Copper, Futures and Codelco

Abstract

Large financial losses associated with transactions in futures markets has become a common story in the news media. This paper studies the economic dynamics associated with the optimal use of these markets, using the case of the Chilean state copper company Codelco as an example. Between November 1993 and January 1994, Codelco lost approximately US$178 million in futures markets. The question arises of whether such occasional large losses are typical of transactions in futures markets or, in this case, due to error or inefficient management. This paper addresses the question by studying a maximization problem relevant for a firm such as Codelco. In the model, the firm chooses its operations in futures markets subject to stochastic processes estimated for spot and future prices for copper. Results indicate that the use of futures contracts does result in higher average income, but it occasionally generates significant losses over short periods of time. Nevertheless, the model does not generate large losses during the November 1993 to January 1994 period of the Codelco losses. The results also demonstrate that profits generated by using futures are a direct result of the intrinsically nonlinear nature of the stochastic processes of spot and future prices.