South-Western College Publishing - Economics  
The Downside of Wrong Expectations
Subject Copper trade shows the downside to financial derivatives.
Topic Resource Markets
Key Words

short-sell, copper, China, price

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Reference ID: A138819692
News Story

A Chinese copper trader allegedly sold 200,000 tons of copper short, assuming that the price would fall and that he would be able to buy back the orders at a lower price. The price didn’t fall. And now no one can find him or all the copper he owes.

A short sale is effectively a standard trade in reverse—when traders expect prices to fall, they “borrow” the product and sell it, hoping to buy the product back at a lower price in a simple paper transaction that would not involve any delivery of the actual commodity. Liu Qibing, a Chinese trader with the firm Strategic Commodities, assumed copper prices would fall, as did many other traders. Copper prices have been increasing since 2002, and traders hope to be on the top of the price bubble when it bursts. Since 2003, when Mr. Liu supposedly took his short position on the sale, copper prices have risen 30%—currently at about $4,200 per ton. The price rise is not due merely to speculation, either. The price has risen thanks to a steadily increasing demand for copper for production processes as well.

So what’s the big deal? Most commodities traders aren’t so overconfident that they short-sell 200,000 tons (that’s a lot!). With global supply almost at capacity, there’s little enough copper to go around. Markets are rife with speculation that on 31 December, 2005, when the option is set to expire and Mr. Liu must repay his 200,000 tons, not enough copper will even exist for Mr. Liu to make delivery—and that speculation has fueled increased demand, raising the price of copper still further. If there isn’t enough copper for him to repay his debt, the price will increase further. The market news bodes ill for Mr. Liu’s ability to recoup his investment.

Questions
1.

What will happen to the price of copper assuming that Mr. Liu does repay his 200,000 tons of copper at the end of December? Illustrate your answer with a graph of supply and demand.

2. What should be happening to the price of new homes as a result of this price increase? Why?
3. Economic theory suggests that economic agents are rational. Do you think Mr. Liu’s actions were economically rational? Why or why not?
Source “Crouching trader, leaping prices.” The Economist. 17 November 2005. http://www.economist.com
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