Sunday, July 25, 2010

Chocolate Speculator Nonsense

A New York Times article claims that hedge fund manager Anthony Ward has found a brilliant way of securing large profits from speculation. He buys large quantities of cocoa, something which drives up the price of cocoa, and then later sells the cocoa at a higher price.

It should be obvious that there is something seriously wrong with this trading strategy, unless some other information exists that will create high prices in the future. Assuming the reports about Ward's behavior is true, that he has purchased large quantities of cocoa and stored it, then that will certainly raise the spot price of cocoa. But unless he plans to store it indefinitely (and that seems unlikely as the cocoas will likely turn bad eventually), this won't increase prices in the future as the eventual sale of those large cocoa quantities will depress prices in the future.

Thus, there is nothing in the trading mechanism of buying now to increase the current spot price and then sell later that will guarantee a profit since the future price will be depressed by those sales. Ward's alleged bet only makes sense if he believes (as he presumably does if he has made those bets) other factors push up the price.

But what about this argument: "The fear is that Mr. Ward will become the go-to source until the annual cocoa harvest, which starts in October. With candy makers starting to stock up for the holiday season, they may be forced to pay him ever-higher prices — and cocoa has already jumped 150 percent since 2008."

This overlooks that Ward hasn't really reduced supply. All he has done is to buy the output of certain producers, thus reducing their supply, but at the same time creating a new supply source in the form of his company. This doesn't reduce supply, it only changes the identity of the suppliers from the producers (or possibly other speculators) to Ward.

Perhaps not surprisingly, Paul Krugman tries to defend his news paper's explanation:

"Does he have an incentive to hold some of that supply off the market, and in effect dump it into period 2? Yes! Suppose he owns a million candy bars: by taking one of those bars off the market until period 2, he may lose some money on that bar, but he drives up the price on the other 999,999 bars. This may give him an incentive to “dump” some of his candy into the next period, even if it looks on the surface like a money-losing proposition.

Or to put it another way, by acquiring a large share of period 1 supply, Chocfinger may have created a situation in which his marginal revenue from a current (as opposed to future) candy bar sale is quite low, making it profitable to hold bars off the market."

What Krugman describes is actually the theory of why some companies in the absence of "perfect competition" has an incentive to restrict output even though the price is higher than the marginal cost. Yet for that strategy to work output has to be permanently restricted. While holding a candy bar to a future period may increase the current price of other candy bars currently sold, it will depress the price of those future sales as total future supply will be larger.