Commodity futures prices can serve as a mechanism for price discovery either for the present price or for determining expected future prices. A market is defined as an efficient market if the market accounts for all public and non-public information in determining an equilibrium price in the market. Commodity futures markets are often referred to as efficient in the price discovery process. That is, the price quoted for a commodity on the futures market is thought to be the best measure of the actual price, either current or in the future. Therefore, if you would like a good predictor of what prices will be four months from now, the closest deferred (four month out) futures price quote for that commodity may be the best and easiest aggregate price forecast.

Tables 1 and 2 provide closing future price quotes for corn and live cattle, respectively, for December 18, 1998. On December 18, 1998 these price quotes for corn and live cattle could be thought of as a forecasted price for the months listed on the left-hand side of the tables. For example, if you wanted a forecast of what corn price was going to be for the U.S. in March of 1999, you could use the March 1999 CBOT futures closing price of $2.19/bushel as a forecasted price. Similarly, if you were interested in a forecast of live cattle prices for December 1999, you could use the December 1999 CME live cattle futures price quote of $64.85/cwt.

Why does someone care about forecasting price? Knowing what the grain price will be in March 1999 is helpful in evaluating storage decisions. Knowing what the live cattle price will be in December of 1999 is helpful in making retained ownership decisions. Also, knowing expected prices can help in making forward pricing decisions. That is, if you could forward price corn for March 1999 at $2.24/bushel, you would know that the offered price is above the expected price (typically this will not be the case in forward pricing agreements because the entity offering the forward price contract requires a price discount to assume your price risk). Expected prices can help grain producers decide which cropping alternative to plant in the spring. Lastly, expected prices can be useful in planning annual cash flows and loan requests.

What about Determining a Local Price?

Agriculture producers and agribusinesses face a diverse array of marketing and production alternatives. Each time a marketing or production decision is made, farmers or agribusinesses must estimate what impact this decision will have on their risk management plan. None of these are more difficult to answer than, "What price can I expect?" No matter the time of year, this question always looms in a farmers or agribusinesses decision process. With changes in the domestic farm program, producers must now ask themselves, which crop will I plant given my known input costs and expected harvest time prices? During this same time and into crop maturity, producers then must ask themselves, should I forward price a portion of my crop? Finally, in the fall producers must ask themselves, should I store my crop? Or for the cow-calf producer, should I retain ownership on a portion of my heard beyond weaning? Similarly, agribusinesses must determine price expectations to know what forward price to offer.

Commodity futures exchange markets provide a mechanism for price discovery on an aggregate level through arbitrage between multiple buyers and sellers. However, price discovery at a given location is not nearly as clearly defined because local supply and demand relationships are not as well known. However, historical basis provides a linkage between these two markets (see An Introduction to Basis). Therefore, a simple, low cost, and relatively good predictor of the local cash price is the futures contract [month] price of interest adjusted for a multiple year average basis for that time. An expected price, where E denotes an expectation, can be found using:

For example, assume a cow-calf producer would like a forecast for April live cattle prices in his/her local market. The producers best expectation of that cash price might be the April live cattle futures price adjusted for an expected basis (say 5-year average basis).

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