FIGURE 2-9 Supply-price relationship (a) Shift in supply, (b) Supply curve, including extremes.

The demand line D and the original supply line 5 meet at the equilibrium price P. after the increase in supply, the supply line shifts to S. The point of equilibrium P represents a lower price, the consequence of laier supply m-ith unchanged demand. Because supply and demand each have varj-ing elasticities and are best represented by curves, the point of equilibrium can shift in any direction in a market with changing factors.

Equilibrium will be an important concept in developing trading strategies. Mthough the supply and demand balance may not be calculated, in practical terms equilibrium is a balance between buyers and sellers, a price level at which everyone is willing to trade, although ahvaj-s happy Equilibrium is associated with lower volatility and often lower volume, because the urgency to buy or sell has been removed.

FIGURE 2-1(1 Equilibrium with shifting supply

Cobweb Charts

The point at which the supply and demand lines cross is easily translated into a place on a price chart where the direction is sidewaj-s. The amount of price volatility during this sidewaj-s period depends upon the price level, market participation (called noise), and various undertones of instability caused by other factors. Very little is discussed about how price pattems reflect the shift in sentiment between the supply and demand lines, yet there is a clear representation of this action using cobweb charts.

Figure 2-1 la shows a static (sjnimetric) supply-demand chart with dotted lines representing the cobweb .3 A shift in the perceived importance of supply and demand factors can

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FIGURE 2-11 Static supply-demand cobweb, (a) Dotted lines represent a shift of sentiment from supply to demand to

supply, and so forth, (b) The price pattem likely to result from the cobweb in ia

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cause prices to reflect the pattem shown by the direction of the arrows on the cobweb, producing the sidewaj-s marfcel shown in Figure 2-llb. If the cobweb was closer to the intersection of the supply and demand lines, the volatility of the sidewaj-s price pattem would be lower; if the cobweb was further away from the intersection, the pattem would be more volatile.

Most supply-demand relationships are not static and can he represented by lines that cross at oblique angles. In Figure 2-12a, the cobweb is shown to begin near the intersection and move outward, each shift forming a different length strand of the web, moving away from equilibrium. Figure 2-12b shows that the corresponding price pattem is one that shifts from equilibrium to increasing volatility A reversal in the arrows on the cobweb would show decreasing volatility moving toward equilibrium.

Building a Model

A model can be created to explain or forecast price changes. Most models explain rather than forecast. Explanatory models analyze sets of data at concurrent times, that is, they look for relationships between multiple factors and their effect on price at the same moment in time. They can also look for causal, or lagged relationships, in which prices respond to other factors after one or more days. It is possible to use the explanatory model to determine the normal price at a particular moment. Although not considered forecasting, any variation in the actual market price from the normal or expected price could present frading opportunities.

Methods of selecting the best forecasting model can affect its credibility An analytic approach selects the factors and specifies the relationships in advance. Tests are then performed on the data to verify the premise. Many models, though, are refined by fitting the data, using regression analj-sis or shotgun testing, which applies a broad selection of variables and weighting to find the best fit. These models do not necessarily forecast but are definitely using perfect hindsight. Even an analytic approach that is subsequently finetuned could be in danger of losing its forecasting qualities.

The factors that comprise a model can be both numerous and difficult to obtain Figure 2-13 shows the interrelationship between factors in the cocoa industry Although this chart is comprehensive in its intramaiket relationships, it does not emphasize the global influences that have become a major part of price movement since the mid-1970s. The

FIGURE 2-12 Dynamic supply-demand cobweb, (a) Dotted lines represent a cobweb moving away from equilibrium. ib) The price pattem shows increasing volatility.

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change in value of the U.S. dollar and the volatility of interest rates have had far greater influence on price than normal fundamental factors for many commodities.

Models that explain price movements must be constructed from the primarj- factors of supply and demand. A simple example for estimating the price of fall potatoes is

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FIGURE 2-13 Cocoa factors.

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where P is the average price of fall potatoes recerved by farmers; PPI is the Producer Price Index; S is the apparent domestic free supply (production less exports and diversions); D is the estimated deliverable supply; and a, b, and are constants determined by regression analj-sis.

This model implies that consumption must be constant (i.e., inelastic demand); demand factors are only implicitly included in the estimated deliverable supply Rxports and diversion represent a small part of the total production. The use of the PPI gives the results in relative terms based on whether the index was used as an inflator or deflator of price.

A general model, presented by Wej-mar. may be written as three behavior-based equations and one identity:

where is the consumption, P is the price, P is the lagged price, H is the produaion (harvest), I is the inventory, P is the expected price at some point in the future, and e is the corresponding error factor.

The first two equations show that both demand and supply depend on current and/or lagged prices, the traditional macroeconomic theory, production and consunption are thus dependent on past prices. The third equation, inventory level, is simply the total of previous inventories, plus new production, less current consumption. The last equation, supply of storage, demonstrates that people are willing to carrj- laier inventories if they expect prices to increase substantially. The inventory function itself equation (c), is Comm. posed of two separate relationships-manufacturers