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Let us begin our discussion by considering a highly artificial and simplified situation in which there would be a definite normal relationship between the prices of wheat for immediate delivery and for delivery at any specified future date. We shall assume: 1. That there is no carry over; that is, the last bushel of the old crop has gone out of the market at the end of the crop year, say on June 30.
2. That the entire new crop of the world has "come in" at one time, July 1, and is accessible. In practice this would doubtless have to mean that a very large portion of it had reached central markets where it could be retained as a visible supply, and there would have to be no doubt that the balance of it could be made available without delay when wanted for consumption.
3. That no additional wheat could possibly reach the market until July 1 of the following year.
4. That costs of storing grain do not change during the year.
5. That everyone who is interested in the wheat trade has full information concerning the available supply.
6. That everyone in the wheat trade has complete information concerning the fact that wheat is to be consumed uniformly throughout the year and at such a rate as exactly to exhaust the supply on June 30.
7. That everyone concerned can be counted on to act with pecuniary rationality.
With these conditions existing, one might expect to find a definite and normal relation existing at any given time between the spot and the futures contract prices, and an absolute uniformity in the price of each futures contract throughout its life. The situation which would exist on July 1 might be viewed in the following way:
XA=price of cash wheat on July 1.
YC=price of June futures on July 1.
Successive ordinates of AC represent successive prices of cash wheat through the year.
AM, AF, AH, AD represent the carrying charges to September 30, December 31, May 31, and June 30.
XM, XF, XH, represent the prices of September, December, and May futures; these prices are constant.
Since, according to the assumptions, the supply is known, its availability certain, its total consumption fixed at a uniform rate, and all persons concerned are acting rationally, the price on July 1 of wheat deliverable the 30th of the following June would be higher by exactly the carrying charge between the two dates. The price of cash wheat would increase uniformly from the beginning to the end of the year.
If at any time the "spread" between spot and future prices should exceed the amounts indicated there would be an immediate and certain profit for anyone who would buy cash grain, sell futures, put the grain in storage, and later deliver it on the contracts. Under these conditions no one could rationally sell any cash grain. If, on the other hand, the spread became less than the carrying charge it would be unprofitable for anyone to hold any grain, for it would be cheaper to sell one's holdings and replace them by purchasing futures and accepting delivery on them.
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