We all understand the idea of buying low and selling high, but Mr Smith is unique. He wants to sell high and buy low, and wants to ‘short’ a commodity. You explain to Mr Smith that, while it may seem impossible, or at least dishonest, to sell something one does not have, this is exactly the type of transaction made possible by financial derivatives. Specifically, we are going to buy a put option – a contract wherein we agree sell a commodity at some point in the future at a price to be specified today, called a ‘strike price’. We are selling short, or ‘shorting’ this commodity. Our counter party who wrote the put option, i.e. they wrote the contract we bought, are said to be ‘going long’. If the strike price is the same as today’s price, then it’s as simple as this: we are betting the price will fall and our counter party is betting it will rise. If the price falls, we can buy the commodity at the new, lower price then turn around and sell it at our higher strike price. The difference in prices, minus some fees and taxes, is our profit margin. If the price rises, then we must still fulfill our obligation by purchasing the commodity at the new price. But in this case, since the new price is higher, we will lose money and our counter party will gain. This time the difference in prices is their profit margin. So all this comes down to a bet about whether the price of some commodity will rise or fall. Suppose the following three commodities have all experienced a recent sharp increase in prices. Mr Smith thinks these are “bubbles” . He thinks their prices are unsustainably high and that it will soon burst and the prices fall.
White Pearls in Mexico. Pearl divers are very competitive but Mexico is remote and there are few people with the skill to collect pearls.
Computer Memory. New developments in information technology are expected to reduce the cost of producing data storage in the near future.
Gold. There is no reason to expect the supply or gold, or the cost of finding and extracting it will change in the foreseeable future.
a. Assuming all else is held constant, which of these should Mr Smith short and why? That is, if the bubble bursts and we transition to a new long-run equilibrium, which of these commodities do you think will experience the greater decrease in price?
b. What would the long-run supply curves look like for these commodities
c. Which of these commodities is likely to see the smallest decrease in price and why?