices and Price Indexes, Annual Sup-
plements, 1971-1975.
10
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imagine a situation where the coefficient of variation indicates
relatively volatile prices, but where the prices are predicta-
ble. Figure 3 shows two hypothetical price series and their
respective means,/< ,and>^B. Price series A has a higher co-
efficient of variation, but at the same time is more predicta-
ble than series B when past prices are used to predict future
prices. This is because the coefficient of variation describes
the difference between the mean of the price series and the
actual price observation. It is clear that the observations on
series B are closer to their mean than observations for price
series A.*
If futures prices are relatively predictable from past
demand and supply relationships, the impact of uncertainty
caused by volatile prices can be lessened. Short-run future
price expectations can be used to establish forward contracts,
thereby guaranteeing input supplies or market outlets, and to
guide production and inventory decisions.
We contend here that reliable expectations concerning
futures prices for secondary materials are more difficult to
formulate because of their extreme price fluctuations. A com-
parison of the predictability of futures prices using the most
recent past price for primary and secondary materials supports
this proposition. Our results were unambiguous (see Appendix
A). Secondary materials prices were much more difficult to
predict than were primary material prices.
Price
Time
Figure 3. Time profile of two hypothetical price series.
*This situation may be a partial explanation for the relatively
high coefficient of variation for woodpulp prices which have,
historically, been increasing, and, since they are basically
administered prices, are not subject to downward pressure.
11
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THE IMPACT OF UNCERTAINTY ON RESOURCE ALLOCATION
It will be argued here that price uncertainty created by
the volatile nature of scrap markets biases short-run produc-
tion decisions and longer-run investment decisions in favor of
the more price-stable primary materials. Furthermore, this
bias is reinforced by the inability of scrap markets to provide
any mechanism for coping with the risk created by price uncer-
tainty. Although the literature on decision-making under
uncertainty is new and perhaps incomplete, a few preliminary
observations are worth noting.
In his general treatment of the theory of the firm under
price uncertainty, Sandmo showed, among other things, that the
output under price uncertainty will be less than where output
price is known [37]. Using a slightly different assumption
concerning the behavioral motives of the firm, Stevens argued
that uncertainty will lead to socially optimal capital and
labor input levels which are lower than would be the case
under certain price conditions [42]. The net result is that
output and input use levels will be lower under demand uncer-
tainty than under certain price and demand conditions.*
Because of uncertainty over present and expected prices
for scrap materials, short-run production and inventory deci-
sions are, at best, difficult to make in an orderly and
rational manner. The result is a disincentive to rely on
secondary materials as inputs to production processes. In
addition, it is reasonable to assume that longer-run decisions
concerning investment in secondary processing technology are
also affected. In general, one would expect, everything else
being equal, that investment in the paper and steel industries
is biased away from recycling technology. The uncertainty in
the scrap markets causes firms to discount expected returns
from secondary investment alternatives more heavily than re-
turns from investment in primary technology. It is well
documented that unpredictable market fluctuations, leading to
uncertainty over present and expected prices for scrap, are
a major deterrent to increased recycling of wastepaper and
ferrous scrap.**
The impact of uncertainty is exacerbated in the scrap
markets by the inability of producers or consumers to protect
* The authors recognize that this discussion of uncertainty and
the theory of the firm barely scratches the surface of the re-
cent work in the field, most of which is beyond the scope of
this report. For a more complete understanding of this topic,
the reader is referred to [37, 38, 42, 27].
**See [1, p. 30] and [5, p. 52].
12
-------
themselves from the inherent risk of an uncertain market envi-
ronment. Typically, through forward contracting and/or vertical
integration, firms are able to decrease the effects of demand
and supply uncertainty. But precisely because of high price
uncertainty, buyers and sellers of scrap are not willing to
enter into long-term agreements, even though industry members
admit that forward contracting is necessary to stabilize demand
and supply conditions. Forward contracts involving wastepaper
and ferrous scrap are rarely for more than a month or so in
advance. As one industry member remarked, "Who wants to sign a
contract calling for delivery of a carload of scrap in three
months when no one has any idea what it will be worth?"*
Neither side of the market wants to commit itself to a price
that is unpredictable.
Furthermore, vertical integration by user mills back to
the scrap dealers, at least in the past, has not been a viable
alternative.** First, as mentioned earlier, management of large
user mills have developed a major short-run commitment to pri-
mary input sources for tax purposes and other reasons. Second,
the geographical dispersion of the market makes it unsuitable,
from the mills' viewpoint, for acquisition. Third, and proba-
bly most important, the social stigma attached to scrap dealers
in general deters mill management from direct activity in scrap
markets [8, p. 116].
The remainder of this report examines the feasibility of
futures markets as a mechanism for rectifying the impacts of
uncertainty on resource allocation in scrap markets. An or-
ganized futures market in certain scrap materials would pro-
vide a means of forward trading in these commodities, would
generate forward prices, and would allow industry members to
hedge some of the risk of making forward commitments in scrap.
The next section will describe how futures markets provide
a market for forward trading and risk management, in addition
to increasing the flow of market information.
* From a telephone conversation with a ferrous scrap buyer
(who requested that he not be identified).
**0bviously, the following discussion on vertical integration
is most applicable to firms using some secondary inputs but
relying mainly on primary inputs.
13
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SECTION 4
FUTURES MARKETS AND
THEIR ECONOMIC IMPACT ON THE CASH MARKET
FUTURES MARKETS
Organized futures trading in the United States began in
1865 when wheat futures contracts were listed on the Chicago
Board of Trade. Informal markets satisfying many of the same
needs were common before that date. In Europe and the United
Kingdom, organized commodity exchanges, of one form or another,
date back to the late sixteenth century.*
Although different in form and structure from the current
U.S. practices, all of these exchanges developed to satisfy the
need for a central marketing place for commodity trading. In
a sense, this central marketing place, by bringing buyers and
sellers together, lowered the transaction costs of trading in
an uncertain market environment. In the United States, the
early futures markets were for agricultural commodities.
Today, futures contracts are traded in such diverse commodities
as plywood, frozen orange juice, copper, foreign currencies,
and interest rates. Table 3 lists some of the nonagricultural
commodities traded on U.S. futures markets and the dates when
trading was initiated.
The characteristics of futures markets that distinguish
them from other markets (for example, cash, contract, or for-
ward delivery markets) have been enumerated by Gray [19, pp.
2-3]. Futures contracts are traded on an organized commodity
exchange under the rules promulgated by the exchange. The con-
tract, which calls for delivery of a commodity at some future
date, is standardized as to quality and quantity to be de-
livered as well as to all other terms of delivery. Only the
day of delivery within the delivery month is left to the dis-
cretion of the seller. For example, the copper contract
traded on the Commodity Exchange, Inc. (Comex) in New York
calls for delivery of 25,000 pounds of 99.9 percent pure copper
cathodes. The delivery months are January, March, May, June,
July, September, and December. Delivery can be made from any
*For a more detailed discussion of the historical development
of U.S. futures markets, see [22, pp. 71-94].
14
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TABLE 3. SELECTED LIST OF
NEWLY INTRODUCED NON-AGRICULTURAL FUTURES CONTRACTS
Commodity
Year of
introduction
Volume traded
in 1974
(number of contracts)
Gold
(Commodity Exchange
Inc.)
Lumber
(Chicago Mercantile
Exchange)
Plywood
(Chicago Board of
Trade)
Mercury*
(COMEX)
U.S. Treasury Bills
(International Monetary
Market)
British Pound
(IMM)
Mexican Peso
(IMM)
Government National
Mortgage Association
8% Securities
(Chicago Board of
Trade)
1974
1969
1969
1967
1976
1972
1972
25,050
3,528
383,322
86
294,829**
11,842
82,054
1975
113,538**
* Ceased trading in 1975 because of lack of interest.
**Volume traded from January-November 1976.
15
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one of six Comex warehouses located across the country. A
seller gives notice of delivery by issuing a warehouse receipt,
a negotiable instrument transferring title to the copper in
the warehouse, at any time during the delivery month for which
he has sold a contract.
Table 4, reproduced from the Wall Street Journal, gives
the futures prices for copper on Wednesday, April 27, 1977.
Opening, closing, high, and low prices during the day are
quoted for each delivery month up to a year in advance. On
that day, for example, trading in July copper futures opened
at 65.2jzf per pound and closed at 64.2jz!, down .40^ from the
previous day's selling price. The high and low prices for the
July contract during 1977 were 83.2jzf and 58.4gf, respectively.
A total of 6,250 contracts were traded that day.
A futures market is an impersonal market in that actual
buyers and sellers are unknown to each other. It is also a
very public and competitive market, since all trades in a par-
ticular commodity are made by open outcry in the specified
trading area, or "pit," of the exchange. Floor traders, who
must be members of the exchange, sell to and buy from a clear-
inghouse which is usually part of the exchange.*
TABLE 4. COPPER FUTURES PRICE QUOTATIONS*
Month
May
June
July
Sept.
Dec.
Jan. 78
March
May
*Estimated
25,000 Ibs
Open
64.10
65.20
66.10
67.60
68.00
68.80
69.60
sales,
. ; cents
High
64.30
65.30
66.30
67.70
68.00
68.90
69.60
6,250;
per Ib
Low
63.20
64.20
65.20
66.70
67.10
68.00
68.80
Close
63.20
63.70
64.20
65.20
66.70
67.10
67.90
68.70
Change
-.40
-.40
-.40
-.40
-.30
-.30
-.30
-.30
High Low
82.60 57.30
83.20 58.40
81.80 59.20
76.60 60.80
75.90 61.70
76.70 67.20
76.40 68.10
sales Tues., 3,815. Copper (CMX)-
.-S (Wall Street Journal, 28 April 1977)
*Besides acting as an intermediary between buyers and sellers,
the clearinghouse oversees all trading activities.
16
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Although it is a legally binding commitment to deliver or
purchase the specified commodity, a futures contract does not
transfer title of commodity ownership. A position with the
clearinghouse, long if a futures contract has been purchased
or short if one has been sold, can be liquidated by taking an
offsetting position in the market or by taking delivery of the
commodity. For example, if a trader were to buy a December
copper contract in June and sell a December contract in Sep-
tember, his net position with the clearinghouse would be zero
after the September transaction had been made.
There are two categories of traders in futures contracts:
hedgers and speculators. Speculators buy and sell futures con-
tracts in hopes of profiting from favorable movements in the
futures prices. They have no position in the cash market and
rarely intend to make or take delivery of the commodity in
which they are trading. The activity of speculators promotes
liquidity in futures markets by making it easier for hedgers
and other traders to establish trading positions.
Hedgers, on the other hand, use futures markets to reduce
the risk of an unfavorable movement in the cash price that
would affect a position they hold or plan to hold in the cash
market.* Normally, a hedge consists of taking a position in
the futures market that is the opposite of a planned or actual
position held in the cash market. A buyer in the cash market
becomes a seller of futures contracts, and vice-versa.
A futures market is not a delivery market. Actual delivery
in satisfaction of a futures contract is rare; many contracts
traded on commodity exchanges experience less than 1 percent
delivery rates [14, p. 8]. Oddly enough, the assurance that a
standard grade and quantity of a commodity will be delivered
eliminates the desire to take delivery, since the contract
specification and/or the delivery terms usually do not repre-
sent the most profitable terms for actual purchase or sale.
In most cases, the buyer or seller is better off negotiating a
cash market transaction and using the futures market to hedge
that decision. As a result, the hedging and forward pricing
roles of a futures market, which we will discuss in the next
section, become more important than the delivery role [19, p. 6],
Futures markets exist mainly to facilitate the holding of
contracts [51]. In a sense, they act as a substitute for a
later transaction that may take place in the cash or forward
contract market [19, p. 7]. Futures markets, therefore,
*For the purposes of this paper, an extremely simplified notion
of hedgers1 motivations and of hedging has been adopted. For
a more realistic definition and discussion of these concepts,
see [49] and [50].
17
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supplement those markets already in operation, rather than re-
place existing ones.
ECONOMIC IMPACTS OF FUTURES MARKETS
It is useful to divide the economic impacts of futures
trading on the cash market into three general categories:
(1) the impacts on pricing in the cash market; (2) the impacts
on risk management; and (3) the impacts on market information.
The specifics of each will be discussed in turn.
Pricing Function of Futures Markets
Futures markets are often described as price discovery
mechanisms [32, p. 45]. A futures market acts as a central
clearing device for traders in a commodity. These traders buy
and sell futures contracts based on their expectations and in-
formation concerning current and future demand and supply con-
ditions. Traders with good forecasting tools and skills and
better information are rewarded at the expense of less skilled
traders. This competition assures generation of good predic-
tions of future prices. In fact, the prices generated on
futures markets represent unbiased predictions of future cash
prices based on the currently available market information
[18, p. 73]. Therefore, while the June futures price of a con-
tract, calling for December delivery, will not necessarily
equal the actual cash price in December, it does represent an
unbiased prediction of the cash price for the commodity in
December. Thus, by providing a forum for the assimilation and
dissemination of market information and expectations, futures
markets act as price discovery mechanisms.
The forward prices generated on futures markets signal
decision-makers when to produce, consume, or hold stocks, and,
in a sense, regulate production and consumption of the com-
modity [32, p. 46], Accordingly, futures prices should also
act to stabilize current cash price series. Smyth shows that
prices resulting from production plans based on public price
forecasts will be more stable than prices generated through
reliance on past prices to guide production plans. If one
views futures prices as forward prices, the same result should
hold if producers or other members of the industry use these
prices in determining production plans. In essence, as forward
prices are translated into more orderly transformations of
market positions, a "dampening of intraseasonal and inter-
seasonal prices movements" can be expected [14, p. 36].
In theory, at least, futures trading should have a
stabilizing impact on cash markets; nevertheless, empirical
verification is inconclusive. For example, both Working and
18
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Gray found reduced price variability in the U.S. onion market
after futures trading had been initiated [50, 16]. But a U.S.
Department of Agriculture study of the onion market found that
futures trading had little or no effect on the variability of
onion prices [25].* Powers investigated the impact of futures
trading on price fluctuations in the pork bellies market and
demonstrated a dampening on the random element of the short-
term cash price series [34]. This result cannot be readily
translated into a reduction of the overall variance in the
price series unless it is assumed that the random element
accounts for a large portion of the variation in the actual
cash prices. Unfortunately, however, that assumption does not
appear to be justified.
Peck1 empirical tests of her hypothesis that producer
supply response should increase with futures trading in a com-
modity are not conclusive [32]. Although a shift in producer
supply response did occur after futures trading in onions was
initiated and again after it was halted, she could not estab-
lish a cause and effect relationship between these events.
Some other structural shift may have occured for which her
model did not account.
The empirical analysis of the impact of futures trading
on the responsiveness of plywood supply to price signals,
described in Appendix E, shows that with a futures market a
given change in price would result in a larger change in the
quantity of plywood produced. That is, the responsiveness of
supply to price increased after futures trading in plywood was
initiated.
There are some who argue that the speculative activity in
futures markets has a destabilizing effect on cash prices.
Although the empirical evidence is not all in, such a viewpoint
does not seem justifiable. Speculators form expectations of
current and future prices of a commodity. When prices generated
in the market (cash or futures) deviate from these expectations
sufficiently to create expected profits for traders, some
traders will enter the market in hopes of profiting from the
price change. Thus, if speculative expectations are based on
the best available market information, speculators act to sta-
bilize prices at their true value.
If, however, speculators base their price expectations on
the actions of other speculators, speculative trading may, in-
deed, have a destabilizing effect on prices. In futures
*The different conclusions based on the same basic methodology
can be explained, at least in part, by the availability to
Johnson of other, more extensive, futures trading data. See
Johnson's discussion in [25, pp. 34-41].
19
-------
markets, this type of speculative behavior is termed "movement
trading." Price levels resulting from movement trading can
deviate significantly from those that would be generated by a
rational assessment of present and future market conditions.
Empirical research has shown, though, that most commodity
futures markets do not exhibit evidence of significant movement
trading.* Furthermore, currently accepted theories concerning
hedging in futures markets assign speculators a major role in
assuring well functioning futures markets. Speculators enter
a market in response to hedging demand, adding necessary
liquidity to the market. In addition, it has been suggested
that speculation above that required by hedging tended to re-
duce price distortion in the frozen orange juice concentrate
futures market [48].
Market Information Effects of Futures Trading
Closely allied with the pricing function of futures trad-
ing is the market information function. Information originates
from a variety of sources. Exchanges regularly publish and
make available statistics on trading volume, price, and the
open interest for the commodities traded on their floors. Com-
mission houses publish supply and demand estimates and make
price forecasts available to their customers. Traders use
this information, as well as information from other sources,
such as government agencies, in forming expectations concerning
future market conditions. This information is reflected in
the futures prices generated on the exchange and, in this
sense, futures markets act to assimilate and disseminate market
information. Futures prices are quoted on a daily basis in
most major newspapers and are therefore readily available to
all market participants, whether or not they trade in futures.
We have already pointed out that these prices are used in
formulating production, consumption, and inventory decisions.
To an extent, all markets act as information-gathering and
-assimilating points. The ability of a futures market to in-
crease the normal flow of market information results from:
(1) providing a central marketing place; (2) increasing the
number of traders in the market (thereby increasing the com-
petitiveness of the market); and (3) lowering the transaction
costs of information exchange.
*Significant movement trading in a commodity traded on a futures
market would be evidenced by serial dependence of the futures
prices generated for that commodity. Several studies have per-
formed time series analysis on futures prices, and, while it is
beyond the scope of this paper to describe the studies or their
results, in general, only minor distortions from serially in-
dependent prices have been found. The interested reader is re-
ferred to [26, 36, 7] .
20
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In general, the increased flow of market information from
futures trading leads to better informed market participants
and a more responsive marketplace. As a result, "market prices
provide more accurate signals for resource allocation when
there is futures trading in a commodity" [11, p. 1235],
The Risk Management Function of Futures Markets
Commerical buyers and sellers of commodities traded on
futures markets, or of closely related commodities, are able to
manage or reduce the risk of volatile cash prices by hedging in
futures markets. As mentioned earlier, a hedge consists of
taking an opposite position in the futures market from one held
in the cash market. The key to the hedging role of futures
trading is that near futures prices and the cash price of a
given commodity tend to move together, since they are influenced
by the same demand and supply information. Thus, by taking op-
posite positions in the cash and futures market, a loss in one
market can be offset by a gain in the other. Any commodity can
be traded against any futures contract as long as the prices
for the commodity and the futures contract are highly corre-
lated. Copper scrap, for example, is not traded on any
organized commodity exchange, but purchases and sales of copper
scrap can be successfully hedged against either the copper
futures contract traded in New York or that traded in London.
This is so because the price of copper scrap is highly corre-
lated with the cash price of refined copper which, in turn, is
correlated with the nearest copper futures contract price, as
shown in Figure 4. The effectiveness of the hedge depends on
the degree of correlation between the futures and cash prices.
For the purposes of this study, two basic types of hedging
activities will be outlined: the buying hedge and the selling
hedge. In essence, a buying hedge involves the purchase of
futures contracts, and a selling hedge the sale of futures
contracts. Depending on the circumstances, both are useful to
commercial producers, consumers, and merchandisers of the given
commodity.
A trader uses a buying hedge when he is interested in
establishing a forward price for a planned or actual commitment
in the cash market. For example, a copper scrap dealer, who
has no stock on hand, may be offered what appears to be a
profitable price for some scrap. By entering into this forward
contract, he risks a rise in the cost of the copper scrap he
will buy for fulfillment of the formal contract. Since, as
previously shown, copper scrap prices are correlated with cur-
rent month copper futures prices, he can protect himself from
a rise in the cash price by purchasing an equivalent amount of
copper futures.
Table 5 illustrates a hypothetical buying hedge. In April,
21
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COPPER Review of weeks ending 7/25/75—7/23/76
N)
Q
Z
2
76
70
64
58
52
46
40
WEEKLY HIGH
FRIDAY CLOSE
WEEKLY LOW
COMEX NEAREST FUTURES PRICE
LONDON WIREBAR SPOT PRICE
(SECOND SESSION)
SCRAP #2 PRICE
Figure 4. Copper prices: futures, wirebar, and #2 scrap
-------
the scrap dealer contracts to provide 25,000 pounds of # 2 cop-
per scrap in two months at 48.50 per pound. At the same time,
he purchases one July copper futures contract that is currently
trading for 64.2?! per pound. In June, he has an opportunity
to buy the needed scrap, but the price has risen to 50.50 per
pound for a loss of 20 on his contract transaction. During
this period, the copper futures contract should also have
risen in price, thus enabling the dealer to offset the 20 loss
by selling his futures contract for 20 more than what he paid
for it. His net loss would be zero.
A selling hedge enables a commercial trader to protect
previous purchases from a price decline, in other words, to
protect inventory holdings. For instance, if a copper scrap
dealer has accumulated a certain quantity of scrap in his
yard in anticipation of a rise in the cash price of the scrap
during the period in which he holds the inventory, he can
protect himself from an adverse change in the cash price by
selling copper futures.
Table 6 outlines a hypothetical selling hedge. In April,
the dealer buys 25,000 pounds of # 2 copper scrap at 48.50 per
pound and sells a July copper futures contract at 64.20 per
pound. The cash price of the scrap drops to 46.50 by June,
and he decides to sell his inventory at a loss of 20 per pound.
At the same time, he buys back the futures contract at 20 less
than what he paid for it. Again, the net loss is zero.
TABLE 5. EXAMPLE OF A BUYING HEDGE
Activity Cash Futures
April:
Buy July 64.20
Sell 48.50
June:
Buy 50.50
Sell* — July 66.20
*Loss, 2.000; gain, 2.000; net loss, 0.
23
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TABLE 6. EXAMPLE OF A SELLING HEDGE
Activity Cash Futures
April:
Buy 48.5jzf
Sell July 64.2£
June:
Buy 46.5jZ< July 62.2£
Sell* —
*Loss, 2.00jzf; gain, 2.00(zf; net loss, 0.
A few caveats are in order, however, with respect to the
hypothetical situations presented in Tables 5 and 6 as discussed
above. First, the descriptions of buying and selling hedges
are extremely simplified. Normally, the decision on whether to
hedge will depend on a host of factors, including the basis at
which the hedge can be established and the trader's expecta-
tions of the most likely outcomes;* rarely will a hedger
routinely hedge his cash market transactions. Furthermore,
hedges will almost never exactly offset the gain or loss in the
cash market transaction; most prices are not perfectly corre-
lated.
All the same, these cautions should not obscure the im-
portance of the hedging role of futures markets. Through a
rational hedging program, commerical buyers and sellers can
manage the risk of cash price movements that may affect their
cash market position. Where risk is defined as variance in
income, futures markets act to stabilize producer and consumer
income. By offsetting losses and gains in the cash market
through appropriate hedging plans, vagaries in income can be
lessened.
A futures market is generally most effective in stabiliz-
ing income when income variability results mainly from price
fluctuation [31] . Routine hedging on the basis of expected
output can cause greater income instability if the main source
*The basis is defined as the difference between the cash price
of a commodity and the near futures price.
24
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of uncertainty is output variation.* Generally, if the varia-
tion in the basis is less than the cash price variation, returns
will be more stable when positions are hedged in a futures mar-
ket, assuming hedges can be placed over a sufficiently long
period to cover the period of price instability.
SUMMARY
In summary, two points should be emphasized. First, a
well functioning futures market increases the quantity and
quality of market information available to participants in the
cash market. This, along with the price discovery role of
futures markets, decreases uncertainty in the marketplace.
Second, futures markets provide a mechanism for managing,
through hedging, the remaining price uncertainty.
The discussion in Section 3 regarding uncertainty and re-
source allocation in the secondary materials markets raises
two questions. First, is a futures market in secondary
materials feasible? Second, what would be the possible impacts
of a scrap futures market on secondary markets? Sections 5 and
7 will address these questions.
*For example, imagine a wheat farmer who, on the basis of an ex-
pected yield of 15,000 bushels from his acreage, sells throe
5,000-bushel futures contracts at the beginning of the crop
year at $2. 50 per bushel. At harvest time, the farmer finds
that the price of wheat has risen to $3.00 per bushel, but
because of a major drought during the crop year he is only able
to harvest 5,000 bushels. He has to buy back his futures con-
tracts at $.50 more than he paid for them, for a loss of
$7,500. His gain from the price of wheat rising is only
$2,500. He would have been better off not hedging at all.
Although simplistic in nature, this problem is common for many
producers of agricultural crops where output uncertainty be-
cause of weather is of major proportions.
25
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SECTION 5
FUTURES TRADING IN SECONDARY MATERIALS
Of the hundreds of commodities that are bought and sold
daily, only about 35 are actually traded on foreign and U.S.
dbmmodity exchanges. The various criteria used to judge
whether a commodity can be successfully traded are vague;
furthermore, there is little consensus among commodity spe-
cialists as to their relative importance. Consequently, even
after conducting extensive research, an exchange will fre-
quently base its decision on whether to trade a commodity on
instinct.
Nevertheless, it is possible to identify, based on a re-
view of the relevant literature and conversations with com-
modity specialists, some elements that affect a commodity's
ability to be successfully traded on a futures market. The
broad criteria that are considered important for a successful
futures market in a commodity will be presented first. An
evaluation of specific characteristics of wastepaper and fer-
rous scrap markets, in light of the general and more specific
criteria, will follow.
GENERAL ELEMENTS NECESSARY FOR SUCCESSFUL FUTURES TRADING
It is essential for successful futures trading that a
hedging need exist within the industry. In other words, "there
must be a reason for commercial buyers and sellers of the com-
modity to want to substitute futures contracts temporarily for
merchandising contracts" [17, p. 122]. This implies that there
must be sufficient variation in the cash price to make buyers
and sellers want to use a mechanism to "insure" against price
risk. Once hedging demand has been assured, it is necessary
to attract speculation to take up the long side, or buyers'
side, of the market; speculators are usually attracted to
markets with large hedging volume and fluctuating price.*
Closely tied to the above concepts is the necessity of designing
*In futures markets, short hedging usually exceeds long hedging,
The reasons for this are complicated and not particularly
germane to this paper. The interested reader is referred to
[14, p. 27] .
26
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standard contract terms, quality, storage, delivery require-
ments, etc., that follow accepted industry practice.
Furthermore, there must be a general industry acceptance
of the futures market. Ignorance concerning the functions of
futures markets, ill-informed or misconceived notions regarding
futures trading, and possible fears of losing market control
may cause industry to shun the market, and result in a possible
lack of trading volume.
The general elements of a successful futures contract,
discussed above, are interdependent. Industry acceptance of a
futures market is determined in part by its perceptions of
hedging needs and in part by an exchange's ability to design
a standard contract that follows accepted industry procedures,
does not bias the futures prices, and overcomes regional
marketing differences. The importance of these interdepen-
dencies will become more apparent later in this discussion.
It is clear that a need exists in the wastepaper and
ferrous scrap markets for some mechanism to manage price risk
and to reduce the impact of uncertainty in the marketplace.
Despite general agreement among scrap industry members concern-
ing the need for some mechanism to cope with uncertainty in the
marketplace, there is some doubt among participants in the
scrap industries that futures markets represent a practical,
or even desirable, alternative. These doubts typically result
from an incomplete understanding of futures markets and their
operation. Common fears are that futures markets would super-
sede the normal marketing procedures for scrap, and that
speculators would enter the market and drain industry members
of their profits.
The next subsection will discuss the specific criteria
for successful futures trading and their applicability to the
secondary materials markets. The purpose is to isolate the
important considerations, rather than to propose solutions.
The solutions must come from interaction between an exchange
and the industry. Further on, a potential role for the gov-
ernment in this process will be presented.
SPECIFIC ELEMENTS OF SUCCESSFUL FUTURES TRADING
The general elements of successful futures trading dis-
cussed above suggest, in turn, several specific elements vital
to successful wastepaper and scrap steel futures contracts.
These are presented below.
(1) The existence of a competitive marketplace (many
buyers and sellers) is an important consideration, partly to
insure sufficient trading volume and partly to insure that
one side of the market is unable to control the entire market.
27
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If there were many sellers but only a few buyers, the buyers
would be able to influence the futures price. In that situa-
tion, the sellers would soon recognize the buyers' advantageous
position, and would no longer participate in the market. The
reverse would occur if buyers, rather than sellers, dominated
the market.
Measuring the competitiveness of an industry generally re-
quires some knowledge of the structure, conduct, and performance
of the firms in that industry [10]. In the event that complete
information on these matters is unavailable, the concentration
ratio is a useful substitute means of evaluating an industry's
competitiveness. Concentration ratios typically show the per-
cent of the total value of shipments accounted for by the
largest 4, 8, and 20 firms in an industry. Table 7 lists the
four-firm concentration ratio for different sectors of the
steel and pulp and paper industries for 1967 and 1972.
Based on the 1967 data, Guthrie concludes that the pulp
and paper industry is relatively competitive. His conclusion
was based on the fact that all but two sectors, pulp and sani-
tary products, had ratios of less than 30; he considered a
concentration ratio of less than 30 for the four largest firms
to be fairly low, "since economies of scale in the production
of most paper and paper products are substantial" [20, p. 192],
The addition of the 1972 data does not affect this conclusion.
Although there are some slight changes, all sectors but pulp
and sanitary products indicate relatively competitive market
conditions.
If this same criterion is applied to the concentration
ratios for different sectors of the steel industry, the same
conclusion holds; all but one sector, the blast furnaces and
steel mills, have ratios of close to or less than 30. The
1972 ratio for blast furnaces is 45, high in comparison with
the other ratios; however, it is probably a poor indicator of
the competitivenss in that sector of the market with respect
to purchases of scrap materials, since it does not account for
foreign competition for scrap.
Although no concentration ratios are available for the
seller or scrap dealer side of the markets for wastepaper and
ferrous scrap, it appears that this sector fits very well into
the competitive mold. There are approximately 1,800 firms in
the basic U.S. ferrous scrap industry, most of which are small,
family-run operations (over 80 percent of the firms have annual
output volumes of less than 30,000 tons) .[35, pp. 179-81]. The
dealer side of the wastepaper market is much the same; in 1963,
there were 2,711 wastepaper dealers in the United States [12,
p. 41]. Of 109 respondents to a survey by Battelle, 61 firms
handled less than 50,000 tons of wastepaper in 1969, and only
12 handled over 200,000 tons [5, p. 108]. Furthermore, most
28
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TABLE 7. CONCENTRATION RATIOS FOR SELECTED SECTORS OF
THE PULP AND PAPER, AND STEEL INDUSTRIES (4-FIRM RATIOS)*
Item
I.
Paper and Pulp:
Pulp Mills
Paper Mills
Paperboard Mills
Sanitary Products
Folding Boxes
Set-up Boxes
1967
45
26
27
63
22
12
1972
59
24
29
63
28
11
Corrugated and Solid
Fiber Boxes 18 18
II. Steel:
Blast Furnaces and
Steel Mills 48 45
Steel Pipes and Tubes 26 23
Grey Iron Foundries 27 34
Steel Foundries NA 24
Steel Wire and
Related Products 24 18
*Source: U.S. Department of Commerce, Bureau of the Census,
Census of Manufacturing, 1967 and 1972.
dealers are located near a few major cities, and competition
is, therefore, intense.
On the whole, the ferrous scrap industries and wastepaper
industries are relatively competitive. It is doubtful that
one side of the market could exert control over the other,
should futures markets be initiated in either commodity.
(2) The difficulty in defining a standard contract for
trading may be the most formidable barrier to successful
futures trading in scrap materials. Two specific concerns
29
-------
stand out: the definition of a standard contract grade; and
the definition of standard pricing and delivery arrangements.
These are discussed below.
Standard Contract Grade
As mentioned earlier, a futures contract calls for delivery
of a standard grade of a commodity. This grade must be speci-
fied within small tolerances, whose delineation must be accepta-
ble to members of the industry. Furthermore, this grade should
represent a sizable portion of the commercial transactions in
the cash market for the particular commodity, to assure that
there will be potential buyers to take delivery on the contract,
as well as sellers to make delivery.
Very few commodities are a single, standard grade. Wheat,
for example, is not simply wheat—it is red wheat, winter wheat
No. 1 or No. 2, and so on. Even within a grade there are dif-
ferences in protein content due to differences in seasonal
growing conditions. What is important is that these grades
are standardized, and can be distinguished by sight, touch,
chemical analysis, or other means. A futures contract, using
these physical characteristics, defines a specific grade for
delivery. Each contract in a commodity specifies the same
delivery grade.* In this sense, the contract is homogeneous
[46, p. 274]. At least in the case of a single contract grade,
each buyer knows exactly the grade and quality of the commodity
that will be delivered if he decides to take delivery.
Critics of futures trading in scrap argue that the hetero-
geneity of wastepaper and iron and steel scrap preclude success-
ful futures trading in those materials. In addition, they
argue that because different grades of wastepaper and ferrous
scrap do not always substitute for one another in production
processes, a grade that is useful for one type of mill may be
useless to another. In the United States, trade associations
for these two industries publish suggested standards for parti-
cular grades of scrap. While these standards carry no legal
weight, they do serve as guidelines for buyers and sellers of
scrap.
There is an apparent consensus among industry members
knowledgeable of futures markets and commodity exchange offi-
cials that the present specification guidelines for ferrous
scrap are not sufficiently rigorous to be used in designing
a futures contract. Grade specification, at least on the
buying side of the market, appears to be mostly a function of
*In practice, there are contracts that allow other grades to be
delivered in lieu of the par grade, but with associated pre-
miums and discounts based on its value relative to the par grade,
30
-------
the product for which the scrap will be used as an input. This
is not an insurmountable problem, but it does require that scrap
buyers, sellers, and exchange officials meet and outline formal,
concise tolerances in terms of allowable contaminant levels,
and formulate descriptions for at least the major grade of
scrap.*
For two reasons, No. 1 Heavy Melting and No. 1 Bundles
seem to be appropriate grades for a ferrous scrap futures con-
tract. First, they are relatively homogeneous. They are
derived from a few known sources and have a history of use in
the industry. Buyer confidence in both No. 1 Heavy Melting
and No. 1 Bundles is great. Second, both grades account for a
large portion of the commercial transactions in ferrous scrap;
together, these two grades constituted 32 percent of all pur-
chased scrap receipts in 1975 [24, p. 7],
The published specification guidelines for wastepaper,
like those for ferrous scrap, are too lax for futures trading.
The choice of the particular grade for trading, though, is
confused somewhat by the lack of data concerning industry-wide
purchases of specific grades of wastepaper. The available
data detail consumption of wastepaper only by broad grade
classification (e.g., Mixed Papers, Newspapers). Using these
data, corrugated materials would be the general class of waste-
paper from which a delivery grade should be chosen (in 1976,
corrugated materials accounted for 41 percent of all wastepaper
consumed in the manufacture of paper and paperboard).** Cf the
six or seven different grades of corrugated materials, one
that is of high quality and that constitutes a significant
portion of the commercial transactions in corrugated wastepaper
would have to be chosen.
It is suggested, at least for initial trading, that a
futures contract in ferrous scrap or wastepaper be confined to
one grade. Otherwise, buyers who can use only the par grade
in their production processes might be hesitant to take
delivery on the futures market for fear of receiving the non-
par grade. This does not mean that such a contract would be
of use only to those buyers and sellers who deal in the parti-
cular grade traded. As long as the prices for different
grades of ferrous scrap and of wastepaper move together closely,
the contract can be used to hedge commercial transactions in
* It is important to note that only the grade or grades to be
used as contract grades need to be respecified; they are the
only ones that will be delivered on the futures market.
**American Paper Institute, 1976-1979 Capacity; Paper, Paper-
board, Woodpulp Fibre Consumption (New York: American Paper
Institute, 1977) .
31
-------
other scrap grades; the trader need never consider making or
taking delivery on the market.
Appendix B shows the results of statistical tests performed
on the price series for individual grades of ferrous scrap and
wastepaper. The individual grades of ferrous scrap are highly
correlated; thus, a futures contract in No. 1 Heavy Melting
could be used to hedge market transactions in other grades.
There is less correlation among wastepaper prices. Consequent-
ly, it is unlikely that a one-grade wastepaper contract could
serve as a guide for hedging activities in other grades of
wastepaper.
Because prices for various wastepaper grades are not
closely correlated, it could be argued that trading in separate
contracts for each grade should be instituted. Although
feasible, several different contracts in wastepaper could re-
duce the potential number of buyers and sellers in any one
contract, and thus impair the liquidity of the market.
Standard Pricing and Delivery Arrangements
As stated earlier, a futures market is not a delivery
market. Typically, only a small fraction of the total volume
of contracts traded are satisfied by delivery. Even though
delivery is relatively uncommon, a futures market requires
that delivery can take place. In essence, it is the threat of
delivery on a futures contract that forces the basis toward
zero during the delivery month. It is this tendency for the
cash price to equal the futures price in the month of delivery
that enables futures markets to be used as an effective hedging
device. If, for example, the cash price during the delivery
month significantly exceeds the futures price, holders of
futures contracts will take delivery of the commodity on the
futures market and sell in the cash market. The increased
current cash market supply causes the cash price to fall to
the level of the futures price. Thus, terms that insure
delivery on the contract are essential elements of a successful
futures contract. Terms that complicate delivery also increase
the cost of delivery, and cause hedgers to be reluctant to
make or take delivery on a contract.
Futures markets traditionally use one of two types of
pricing arrangements: (1) delivered to the market city; or
(2) F.O.B. a natural shipping point. The choice of system
depends upon which side of the cash market normally assumes
responsibility for transportation charges. If it is the
buyer, then F.O.B. shipping point would be the appropriate
choice; if it is the seller, pre-paid to market city should
be chosen.
In the case of wastepaper, the election of method is
32
-------
complicated by the lack of a standard industry procedure relat-
ing to pricing arrangements. Normally, the assumption of
transportation charges is determined by the specific agreement
between the buyer and the seller. Many of the agreements are
F.O.B. shipping point, with the buyer assuming the transporta-
tion charges [5, p. 48]. This procedure seems to be used
primarily for short-distance transactions, where both the scrap
and the scrap dealer are located in or near the same market
city. Longer-distance hauls may be priced pre-paid to destina-
tion.
Ferrous scrap transactions are apparently more standardized
--the seller almost always pays the transportation charges.
Because this method is normally employed for most ferrous scrap
transactions and for the higher quality grades of wastepaper,
its use is recommended for ferrous scrap and wastepaper futures
contracts.
Once the appropriate pricing arrangement has been chosen,
it is necessary to choose the base point from which the prices
will be established. This base point usually also refers to
the area or market city from which and to which delivery is
made on a futures contract. For example, wheat traded on the
Chicago Board of Trade is priced delivered to Chicago, the
natural marketing point for that commodity. Plywood, on the
other hand, is priced F.O.B. Portland, Oregon, since that area
of the Northwest contains a heavy concentration of plywood
sellers.
There are four criteria considered important in selecting
a base point [29, p. 7].
(1) There should be only one base pricing or delivery
point. Otherwise, a buyer of a futures contract may be un-
certain of the point of origin of his purchase, and this
uncertainty may reduce market liquidity.
(2) The base point should be a natural merchandising
channel for the commodity in question. In other words, the
base point city or area should be one where the commodity is
consumed, stored, and passes through under normal business
transactions.
(3) To provide a point for creating an average price,
the base point should be a natural loading point for shippers
in the industry.
(4) Storage and/or production facilities should exist so
that physical delivery can be made at a known cost.
Although in the strictest sense no central marketing place
exists for wastepaper and ferrous scrap, the market for these
33
-------
commodities is highly concentrated. Figure 5 shows the location
of wastepaper dealers in the United States. Wastepaper buyers
and sellers are concentrated primarily between Philadelphia
and Boston, with another large market in Chicago. Figure 6
shows the large intraregional movement of wastepaper within the
area loosely bounded by those cities. Any one of the large
cities within this area could be used as the base point; it
has been suggested that New York would be appropriate, since
this area already accounts for a large portion of the commer-
cial transactions in wastepaper.
Ferrous scrap dealers and users (see Figures 7 and 8) are
located mainly between Chicago and Philadelphia, with heavy
concentrations in and around Pittsburgh. Because of the large
volume of ferrous scrap movement within this region (see Figure
9), Pittsburgh would be a likely candidate for a base point for
pricing and delivery.
In conclusion, although no central marketing place for
ferrous scrap or wastepaper exists, the markets for these
commodities are sufficiently concentrated so that one city
within the regions mentioned above could serve as a base point
for pricing and delivery. There are enough buyers and sellers
within the areas who normally take and receive shipment of
scrap to insure that delivery could take place on a scrap
futures contract.
There are two different instruments for initiating delivery
of a commodity on a futures market, the warehouse receipt and
the shipping certificate. Both are certificates of title
transfer. The warehouse receipt is traditionally used to
transfer title to a commodity traded on a futures market. It
says, in effect, that the seller will ship the commodity to
the buyer from an exchange-owned and -regulated warehouse in
which he stores the commodity. In essence, the warehouse
receipt signifies delivery from inventory or storage. The
shipping certificate, on the other hand, is used for commodities
for which only small inventories are held (e.g., plywood, live
cattle, porkbellies). It calls for delivery from current pro-
duction.
Only those sellers that an exchange has declared "regular"
for delivery can issue delivery instruments. A seller becomes
"regular" by submitting to a check of its integrity (both
financial and otherwise) by the clearinghouse, and by agree-
ing to abide by the rules and regulations of the exchange.
The shipping certificate would be the appropriate delivery
instrument for scrap futures, since inventories of ferrous
34
-------
ui
^"rvvKaTA ,.*»«TA^""i"*»tfe*
WESTERN TRUNK {,_INE
IOWA >,y
Q
NCWMEXCO
&S« " '
\ i o
v~
Integrated boarTJvgjid pulp
Integrated paper and pulp
Integrated pulp,paper fc board
Non-integrated board
Non-integrated paper
Non-integrated paper and board
Paperstock dealer concentration (6 or more per city)
Source: Resource Planning Institute, Raw
Materials Transportation Costs and Their
Influence on the Use of Wastepaper and
Scrap Iron and Steel, vol. 1. Springfield,
Va.: National Technical Information Ser-
vice, PB 229-816, 1974, p. 79.
Figure 5. Locations of paperstock dealer and broker concentrations
and major paperstock users.
-------
(Tl
IESTERN TRUNK
MOUm'AIN-PACIFI
1/8" width represents 500
ton interregional movement
Source: Resource Planni-n^s Institute. Raw
Materials Transportation Costs and Their
Influence on the Use of WasteHa^er and
n 1/8" diameter represents 1,000
ton intraregional movement
Scrap Iron and Steel^ vol. 1. Springfield,
Va.: National Technical Information Ser-
vice, PB 229-816, p. 91.
Figure 6. Interregional and intraregional rail movements
of wastepaper - 1969.
-------
to
ESTEKH TRUNK LINE —
U
"evswT"——•r
ro i OFFICIALO
COLORADO JQ
I MOUNTAIN-P/JCIFIC
Iron and steel scrap dealer and
broker concentration (6 or more per
Electric furnaces
Source: Resource Planning Institute, Raw,
Materials Transportation Costs and Their
Influence on the Use of Wastepaper and
Scrap Iron and Steel, vol. 1. Springfield,
Va.: National Technical Information Ser-
vice, PB 229-816, 1974, p. 43.
Figure 7. Locations of iron and steel scrap dealers and
broker concentrations and electric steel-making furnaces.
-------
U)
en
ESTERN TRUNK UrNE_ Q--
OWA
O iron and steel scrap dealer & i j**+*
broker concentrations (6 or more pe\v,cyty}V
A Open hearth or basic oxygen steel- \ J
making furnaces 'V $
V Integrated blast and open hearth or basic \ «
oxygen steel-making furnaces \ l\
***V»Jl
Source: Resource Planning Institute,
Raw Materials Transportation Costs and
Their Influence on the Use of Wastepaper
and Scrap Iron and Steel, vol. 1. Spring-
field, Va.: National Technical Information
Service, PB 229-816, 1974, p. 42.
Figure 8. Locations of iron and steel scrap dealers and broker concentrations,
open hearth or basic oxygen steel-making furnaces and integrated blast
and open hearth or basic oxygen steel-making furnaces.
-------
UJ
[^psas^
WESTERN TRUNK LINE
1/8" width represents 500
ton interregional movement
1/8" diameter represents 10,000
ton intraregional movement
er and
Scrap Iron and Steel, vol. 1. Springfield,
Va.: National Technical Information Ser-
vice, PB 229-816, 1974, p. 61.
Figure 9. Interregional and intraregional rail movements
of scrap iron and steel - 1969.
-------
scrap and wastepaper are held for only short periods of time.*
Furthermore, because the shipping certificate calls for delivery
from current production, the present shortage of adequate stor-
age facilities for delivery of scrap from inventory would not
pose a significant problem.
It might be useful at this point to give two examples of
when and how delivery might take place on a scrap futures con-
tract, in order to illustrate some of the concepts discussed in
this section.
(A) A Pittsburgh-based steel mill buys a July ferrous scrap
futures contract calling for delivery in Pittsburgh at $55 a
ton. At the end of May, the steel mill consults the cash market
and finds that the current available cash price for that grade
of scrap is $52 a ton plus freight from Youngstown at $9.50 a
ton. Since the total cost of purchasing the scrap on the cash
market is $61.50 a ton, the buyer would stand for delivery under
the terms of the futures contract. At this point, the seller of
that contract would issue, through the clearinghouse, a shipping
certificate to the buyer giving him title to the scrap and ask-
ing the buyer to specify a delivery point. If, however, the
cash price for the scrap had been $45 a ton, the steel mill
would have bought in the cash market and sold the futures con-
tract at the going price of $56.
(B) A steel mill in the Youngstown area is faced with the
same price and availability situation described in (A). It can
elect to take delivery on the futures market at $55 a ton plus
freight to Youngstown or to take delivery in the cash market at
$52 a ton. It would clearly be more profitable for the mill to
sell the futures contract and to buy in the cash market.
These examples should adequately emphasize the importance
of sufficient numbers of suppliers and buyers in the base point
marketing city as a means of insuring that some deliveries in
satisfaction of futures contracts can, in fact, take place.
Unless there are enormous price differentials between the base
point city and other consumption centers, buyers in the non-
base point markets will never use the futures markets as de-
livery mechanisms, but only as hedging markets.
If, after a trial period, the futures market is biased
relative to the cash markeL because of insufficient threat of
*It has been suggested that the use of a warehouse receipt might
help develop an inventory holding system for wastepaper and fer-
rous scrap that would act as a buffer to large price swings.
Although perhaps conceptually appealing, institution of such a
system may lack industry support, since large inventory holdings
are not a part of their normal business operations.
40
-------
delivery, it would be possible to specify non-par delivery
points in the contract. If, for example, it were found that a
wastepaper contract based on New York delivery was too limited
in scope, it might be possible to use another major marketing
point (e.g., Chicago) as a non-par point. In that case,
deliveries on the market could be made to both Chicago and New
York, although the contract price would still be in terms of
delivery to the par location. Prices at non-par points would
be calculated by discounting the contract price by an amount
reflecting the difference in delivery and marketing costs be-
tween the par and non-par points.
In order for a contract allowing delivery at non-par points
to be an effective hedging device for traders in the non-par
markets, a stable and predictable relationship must exist be-
tween the cash price in the non-par market and the futures
price in the par delivery market. This stability will not be
possible if the markets for a particular commodity are distinct,
with different factors affecting prices in each area.
The cash prices for ferrous scrap are highly correlated
among U.S. cities (see Appendix C), with the exception of San
Francisco. This high degree of correlation is not surprising,
since demand for scrap is tied to demand for steel products
in general, which in turn is tied to business cycle swings in
the overall economy.
The cash prices for selected grades of wastepaper are not
as closely correlated among different cities as are those for
ferrous scrap. Although the price correlations for a single
grade of wastepaper among different cities are rather high
(except between the west coast and the other cities), the cor-
relation between grades by city are somewhat low.*
One last point concerning non-par delivery points should
be made. The existence of alternative delivery points creates
uncertainty for the buyer, since the point from which or to
which delivery will be made is at the seller's discretion.
Thus, the buyer is at a disadvantage. This will generally
result in a distortion of the cash price relative to the future
price. This is not necessarily bad, if this distortion is
*The low correlations for the wastepaper prices are, in part,
due to the manner in which the data is reported. The prices
are not continuous, but instead are discrete in the sense that
prices tend to move from one level to another in jumps rather
than in smooth gradation. This suggests that the prices used
here are probably not true market prices.
41
-------
known with some certainty and can be accurately predicted.*
Inspection of commodities to be delivered on a futures con-
tract is done either by the government or by private agencies
overseen by the exchange clearinghouse. Typically, an exchange
will attempt to follow accepted industry practices as closely
as possible in designing the inspection terms for the contract.
Inspection procedures vary widely depending on the com-
modity in question. There is no formal inspection of certain
commodities, such as metals. Instead, the exchange relies
upon the integrity and guarantees of the refiner. For plywood,
certified Western Plywood Association (WPA) graders conduct
inspections at the loading point, using WPA-established stan-
dards. When government standards exist, they are generally
used by an exchange in designing the contract, and the govern-
ment usually takes responsibility for inspection.
In the ferrous scrap and wastepaper industries, no formal
inspection by an independent source is conducted. Instead,
the buyer generally has the right to inspect and grade all
purchases. This is called the "right of rejection." After
making delivery, the seller has the option of accepting the
decision of the buyer or shipping the delivery back.
At least for ferrous scrap, the extensiveness of the
inspection procedures varies according to the grade of scrap
supposedly being delivered. The higher the grade, the less
inspection. All deliveries are visually inspected. For waste-
paper, only a visual inspection is normally conducted. In
both cases, the buyer relies on the past performance of the
seller in determining how far to carry the inspection proce-
dures.
When it formulates inspection procedures for scrap
futures contracts, an exchange must make certain these proce-
dures are fair and do not favor one side of the market at the
expense of the other. Otherwise, the side against which the
procedures are biased will not participate in the market. A
possible means of ensuring fairness might be to have those
sellers who are regular for delivery submit to random inspec-
tions by a private agency hired by the exchange. The type
and extent of the inspection procedure used should depend
on the contract grade chosen.
*For example, since deliveries on the copper contract traded in
New York can be made from any of five or six exchange ware-
houses, the futures price is always quoted at a discount rela-
tive to the cash price of copper. Traders know with great cer-
tainty what this discount will be and take it into consideration,
42
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INDUSTRY CONCEPTIONS CONCERNING FUTURES MARKETS
Most of the major objections to a scrap futures market
that have been raised by industry members have already been
indirectly discussed in this report. Many of these objections
reflect a misunderstanding of futures markets and their opera-
tion. Just over a year ago, a scrap industry executive outlined
what he viewed as the principal problems with a futures contract
in ferrous scrap.* Because they mirror what have been found
(through correspondence with industry members) to be the general
industry concerns regarding both ferrous scrap and wastepaper
futures contracts, they will be discussed here.
(A) "There must be a standard product." The issue of
contract homogeneity was explored earlier in this section, and
the need to redefine contract grade specifications was dis-
cussed. This problem, however, also relates to a larger issue,
the "right of rejection." On a futures market delivery, the
buyer must accept the grade shipped on the contract. Since
the buyer has no control over the inspection procedure, it is
uncertain whether scrap buyers would be willing to use the
market. This, of course, is only a problem when the buyer
elects to take delivery on the market, and, even then, the
exchange has guaranteed the grade to be delivered by forcing
all sellers in the market who want to deliver on futures con-
tracts to submit to an investigation of their financial and
personal integrity.** In this case, the buyer should be in-
different as to the identity of the seller.
(B) "Buyers and sellers are unknown to each other." Since
all trades on a futures market are made through a clearinghouse,
the buyers and sellers are indeed unknown to each other. The
problem implied by this statement is that a futures market in
scrap would end the standard system of contracting, which re-
lies heavily on the past performance of scrap sellers. As
noted in (A), this would not only be the case if a buyer
decided to take delivery, and should not be a problem if the
exchange guarantees the delivery.
Both (A) and (B), above, indicate that scrap buyers and
sellers erroneously perceive futures markets as delivery
* From a speech by Ralph Michaels at the Ferrous Division Meet-
ing of BIR, Vienna, Austria, reprinted in Recycling Today, Dec,
1975.
**When disputes arise concerning prices, trades, quantities,
etc., exchange rules allow for arbitration without recourse
to courts of law except on constitutional or violation of
charter by-law grounds [22, p. 17].
43
-------
markets and feel that a futures market will force them to alter
their normal methods of operation.
(C) "There must be established delivery points." Some
specific methods of dealing with this issue were described
earlier in this chapter.
(D) There is apprehension that the additional speculators
attracted to a futures market would somehow downgrade the
integrity of the market, and thus result in price destabiliza-
tion. Furthermore, there is a general feeling that profes-
sional speculators will enter the market and rob industry
members of their own speculative profits. Section 4 reviewed
the role of the speculator in a well functioning futures
market. As to the last point, a futures market would formalize
the speculative activities already taking place in the scrap
industry. If traders are well informed, they will have the
opportunity to generate profits on futures trading as well as
on cash market transactions.*
SUMMARY AND CONCLUSIONS
This chapter has pointed out several aspects of the fer-
rous scrap and wastepaper markets that need to be considered
in designing a futures contract in either commodity. The lack
of a standard pricing and inspection procedure, the lack of a
central marketing place, and the fears and/or misconceptions
of industry members concerning futures markets must be over-
come if futures contracts in those commodities are to be suc-
cessful.
A futures market in ferrous scrap or wastepaper is tech-
nically feasible. With one exception, none of the issues
raised here are insurmountable. The exception is the lack of
correlation among the prices of different grades of wastepaper.
Before any conclusion can be reached concerning the effective-
ness of a wastepaper contract, a detailed analysis of the rela-
tionship between wastepaper prices must be conducted.
The next chapter considers the possible impacts of a
hypothetical scrap futures contract on the markets for ferrous
scrap and wastepaper.
*0f course, a futures market would increase the competition for
speculative profits. Some who gained without a futures market
would lose with a futures market.
44
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SECTION 6
IMPACTS OF FUTURES TRADING
ON MARKETS FOR SECONDARY MATERIALS
The impacts of a futures contract in a particular secondary
material can be projected only to the extent that the reactions
or responses of users of the contract are known. In a broad
theoretical context, it is possible to consider how profit-
maximizing behavior on the part of scrap dealers and scrap
consumers would be affected by the availability of a scrap
futures contract.
In addition to the use of theoretical predictions, insight
into the actual impacts of futures trading can be gained through
an analysis of historical data. Although restricted to com-
modities other than scrap, historical data do provide a basis
for making inferences as to the effect of futures trading on
market supply and demand curves. Section 4 and Appendix E
discuss some of the empirical work in this area and contain,
as well, an econometric analysis of the impact of futures
trading on plywood supply response.
This section of the report is devoted to a theoretical
discussion of the effect of futures trading on buyers and
sellers of secondary materials. The class of affected indivi-
duals and organizations can be divided into two groups:
(1) participants in futures trading; and (2) nonparticipants.
The first group includes scrap dealers and scrap-consuming
mills, who would use a futures market to hedge their actual
or planned market positions, and speculators, who would use a
futures market for potential financial gain. The second
group, or nonparticipants directly affected by a futures
market, are those dealers and user mills who base inventory
and production decisions at least in part on published futures
market prices.
PARTICIPANTS
As noted in Section 4, dealers and consumers of secondary
materials could use a futures market to hedge their actual or
anticipated cash positions in scrap. A futures market enables
both buyers and sellers to hedge their present and future cash
positions, and to thus remove that element of business risk
45
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associated with uncertain prices for the product. In effect,
hedging in a futures market, when such a market exists, is
consistent with sound business practice.
Hedging would increase producer and consumer income sta-
bility and result in improved access to capital for dealers
and users. Scrap dealers, in particular, would be viewed as
better credit risks by banks and other lenders. Both the terms
of credit and the absolute amounts of credit extended should,
therefore, be more favorable to the scrap dealer. In a similar
vein, smaller user mills should find their terms of credit on
capital markets to be improved. As a general rule, stable in-
come histories enable bonds to be floated at a lower interest
rate. Likewise, the stock market would demand a lower average
return for firms with stable earnings and dividend histories.
In sum, lending institutions and financial markets demand a
premium for risk, and if this risk can be reduced through
hedging on a futures market, a potential borrower can expect
to receive new capital on more favorable terms.
Hedging may be of additional use to scrap-consuming mills.
Although unpredictable input costs have a significant impact on
net income at many mills, a more pressing concern at other
mills is, at times, the physical availability of certain grades
of scrap in the quantities required to maintain the desired
level of operations. Hedging against future scrap needs can
reduce quantity/availability uncertainties as well as price
risks.
In the longer run, the risk management role of hedging on
futures markets, by both dealers and user mills, should have an
indirect impact on their level of investment in plant and
equipment. The theoretical literature on investment under
uncertainty is clear. Uncertainty reduces the level of invest-
ment; as a corollary, a reduction in the level of uncertainty
in an industry should, in general, result in an increase in
the level of investment. In terms of the secondary materials
markets, a scrap futures market might reduce the incentive to
rely on primary inputs.
NONPARTICIPANTS
Organized futures trading affects sellers and buyers even
when they do not directly participate in the futures market.
One of the principal functions of a futures market is its for-
ward pricing role. The forward or futures prices are published
daily in many major newspapers and are therefore readily
available to nonparticipants as well as futures market partici-
pants. The forward prices represent unbiased estimates of the
prices that will prevail at the future dates.
Nonparticipants in futures trading may or may not base
46
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their price expectations on the published futures prices, but
the ready availability of the published prices does indicate
that they will be used fairly extensively. To the extent these
prices are used in forming dealer and user price expectations,
they will affect inventory decisions, production plans, and
short-run investments.*
CONCLUSIONS
Futures trading in scrap could result in (1) greater re-
liance on secondary materials as inputs to production processes;
(2) improved credit terms for firms that use the futures market
for hedging purposes; and (3) an increased level of investment
in scrap processing, both by the dealer and by the user mill.
If organized futures trading in scrap is instituted, the
supply of scrap from dealers is likely to shift outward and
become more elastic. Likewise, the demand for scrap by user
mills could shift outward and become more elastic. The actual
changes may be small but the expected direction of change is
unquestionable. The net effect on scrap markets would be
greater price stability and an increase in the quantity of
scrap recovered and reused.**
* To substantiate the above-mentioned hypothetical uses of
futures markets by scrap industry members, an informal tele-
phone survey was conducted in wich a number of copper scrap
dealers/processors were interviewed as to their use of and
participation in the copper futures markets. The results
of these interviews are presented in Appendix F.
**See Section 3.
47
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SECTION 7
PRIVATE AND SOCIAL RETURNS FROM
LISTING A NEW COMMODITY FOR FUTURES TRADING
This section examines the resource allocation question
faced by a private commodity exchange in deciding whether to
list a commodity for futures trading. The question is, does
the market mechanism that influences an exchange's decision
provide the proper signals so that the socially optimal number
of commodities will be listed? This is important not only
for scrap futures, but also for other commodities for which
there is no active futures market at present.
The basic market mechanism affecting an exchange's de-
cision is that of competition. No single exchange has monopoly
power; they must compete with each ether for the commodities
to be listed. Their decision as to whether to list a contract
is based on assessment of the anticipated revenues and expenses
of such a listing.
Exchanges have several sources of revenue. Generally, the
three most important are (1) interest on clearing funds; (2)
fees; and (3) investments. All commission houses are required
to deposit, in exchange accounts, a portion of the margin re-
quirements posted by the customers of the houses. The exchange
returns the funds when an account is cleared, but retains the
accrued interest. During periods of high interest rates, the
interest paid on clearing funds may represent the largest
single source of income to the exchange. In addition, an ex-
change will charge set fees—either clearing fees, which are
generally a small percent of the commission fees paid by the
commission house's members, or service fees, a per traded
contract charge. Many exchanges also obtain revenue from real
estate holdings and other investments. Annual dues paid by
exchange members for the privilege of trading on the exchange
are a fourth source of income. Normally, dues contribute an
insignificant amount of revenue to the exchange.
The costs of listing a contract for futures trading are:*
*The costs and benefits of futures trading, as distinct from the
costs and benefits of listing a commodity for futures trading,
is the subject of some recent interest. See [45].
48
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(1) costs of research involved in developing the futures con-
tract; (2) costs of promoting futures trading in the relevant
commodity (e.g., informing potential buyers and sellers as to
the nature of the process and the advantages to be gained); and
(3) indirect costs associated with the risk of losing prestige
and trader confidence should the contract fail. Once trading
has been initiated, there are (4) the costs of storage, theft
prevention, registration, assaying and inspection, as well as
the normal operating expenses.
Because of the importance of the first two revenue
sources, exchanges are extremely interested in increasing
trading volume on their floors and in initiating new contracts
that will attract substantial trading interest. Since it is
in an exchange's interest to initiate new contracts, it may
be asked whether the private, exchange benefits are less than
the social benefits, thereby inducing an exchange to initiate
fewer than the optimal number of futures contracts.
The following discussion will argue that this is the case,
and that there is indeed an economic justification for govern-
ment involvement in the research and initiation of futures
contracts.
PUBLIC GOOD ASPECT OF FUTURES TRADING
The public good aspect of market information constitutes
one important rationale for governmental support of the com-
modity exchanges' functions. It means, in essence, that the
revenues earned by the exchange may not be related to the
benefits provided to society and that an exchange may receive
the wrong signals from the marketplace.
An exchange is able to recoup part of the value of the
futures trading through commissions paid by traders. However,
the market information contained in the futures prices can be
used by anyone without trading, and an exchange will not be
compensated for its full value. In this sense, futures trading
generates a public good. The costs of excluding a potential
user from the futures prices are prohibitive, and one indivi-
dual's use of the information does not impair the usefulness
for another. In other words, the opportunity cost to an ex-
change of extending utilization to another person is zero,
or at least close to it.
The theory of public good demonstrates that when the
private sector does not receive the appropriate demand signals
for an efficient production level, less than the socially op-
timal amount of the good will be produced. The proper role
for the public section is to "aggregate consumers' demand for
these goods and express it to the private sector" [39, p. 95].
In terms of futures markets, this means that the "publicness"
49
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or "semi-publicness" of the market information produced through
futures trading may result in exchanges researching and initiat-
ing for futures trading less than, the socially optimal number
of commodities. Only governmental intervention in the market
can provide the necessary signals to an exchange to induce the
optimal production of futures contracts.
The government has already set a precedent of public in-
volvement in commodity exchange procedures by such actions as
government inspection of some agricultural commodities, spon-
sorship of research on the characteristics of certain futures
markets, and futures trading feasibility studies. The comments
made here suggest an extension of the current government role.
EXTENT OF GOVERNMENT PARTICIPATION
Economic theory provides the general criteria for deter-
mining the proper level of public investment in supporting
futures trading of selected commodities; marginal social costs
should be equated to marginal social benefits.
The social costs are relatively easy to delineate. These
include the costs borne by the exchange, as discussed above,
as well as any costs incurred by the government in researching,
promoting, or actively participating in the futures market.
Some critics of futures trading in ferrous scrap have argued
that the costs of inspecting scrap to be delivered on a futures
contract would be so high as to preclude trading. Telephone
conversations with scrap buyers indicate that inspection costs
for a ton of ferrous scrap range roughly from $1.50 to $2.00
per ton, depending on the grade and type of inspection. Assum-
ing a contract size of 40 tons, this translates into a total
inspection bill of $60 to $80 per contract. Even if these
figures are underestimated, they would compare favorably with
the typical inspection charges for existing contracts traded
on commodity exchanges. For example, inspection charges paid
by the seller on the New York Mercantile Exchange range from
$20 per contract for potatoes to $150 per contract for platinum.
Measurement of the benefits is more elusive. What is the
value of the benefits that will accrue to society due to the
ability of scrap industry members to hedge against price un-
certainty? What is the value to consumers, or to society, of
better information, in the sense of more informed futures
prices? Last, what is the value of a more efficient allocation
of resources between secondary and primary materials?*
Given that a quantitative comparison of costs and benefits
*A recent study by the Environmental Law Institute, funded by
the U.S. EPA, sheds some light on this issue. See [4],
50
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from government participation in the research, initiation, and
continuing support of futures trading in a particular commodity
is likely to produce incomplete results because of the relative
difficulty of measuring benefits, some sort of ad hoc quasi-
political assessment is necessary. Three broad levels of gov-
ernment involvement in futures trading in scrap materials have
been identified. Each one requires financial support from the
government.
First, the government could become closely involved with
the research and initiation phases of futures trading. It has
already accepted part of this role by financing this study.
Additional participation might require sponsorship of industry
seminars to educate potential users of the usefulness of a
scrap futures contract, or provision of its technical and legal
expertise to the exchange to aid in preparation of the actual
contract. Second, the government may decide to accept as its
responsibility certain aspects of regulating trading in the
market, such as acting as commodity inspector. Third, in the
event of lack of trading interest, it has been suggested that
the government could actively enter the market as a participant
to bolster trading volume or grant subsidies to an exchange to
insure continued listing of the contract.*
Because of the high potential benefits from a scrap fu-
tures contract, there appears to be ample justification for
the government to accept a role that encompasses the first two
involvement levels. Much of the education role can be conducted
through established frameworks, such as the Scrap Advisory Com-
mittee. In addition, there is a precedent of government in-
volvement in inspection routines and regulatory oversight.
Furthermore, if a contract is designed that appeals to industry
members, there would be no need for the government to worry
about assuring sufficient trading volume. If sufficient trading
were not generated in a scrap futures contract after a certain
period of time (many contracts have taken a year or more to
become established), the desirability of direct governmental
participation in the market should be reexamined.
*Such a governmental role has been suggested by McKinnon and
others, but only in terms of acting as a buyer of distant con-
tracts [31]. It is, basically, the competitive nature of fu-
tures markets that generates the benefits from futures trading
mentioned earlier in this paper and, in this sense, direct gov-
ernment participation in futures trading is usually considered
to be "inimical to futures trading" [18, p. 100].
51
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APPENDICES
APPENDIX A. PREDICTION OF SECONDARY AND PRIMARY MATERIALS PRICES
In order to test the hypothesis that secondary materials
prices are less predictable than primary materials prices, it
was necessary to develop a forecasting model that, when applied
to the price series for primary and secondary materials, could
generate predictions for those prices.
One simple method of forecasting future values of the
prices is to postulate a linear auto-regressive relationship
between past prices and current price of the general form:
(1) ..... Xt - Yl*t-I + /2Xt-2 + • • • + ^Pxt-p +&0 + Ut
Equation (1) shows the current price of the commodity, X^, as a
function of past prices lagged to period p, where p£. t. To
simplify estimation procedures, it was assumed that the current
price was a function of price in the preceding period, or:
(2) ..... Xt = yix- + + U
t
Once the parameters have been estimated, equation (2) can be
used to forecast future values of price, since:
(3) .....
For example, if equation (2) is estimated with monthly data up
to December 1975, the value for X in January 1976 can be pre-
dicted by substituting the value of X in December 1975 into
equation (3) .
A /
(4) ..... xJan. 1976 -/lxDec. 1975 +#o
Equations for pig iron, ferrous scrap (all grades) , No. 1
Heavy Melting, woodpulp, wastepaper (all grades) , and Old
Corrugated Boxes were estimated by ordinary least squares using
monthly wholesale price indices for the years 1963-75.* The
*0rdinary least squares is by no means the only estimation tech-
nique that could have been used. For a complete description of
time series nodels and their estimation, see C. R. Nelson, Ap-
plied Time Series Analysis (San Francisco: Holden-Day, Inc.,
1973).
61
-------
estimated coefficients appear in Table A-l. Using the estimated
equations, forecasts of prices for each of the first four months
in 1976 were generated for each commodity series.
To compare the relative predictive power of the data, the
predicted values for price in 1976 were compared to the actual
values using a statistical parameter called Theil's U-measure.
Theil's U-values are calculated by the formula:
-Xt)2
U = '
xt*)
where: X*^ = the predicted value of X in period t
X^ = the actual value of X in period t
A U-value of 0 indicates perfect explanation of the data series
by the model; a value of 1 indicates no explanatory power. The
Theil U-measures for the primary and secondary commodities are
reported in Table A-2.
The results were as expected. The best predictions came
from the primary materials, while the worst were for the parti-
cular grades of secondary products. The U-values for No. 1
Heavy Melting and Old Corrugated Boxes are over five times as
great as for the primary materials. The validity of these con-
clusions is at least partly dependent on the accuracy of the
TABLE A-l. ESTIMATED PRICE FORECASTING EQUATIONS FOR
PRIMARY AND SECONDARY MATERIALS (JANUARY 1963 TO DECEMBER 1975)
Pricey
Pig iron
Ferrous scrap
No. 1 heavy melting
Woodpulp
Wastepaper
Old corregated boxes
C
-20.69
40.69
5.09
-14.36
32.23
36.89
Pricey
1.02
0.98
0.97
1.02
0.98
0.97
R2
0.99
0.95
.94
.99
.96
.95
62
-------
reported prices that were used. Because of the largely verti-
cally integrated nature of the paper and steel industries,
prices for the primary materials tend to be administered prices
and, as such, may not reflect actual demand and supply condi-
tions. Consequently, the results obtained may overstate the
predictability of primary prices, due to inaccuracies in the
reporting of woodpulp and pig iron prices. On the other hand,
scrap prices that are not under the mills' control are probably
much more accurate because they are sensitive to changing market
conditions.
TABLE A-2. THEIL'S U-VALUES FOR
PRIMARY AND SECONDARY PRICE PREDICTIONS
Commodity U-Value
Pig iron 0.029
Ferrous scrap (all grades) 0.120
No. 1 heavy melting 0.152
Woodpulp 0.016
Wastepaper (all grades) 0.095
Old corrugated boxes 0.179
APPENDIX B. CORRELATION ANALYSIS OF WASTEPAPER AND FERROUS
SCRAP BY GRADE
Tables B-l and B-2 are the correlation matrices of the
monthly wholesale price indices for six different grades of
wastepaper and four different grades of ferrous scrap. Un-
deflated data for the years 1964-1975 were used. A value of
1 indicates complete or perfect correlation; a value of 0
indicates no correlation.
63
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TABLE B-l. CORRELATION MATRIX OF WASTEPAPER PRICES BY GRADE
Item*
SCKC
N1NW
N1M
WNB
0CC
MKC
*Abbreviations :
SCKC
1.00
.71
.77
.85
.88
.56
: SCKC -
N1NW -
N1M -
WNB -
0CC -
MKC -
TABLE B-2. CORRELATION
Item*
N1HM
N2HM
NIB
N2B
*Abbreviations :
N1HM
1.00
.99
.99
.98
: N1HM -
N2HM -
NIB -
N2B -
N1NW N1M WNB 0CC
.71 .77 .85 .88
1.00 .90 .77 .76
.90 1.00 .75 .90
.77 .75 1.00 .76
.76 .90 .76 1.00
.41 .45 .48 .52
Semi-chemical kraft clippings
Number 1 newsprint
Number 1 mixed
White news blanks
Old corrugated containers
Mixed kraft clippings
MATRIX OF FERROUS SCRAP PRICES
N2HM NIB
.99 .99
1.00 .98
.98 1.00
.98 .97
Number 1 heavy melting
Number 2 heavy melting
Number 1 bundles
Number 2 bundles
MKC
.56
.41
.45
.48
.52
1.00
BY GRADE
N2B
.98
.98
.97
1.00
APPENDIX C. CORRELATION ANALYSIS OF WASTEPAPER AND FERROUS
SCRAP PRICES BY GRADE AND BY CITY
Table C-l is the correlation matrix of the monthly whole-
sale price indices for ferrous scrap grades by city. Tables
C-2, C-3, C-4, and C-5 are the correlation matrices for selected
grades of wastepaper by city. The ferrous scrap matrix is
based on undeflated data for the years 1964-1975 as published
64
-------
Item*
N1HMB
N1HMC
N1HMP
N1HMPI
N1HMS
N2HMB
N2HMC
N2HMP
N2HMPI
N1BB
N1BC
N1BP
NlBPI
NIBS
N2BB
in Wholesale
TABLE
FERROUS
N2HMPI
.95
.98
.97
.98
.92
.96
.96
.97
1.00
.95
.97
.95
.97
.92
.96
Prices
C-l.
SCRAP
N1BB
.98
.96
.98
.96
.93
.95
.95
.96
.95
1.00
.97
.97
.97
.95
.94
CORRELATION MATRIX OF
PRICES BY GRADE BY CITY
N1BC
.97
.99
.98
.98
.93
.95
.98
.97
.97
.97
1.00
.97
.98
.95
.94
N1BP
.96
.97
.98
.97
.94
.94
.96
.98
.95
.97
.97
1.00
.97
.95
.95
and Price Indices,
NlBPI
.96
.98
.98
.99
.93
.94
.97
.97
.97
.97
.98
.97
1.00
.94
.94
Bureau of
NIBS
.95
.94
.96
.93
.98
.93
.93
.94
.92
.95
.95
.95
.94
1.00
.93
Labor
N2BB
.96
.95
.96
.96
.93
.96
.93
.96
.96
.94
.94
.95
.94
.93
1.00
Statis-
tics. The wastepaper matrices were based on undeflated prices
as published in Fibre Market News; the years 1973-1977 were
used.*
*The monthly prices used in the correlation analysis for waste-
paper are averages of the prices quoted in the Friday editions
of Fibre Market News. Since the prices are quoted as ranges,
the midpoint in the range was used.
65
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TABLE C-l (CONTINUED). CORRELATION MATRIX
FERROUS SCRAP PRICES BY GRADE BY CITY
OF
Item*
N1HMB
N1HMC
N1HMP
N1HMPI
N1HMS
N2HMB
N2HMC
N2HMP
N2HMPI
N1BB
N1BC
N1BP
NlBPI
NIBS
N2BB
N1HMB
1.00
.97
.97
.96
.94
.97
.95
.96
.95
.98
.97
.96
.96
.95
.96
N1HMC
.97
1.00
.98
.98
.94
.96
.98
.97
.98
.96
.99
.97
.98
.94
.95
NlHMP
.97
.98
1.00
.98
.95
.95
.97
.99
.97
.98
.98
.98
.98
.96
.96
NlHMP I
.96
.98
.98
1.00
.93
.96
.97
.98
.98
.96
.98
.97
.99
.93
.96
N1HMS
.94
.94
.95
.93
1.00
.92
.93
.95
.92
.93
.93
.94
.93
.98
.93
N2HMB
.97
.96
.95
.96
.92
1.00
.95
.96
.96
.95
.95
.94
.94
.93
.96
N2HMC
.95
.98
.97
.97
.93
.95
1.00
.96
.96
.95
.98
.96
.97
.93
.93
N2HMP
.96
.97
.99
.98
.95
.96
.96
1.00
.97
.96
.97
.98
.97
.94
.96
*Abbreviations:
NlHMB - Number 1 heavy melting, Birmingham
N1HMC - Number 1 heavy melting, Chicago
NlHMP - Number 1 heavy melting, Philadelphia
NlHMPI - Number 1 heavy melting, Pittsburgh
NlHMS - Number 1 heavy melting, San Francisco
N2HMB - Number 2 heavy melting, Birmingham
N2HMC - Number 2 heavy melting, Chicago
N2HMP - Number 2 heavy melting, Philadelphia
N2HMPI - Number 2 heavy melting, Pittsburgh
NlBB - Number 1 bundles, Birmingham
NlBC - Number 1 bundles, Chicago
NlBP - Number 1 bundles, Philadelphia
NlBPI - Number 1 bundles, Pittsburgh
NIBS - Number 1 bundles, San Francisco
(abbreviations continued on next page)
66
-------
*Abbreviations (continued):
N2BB - Number 2 bundles, Birmingham
N2BC - Number 2 bundles, Chicago
N2BP - Number 2 bundles, Philadelphia
N2BPI - Number 2 bundles, Pittsburgh
N2BS - Number 2 bundles, San Francisco
TABLE C-2. CORRELATION MATRIX OF
WASTEPAPER PRICES BY GRADE FOR NEW YORK AND CHICAGO
Item*
HWEC
FNC
MPC
OCBC
WLSC
HWEN
FNN
MPN
OCBN
WLSN
.99
.70
.42
.64
.94
.78
.97
.54
.80
.85
.37
.58
.96
.82
.44
.79
.84
.75
.96
.86
.97
.72
.45
.68
.95
*Abbreviations:
HWEC - Hard white envelope cuttings, Chicago
HWEN - Hard white envelope cuttings, New York
FNC - Folded news, Chicago
FNN - Folded news, New York
MPC - Number 1 mixed paper, Chicago
MPN - Number 1 mixed paper, New York
OCBC - Old corrugated boxes, Chicago
OCBN - Old corrugated boxes, New York
WLSC - White ledger stock, Chicago
WLSN - White ledger stock, New York
67
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TABLE C-3. CORRELATION MATRIX OF PRICES FOR
HARD WHITE ENVELOPE CUTTINGS BY CITY
Item*
HWEC
HWEN
HWEPA
HWEP
HWEPI
HWEC HWEN HWEPA HWEP
1.00
.99 1.00
.77 .77 1
.99 .99
.97 .98
.00
.79 1.00
.81 .98
HWEPI
1.00
*Abbreviations :
HWEC -
HWEN -
HWEPA -
HWEP -
HWEPI -
Hard white envelope cuttings
Hard white envelope cuttings
Hard white envelope cuttings
Hard white envelope cuttings
Hard white envelope cuttings
TABLE C-4. CORRELATION
, Chicago
, New York
, Pacific
, Philadelphia
, Pittsburgh
MATRIX OF
PRICES FOR OLD CORRUGATED BOXES BY CITY
Item*
OCBC
OCBN
OCBB
OCBPA
OCBP
OCBPI
OCBC OCBN OCBB OCBPA OCBP
1.00
.96 1.00
.97 .93 1.00
.73 .59 .78
.92 .97 .88
.96 .96 .91
1.00
.39 1.00
.52 .95
OCBPI
1.00
*Abbreviations:
OCBC - Old corrugated boxes, Chicago
OCBN - Old corrugated boxes, New York
OCBB - Old corrugated boxes, Boston
OCBPA - Old corrugated boxes, Pacific
OCBP - Old corrugated boxes, Philadelphia
OCBPI - Old corrugated boxes, Pittsburgh
68
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TABLE C-5. CORRELATION MATRIX OF WASTEPAPER PRICES
BY GRADE WITHIN NEW YORK AND CHICAGO
Item*
HWEC
WLSC
OCBC
FNC
MPC
Item*
HWEN
WLSN
FNN
OCBN
MPN
HWEC
1.00
.98
.77
.70
.50
HWEN
1.00
.96
.72
.45
.41
WLSC
1.00
.81
.79
.52
WLSN
1.00
.83
.67
.48
OCBC FNC
1.00
.91 1.00
.79 .59
FNN OCBN
1.00
.77 1.00
.56 .84
MPC
1.00
MPN
1.00
*Abbreviations:
HWEC - Hard white envelope cuttings, Chicago
WLSC - White ledger stock, Chicago
OCBC - Old corrugated boxes, Chicago
FNC - Folded news, Chicago
MPC - Number 1 mixed paper, Chicago
HWEN - Hard white envelope cuttings, New York
WLSN - White ledger stock, New York
FNN - Folded news, New York
OCBN - Old corrugated boxes, New York
MPN - Number 1 mixed paper, New York
APPENDIX D. THE 1954 SCRAP IRON AND STEEL FUTURES CONTRACT
A futures contract in secondary materials is not without
precedent. In 1954, a futures contract in scrap iron and steel
was introduced on the Chicago Mercantile Exchange. The contract
called for delivery of a 40-ton car of No. 1 Heavy Melting
steel, with No. 2 Heavy Melting also deliverable on the contract
at a set discount of $5 per ton. Delivery months were January,
April, July, and October.
69
-------
The contract was a dismal failure. Only 275 contracts
were traded before the contract was closed out one year later.
The trading volume represented only one-fortieth of one percent
of all the ferrous scrap traded in the United States that year.
Although the precise circumstances surrounding the scrap
contract failure are not fully known, a few reasons for the
contract's failure seem obvious. Both buyers and sellers were
opposed to the contract as it was written. The contract pro-
vided for inspection of the commodity by a private firm even
though scrap buyers were accustomed to inspecting their own
purchases. Many local branches of the scrap dealers' trade
association made public denouncements of the scrap contract.
Evidently, the contract was designed with very little industry
participation. Lacking hedging volume, the contract was unable
to attract the necessary speculative trading. Furthermore, it
is likely that many professional traders were not familiar with
the scrap markets. They were not able to interpret the rele-
vant demand and supply information and, therefore, were not
sure of what position to take in the market.
The 1954 contract was plagued by a grading problem, to
which a bad delivery testifies. No. 2 scrap was delivered as
the par grade to a buyer who had paid for No. 1 scrap. It
appears that the specifications were not precise enough or that
inspection enforcement was not strict enough to rule out the
possibility of another grade being delivered as the par grade.
Whether this was due to sloppy inspection or loopholes in the
specifications is unclear.
The failure of the 1954 ferrous scrap contract serves to
emphasize the importance of an exchange working closely with
industry representatives in designing a functional and accep-
table futures contract.
APPENDIX E. IMPACT OF FUTURES TRADING ON SOFTWOOD PLYWOOD
SUPPLY RESPONSE
This section represents an attempt to verify the hypothe-
sized model of the impacts of futures trading on supply re-
sponse. Softwood plywood was chosen for this analysis because
it is a rather new futures contract, initiated in late 1969,
thus insuring that sufficient pre- and post-futures trading
data could be collected (assuming it was available on a monthly
basis and covered the variables of interest).
The procedure used to test for the impact of futures
trading on plywood supply behavior is straightforward. First,
an econometric expression of the monthly supply behavior for
the softwood plywood market was developed and estimated for the
years 1965-1975. Second, the price variable was divided into
two components, one representing the price of plywood before
70
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futures trading, and one the price after futures trading. The
supply equation was reestimated using the two price variables,
and the estimated coefficients were compared to test the hypo-
thesis that supply becomes more responsive to price after the
initiation of futures trading. The following discussion out-
lines the model and the test procedure in more detail.
The Model
The supply of a commodity is typically considered to be a
function of output price, input prices, prices for competing
outputs, and the state of technology in the industry. An in-
crease in output price or in productivity would, everything
else being equal, be associated with an increase in quantity
supplied. An increase in input costs or in the price of com-
peting outputs would normally have a dampening effect on supply.
Theoretically, these are the relationships that should be used
to describe the supply of softwood plywood.
Although economic theory clearly prescribes the relevant
variables to be used in estimating the supply function for a
commodity, the ability to obtain data on these variables limits
the empirical research. This was almost certainly part of the
reason for the disappointing results obtained in the only pre-
vious econometric study of plywood supply.* McKillop took sup-
ply to be a function of the current price of plywood, the price
of veneer logs, wages in sawmills, the price of electric power,
productivity in sawmilling (a proxy for productivity in plywood
production), and a dummy variable [30]. The results, based on
annual data, were discouraging. Only three variables—the dum-
my, the price of veneer logs, and wages in sawmilling—were
significant and, of these, only the price of veneer logs had
the proper sign.
The supply equation for the model was specified on a
monthly data base. Despite the even more severe data limita-
tions imposed by using a monthly base, as opposed to an. annual
or quarterly one, it was felt necessary to use monthly data to
insure a sufficient number of observations for the period after
futures trading. The supply equation was specified as follows:**
* In his study of the plywood futures market, Story estimated a
reduced form equation to test for the impacts of futures trad-
ing. Because this equation could not be associated with either
a supply or demand equation, it is not discussed here.
**Several other functional forms (nonlinear) for the supply
equation were tested. The linear form was finally chosen as
that which provided the best fit, explained the most variance in
the dependent variable, and provided parameter estimates that
were the most reasonable in light of underlying economic theory.
71
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(1) ... QPt = a0 + ax PPt + a2 TRt + a3
where: QP = production of softwood plywood - 3/8" basis
PP = deflated wholesale price index of softwood
plywood - 1967 = 100
TR = trend variable (1 in the first month and in-
creasing by 1 each successive month)
LRIM = Almon lag on the ratio of mill inventories
to mill production
The supply of softwood plywood was characterized as a
function of the current price of plywood, a trend variable,
and the ratio of mill inventories to mill production. The
trend variable was included as a proxy for changes in pro-
ductivity and technology in the industry. This would include,
for example, the development of new technologies that have
permitted the use of different species of wood and smaller
log sizes in plywood production. The impact of mill inven-
tory levels on production is captured through the ratio
variable. In general, the larger the ratio (that is, the
larger the level of past inventories relative to past pro-
duction) , the smaller the current production level. Prices
of substitute outputs were not included, since the substitu-
tion possibilities for a plywood mill, if they existed at
all, would be extremely limited in the short run. The ex-
pected signs for the coefficient, as suggested by economic
theory, are listed in Table E-l .
TABLE E-l. EXPECTED SIGNS FOR
REGRESSION COEFFICIENTS
Supply Sign
a-L positive
a2 positive
a-s negative
72
-------
The estimated supply equation was:*
(2) ...QPt = 926.01 + 2.71 PPt + 2.98 TRt - 433.39 LRIM,._fi
(3.4) (4.0) (-1.8)
R2** = o.83 f ** = .562 RSS = 789880
All coefficients display the proper sign and were significant
at the 10 percent confidence level.
The estimated supply elasticity with respect to price was
0.25. The McKillop study derived an estimate of 0.378 for the
supply elasticity [30, p. 45]. The higher elasticity of supply
can be explained by their use of annual data.
* The supply equation was estimated using monthly data on the
years 1965-1975. The estimation procedure employed was two-
stage least squares, which implies the existence of additional
equations describing the endogenous variables which appear as
explanatory variables in the equation. Initially, two other
equations, describing demand for softwood plywood and mill in-
ventories, were estimated with the supply equation. These
equations were specified as:
(a) ... QSt = b0 + bx PPt + b2 CHWIt + b3 FRIt + b4 RESt+2
(b) ... MIt = C0 + G! QSt + C2
where: QS = quantity of softwood plywood shipped
by mills to wholesalers
CHWI = change in wholesalers' inventories
FRI = Federal Reserve Index of Industrial
Production, 1967 = 100
RES = deflated value of residential con-
struction
MI = mill inventories of softwood plywood
These were later dropped from the analysis because of incongru-
ous results and the lack of a clear theory as to the impact of
futures trading on the specified relationships. The supply
equation was corrected for serial correlation by using a first-
order correction technique.
**The t-statistics and R2 have been included as additional in-
formation, although their significance with two-stage estima-
tion is dubious, f is the value used to correct the problem
of first order autocorrelated disturbances in the initial
equation.
73
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Impact of Futures Trading
The theoretical impacts of futures trading on the cash
market were outlined in Section 4. In general, it can be ex-
pected that increased market information will lead to an in-
crease in the responsiveness of supply to price. In other
words, a given change in price would elicit a larger adjustment
in production levels during the post-1969 period (with futures
trading) than it would in the pre-1969 period (before futures
trading) .
To test this hypothesis, the plywood price variable was
divided into two components.* This involved forming two
separate variables, PI and P2, where PI is the price of plywood
for the period before futures trading and zeros thereafter,
and P2 is the price of plywood after futures trading with zeros
for the period 1965-1969. The supply equation, with PI and P2,
was then estimated on the entire data base, and the estimated
coefficients were compared to the estimates from the original
equation.** An increase in the responsiveness of supply to
price signals would be evidenced by a larger coefficient for
P2, relative to PI.
* Since plywood futures contracts were introduced in late 1969,
the before-futures-trading period was taken to 1965-1969, in-
clusive; the after-futures-trading period was 1970-1975.
**The appropriate statistic for testing the equivalence of two
coefficients is an F-statistic defined as:
RSS(Hn) - RSS(Ha) / N
F =
RSS(Ha) / T - K
where: RSS(Hn) = the residual sum of squares under
the null hypothesis
RSS(Ha) = the residual sum of squares under
the alternative hypothesis
T-K = the degree of freedom in the al-
ternative hypothesis
N = the number of restricted parameters
In the problem discussed here, the hypothesis that coefficients
of PI and P2, say d^ and d2, are the same needs to be tested.
In this case, the null hypothesis is: Hn: d^ = £2, the resi-
dual sum of squares for which is derived from equation (2). The
alternative hypothesis is: Ha: d^ ^ do. Equation (3) provides
the residual sum of squares under this hypothesis. An F-statis-
tic in excess of 3.93 indicates rejection of the null hypothesis
at the 5 percent level, and acceptance of the alternative hypo-
thesis that the two coefficients are significantly different.
74
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The estimated supply equation with the inclusion of PI and
P2 was:
(3) ... Qpt = 966.04 + 2.48 P1.+ 3.54 P2.+ 1.54 TR.
(3.0) ^ (4.4) (1.9)
- 398.15 LRIMt_g
(-1.8)
R2 = 0.84 A = 0.45 RSS = 745300
The F-statistic was calculated to be 6.89 supporting rejection
of the null hypothesis and acceptance of the alternative hypo-
thesis, at the 5 percent confidence level, that there is a sig-
nificant difference between the coefficients PI and P2. The
shift in supply response is graphically represented in Figure
E-l. Before futures trading, the supply curve is represented
by Si. The period after futures trading corresponds to a shift
to the right in the supply curve, or 82/ indicating a more re-
sponsive supply curve. As indicated by theory, the supply of
plywood became more responsive to price signals after the ini-
tiation of futures trading in plywood.*
To assume that the larger coefficient for the price of
plywood after futures trading was due to the introduction of
futures trading presupposes that the supply equation accounts
for all other changes in market structure and conditions that
might have affected the price coefficients. A review of the
plywood market from 1965-1975 identifies only one major market
trend which has not been taken into account that may have had
some long-range impact on the relationship between price and
quantity. This is the trend, at least during the period
analyzed, toward a greater share of the market being controlled
by mill-owned or -operated wholesale establishments. Between
1962 and 1971, the amount of total plywood production handled
by captive wholesalers increased from 32 percent to 50 percent
[9, p. 2]. If this change in industrial structure had any
impact on supply, it would have been to decrease the respon-
siveness of supply to price. Therefore, the shift in the
supply response that was attributed to futures trading may
understate the true impact.
*A discussion of how the supply elasticities for the pre- and
post-futures trading periods can be compared, is presented in
Appendix G.
75
-------
Price
100
75
50
25
0
966
500 1000 1500 2000
Quantity
Figure E-l. Supply response before (S]^)
and after futures trading (82).
APPENDIX F. SCRAP COPPER DEALER INTERVIEW
In an attempt to reconcile the theoretical uses of a fu-
tures market with actual experience, an informal telephone
interview of several copper scrap dealers was conducted. The
interviews concentrated on the participation of those dealers
in the New York or London copper futures markets. The possible
uses of the copper futures markets by copper scrap dealers and
consumers have been described elsewhere in the text, and the
interviews were used to obtain better information on the extent
to which the futures markets were actually used.
The sampling technique was fairly ad hoc; there was no
interest in attaching statistical significance to the responses.
Thirty-eight scrap dealers from six cities—New York, Washing-
ton, Chicago, St. Louis, Phoenix, and Los Angeles—were chosen
on a random basis for the interviews. It was felt that these
cities represented the major market regions for non-ferrous
scrap. The companies contacted were selected from the 1970
Waste Trade Directory and the yellow pages for those cities.
Each firm was asked six questions. The questions and responses
are provided in Table F-l.
Of the 38 firms, 12 said they traded in copper futures.
Most of the trading was for hedging purposes, although some
companies do use the markets for speculative purposes as well.
Generally speaking, the larger the firm, the more likely it
was to trade in futures markets; of the 12 firms that said they
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TABLE F-l. COPPER SCRAP DEALER QUESTIONS
AND RESPONSES (SEPTEMBER 1977)
1. What types of scrap metals do you handle?
15 - non-ferrous
23 - ferrous and non-ferrous
2. How would you classify the size of your operation?
19 - small (less than 15 employees)
13 - medium (more than 15 but less than 50 employees)
3 - large (more than 15 employees)
3 - confidential (would not release information)
3. Do you actively trade in the futures markets for copper,
either in New York or in London?
12 - yes
26 - no
4. If you trade in copper futures, for what purpose do you
trade?
8 - hedging
4 - hedging and speculation
5. If you do not trade in copper futures, why not?
10 - futures markets like gambling; too risky
8 - too small to trade in futures; not worth it
2 - market is too unstable; too much fluctuation in
futures markets
6 - miscellaneous; no knowledge; no demand; too crooked
6. Do you follow the futures markets in copper as a source of
future market information?
21 - yes; use futures prices as guidelines for production
and inventory decisions
12 - no; futures markets not a good indicator of future
events
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traded in copper futures markets, 67 percent were medium-sized
or larger; of the 26 dealers who did not trade, 67 percent were
small operations. The most common answers to the question "If
you do not trade in copper futures, why not?" were that futures
markets are like gambling and are too risky for the small size
of their operation. This is probably a legitimate concern for
those scrap dealers whose standard transaction is much smaller
that the size of the copper contract.
Although less than half of those interviewed actually
participate in futures trading, over 60 percent of the firms
said that they did use the futures prices generated on the
markets to guide production and inventory decisions.
Even though this interview was of an informal nature, it
does provide one valuable piece of information in defense of
the theoretical arguments on the benefits of futures trading
outlined in Section 6. That is, futures markets can confer
benefits on participants in those markets as well as non-
participants. For the participants, a futures market provides
a means of managing risk in an uncertain market environment,
and for non-participants, a futures market generates future
market information that can be used as guidelines for making
rational production, consumption, and inventory decisions.
APPENDIX G. COMPARISON OF SUPPLY ELASTICITIES
The econometric evidence on the impact of futures trading
on the supply of plywood suggested that the supply equation
for plywood took the following general form:
(1) ... Q = a + bP-L + cP2
where: Q = the quantity of plywood supplied
Pj = the price of plywood in the pre-futures
trading period
?2 = the price of plywood in the post-futures
trading period
In the analysis presented in Appendix E, coefficients b and c
were both found to be positive, with c greater in value than b.
In essence, equation (1) defines two supply curves for plywood.
The question to be resolved here is whether the elasticities of
the two curves can be compared in any meaningful way?
To demonstrate the comparison of the supply elasticity be-
fore futures trading to the elasticity after futures trading,
begin with the definition of an elasticity:
(2) ... EQ = (dQ/dP)(P/Q)
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The term (dQ/dP) for the pre-futures trading period equals b.
By substituting equation (1) into equation (2) (the term c?2
drops out since it is equal to 0 in the pre-futures trading per-
iod) and substituting b for (dQ/dP^) , the elasticity for the
pre-futures trading period becomes:
(3) ... Esp = bP1/(a + bP1)
If a is positive, the elasticity given by equation (3) is less
than one and approaches one in the limit as P^ approaches in-
finity.
The supply elasticity for the post-futures trading period
can be computed in a similar manner:
(4) ... Ega = cP2/(a + cP2)
To compare the two elasticities, Esp and Esa, set P^ equal to P2
and call this price P. Then the comparison is between:
[bP/(a + bP)] and [cP/(a + cP)]. Since c is greater than b, it
can be written as b + r, where r is a small positive constant.
By substituting the expression b + r for c the following in-
equality results:
(5) ... bP/(a + bP) < (bP + rP)/(a + bP + rP) < 1
The interpetation of equation (5) is that at any given price the
pre-futures trading supply curve has a lower elasticity than the
post-futures trading supply curve, which in turn is less than
unity.
79
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TECHNICAL REPORT DATA .
(Please read Instructions on the reverse before completing)
1. REPORT NO.
EPA-600/8-78-019
2.
4. TITLE AND SUBTITLE
An Analysis of Scrap Futures Markets for Stimulating
Resource Recovery
7. AUTHOR(S)
Robert C. Anderson
Roger C. Dower
9. PERFORMING ORGANIZATION NAME AND ADDRESS
Environmental Law Institute
1346 Connecticut Avenue, NW
Washington, D.C. 20036
12. SPONSORING AGENCY NAME AND ADDRESS
Municipal Environmental Research Laboratory--Cin. ,OH
Office of Research and Development
U. S. Environmental Protection Agency
Cincinnati , Ohio 45268
3. RECIPIENT'S ACCESSION-NO.
5. REPORT DATE
December 1978 (Issuing Date)
6. PERFORMING ORGANIZATION CODE
8. PERFORMING ORGANIZATION REPOR
T NO.
10. PROGRAM ELEMENT NO.
1DC618
11. CONTRACT/GRANT NO.
Grant No. R804309
13. TYPE OF REPORT AND PERIOD COVERED
Final
14. SPONSORING AGENCY CODE
EPA/600/14
15. SUPPLEMENTARY NOTES
Project Officer: Oscar Albrecht 513/684-7886
16. ABSTRACT
Highly fluctuating prices for secondary materials are seen as risks in
planning decisions, thus causing uncertainty and acting as a barrier to the use
of secondary materials in production processes. Futures markets can provide a
mechanism for transfer of price risk and decrease the uncertainty over future
prices; however, commodities must possess certain characteristics to be
successfully traded on futures markets. Wastepaper and ferrous scrap were
analyzed for these characteristics and the results suggest that futures trading
in these commodities is feasible. The social and private benefits from scrap
futures markets would probably differ, however, and thus there is justification
for government to take an active role in implementing and monitoring futures
markets for scrap materials.
17.
a. DESCRIPTORS
Production planning
Profits
Supply (economics)
Demand (economics)
Expectation
Marketing
Prices
I3. DISTRIBUTION STATEMENT
Release to public
KEY WORDS AND DOCUMENT ANALYSIS
b.lDENTIFIERS/OPEN ENDED TERMS C. COS AT I Field/Group
Solid Waste 5A
Secondary Materials 5B
Futures Markets
Futures Trading
Commodity Markets
19. SECURITY CLASS (This Report) 21 . NO. OF PAGES
llnrla^ified 88
20. SECURITY CLASS (This page) 22. PRICE
Unclassified
EPA Form 2220-1 (9-73)
80
:• U.S. GOVEimittNl nmiWGOniCi: 1979 -657-060/155a
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