Now that the notions of equivalent ways to trade and implicit markets have been established, it is time to apply those perspectives to the theories of why futures markets exist. The purpose of the subsequent chapter is to develop a new theory of futures markets based on the conclusion that a hedging operation amounts to a loan. But before proceeding to that task, it is necessary to discredit the principal existing theories of futures markets.

The majority of scholars have examined futures markets from the perspective of aversion to risk. This perspective has led to two distinct, although closely connected, theories: The older theory is that of normal backwardation; the now dominant theory is best called the portfolio theory of hedging. Both these theories depict the primary function of futures markets as the transferal of risk from handlers of the commodity to those who are more willing to bear it and, in the extreme, have described futures markets as no more than markets for insurance against fluctuating prices. Depending on a processor's or dealer's aversion to risk, he “hedges” his positions in the physical commodity with positions in futures contracts.

These two theories based on risk aversion both err in their fundamental assumption of futures markets as isolated, explicit markets. Although the two theories acknowledge that the positions in futures contracts are taken in reference to positions in the physical commodity, they present the decision to use futures contracts as an after-thought rather than an integral part of the decision to take the position in the physical commodity.