Chapter 4 Markets, Exchanges, and Regulation

1. Chapter 4Markets, Exchanges, and Regulation

2. Markets • The general market rule that has been common law to caveat emptor (“Let the buyer beware”) resulted from unethical sellers in the past and stands true today. This has hinged on the belief that buyers and sellers are of equal power. • Two general types of time contracts: • To arrive contracts call for delivery at some point in the future with title immediately passing from seller to buyer. • Forward contracts call for delivery at some point in the future with title passing only upon delivery. • Timed delivery resulted in a third party, handlers. (continued)

3. Markets (continued) • Over time another axiom emerged, caveat venditor (“Let the seller beware”); the seller is the responsible party and has to act accordingly. • Markets eventually evolved into the modern microeconomic markets we have today.

4. Economic Theory and Markets • Microeconomic theory provides three market classifications: • Perfectly competitive: many buyers and sellers, homogenous product, no barriers to entry and exit; often reclassified as workably competitive. • Oligopoly: two or more firms producing a product that may or may not be homogenous and there are some form of barriers to entry or exit in the market place. • Monopoly: a single producer with significant barriers to entry. (continued)

5. Economic Theory and Markets (continued) • Oligopolies and monopolies are noncompetitive markets because some market power exists. They also refer to the production side—that is, the sellers. • Monopsony—a single buyer • Oligopsony—two or more buyers • The only way to achieve long-run economic profit is to have some form of noncompetitive market activity.

6. Using the Market Concepts and the Role of the Speculator • Various market forms and economic assumptions are critical for arbitragers—traders who attempt to take advantage of market imperfections in order to capture profit (also known as profit takers). • Arbitragers are speculators who have a very sophisticated knowledge of markets and how they function; they provide a vital role of the efficiency of market behavior. (continued)

7. Using the Market Concepts and the Role of the Speculator (continued) • Arbitragers are classified in two major ways: • Market relationship arbitragers (spreaders) look for abnormal patterns in time, place, and form. • Market position arbitragers take positions in the market believing that the market will move in their favor.

8. Market Relationships: Temporal • The difference between two markets that are separated by time and where the product is storable, if the markets are workably competitive, should be the cost of carry between the two time periods. • Spreaders use this concept with storable commodities. • They determine what the “normal” price is and then wait for times when the spread is “abnormal.” • Table 4-2 illustrates a “reverse spread” (see next slide). • No matter the type of spread, the profit earned is the difference between the normal spread and the abnormal amount.

10. Market Relationships: Spatial • The difference between two markets that are separated by space should be the cost of transportation. • Arbitragers would trade the differences if they were aberrant from the cost of transportation, just as they would for time differences.

11. Market Relationships: Form • The difference between the price of the raw product and the finished product(s) should be the cost of form change (manufacturing costs). • Arbitragers watch the relationship and trade when the difference is less or more than the cost to transform the products. • There must be a futures contract on the raw product and the finished product for successful spreading.

12. Position Traders • Position arbitragers take a market position if they believe the market is undervalued or overvalued other than by the three major relationships of time, space, and form. • Arbitragers provide two major market activities: • They provide liquidity. • They are the glue for economic activity. • They force the cash and futures markets to be tied together in a derivative relationship.

13. The Exchanges • The first to form a central trading place complete with rules of trade conduct was the Chicago Board of Trade (mid-1860s). • Other exchanges were formed in different areas, making contracts more regionally focused. • Major change between the Civil War and World War II was the creation of a separate clearinghouse. This split the financial risk of default on contracts from the function of trading contracts. • Option trading began in the mid-1970s. • Computerized trading is popular throughout the world; however it has not taken a large hold on the U.S. exchanges. (continued)

14. The Exchanges (continued) • Chicago Board of Trade • First to form as a place for traders to assemble, CBOT is known as the grandfather of U.S. exchanges. • Chicago Mercantile Exchange • Began officially in 1919, CME (the “Merc”) is the world’s largest derivative exchange. • New York Mercantile Exchange • Founded in 1872, the NYME is the premier energy derivative exchange. • New York Board of Trade • Began in 1998, the NYBT offers derivatives in cocoa, coffee, orange juice, sugar, and milk. (continued)

15. The Exchanges (continued) • Minneapolis Grain Exchange • Founded in 1881, the MGE has been the major market for hard red spring wheat. • Kansas City Board of Trade • The nation’s second oldest exchange (founded in 1856), the KCBT’s major derivative is hard red winter wheat. • Winnipeg Commodity Exchange • Founded in 1887, Canada’s agricultural derivative marketplace trades futures and options contracts on barley, wheat, flaxseed, and canola. (continued)

16. The Exchanges (continued) • Others • Exchanges are numerous, more now than ever. • U.S. exchanges have formed relationships with foreign exchanges allowing for off-hour trading opportunities. • Eurex US is the first fully electronic derivative exchange in the United States.

17. Regulating Groups • Commodity Futures Trading Commission (CFTC) • evolved in 1974. • developed regulations on futures contracts and other derivatives. • has the task of regulating all derivative trading for the benefit of the public. • National Futures Association (NFA) • assists CFTC in the regulation of the markets. • is a self-regulatory group. • Canadian trading regulation is determined by each province and allows for the setting up of Self Regulatory Organizations under the Commodity Futures Act of 1996.