obert Heller (1989) recently suggested a revision to the Federal Reserve's ap-R proach to breaks in the market for equities. The problem he addresses is the threat that liquidity constraints will aggravate shocks to the financial system. The Fed reacted to these October episodes in 1987 and 1989 by supplying liquidity through open-market operations. Heller argues this approach tends to work against monetary policy. He suggests a more direct operation, namely, long positions in stock index futures. These long positions would tend to bid up stock prices, ameliorating needs for additional liquidity. He contends that interventions of this sort will lessen disruptions to monetary policy objectives.
The idea of using futures markets to obtain a public policy goal is not new. During the early 1930's the Federal Farm Board opened futures positions in wheat and cotton to reach its policy objectives. The experience of this intervention offers a case study for this type of action. The evidence from this experience suggests that interventions in futures markets disrupt both the price-discovery process and the hedging function of futures markets. To ascertain the impact on markets, this article examines three issues. First, the Heller proposal depends on the link between futures and cash markets. This linkage is established through the delivery specifications of the futures contract. Second, futures markets serve two key economic purposes: price discovery and risk control. These purposes are developed. Third, government intervention alters the link between futures and cash markets. An example of such intervention is made of the Federal Farm Board's use of the wheat futures market during the early 1930's.
LINKAGE BETWEEN CASH AND FUTURES MARKETS
A well-designed futures contract is linked to the cash market through its final settlement procedure. Before contract expiration, gains and losses in futures are determined by daily settlement prices. In itself, this feature might produce futures prices which are independent of events in the cash market. To link prices in the two markets, the final settlement price at contract expiration is determined from prices in the cash market. This is accomplished in either of two ways. Short futures positions are provided with the right to deliver on their contracts. They will choose I am indebted to Gary Sutkin for his excellent research assistance and to Peter Heffernan for his useful comments. The analysis and conclusions of this article are those of the author and do not indicate concurrence by other members of the research staff, the Board of Governors, or the Federal Reserve Banks.