Chapter 4
Markets, Exchanges,
and Regulation
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Markets
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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)
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Markets (continued)
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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.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Economic Theory and Markets
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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)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Economic Theory and Markets
(continued)
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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
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The only way to achieve long-run economic
profit is to have some form of noncompetitive
market activity.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Using the Market Concepts and the
Role of the Speculator
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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)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Using the Market Concepts and the
Role of the Speculator (continued)
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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.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Market Relationships: Temporal
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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.
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– 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).
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No matter the type of spread, the profit earned is the
difference between the normal spread and the
abnormal amount.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Market Relationships: Spatial
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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.
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Market Relationships: Form
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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.
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Position Traders
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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.
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They force the cash and futures markets to be
tied together in a derivative relationship.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Exchanges
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The first to form a central trading place complete with rules
of trade conduct was the Chicago Board of Trade (mid1860s).
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)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Exchanges (continued)
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Chicago Board of Trade
– First to form as a place for traders to assemble, CBOT is
known as the grandfather of U.S. exchanges.
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Chicago Mercantile Exchange
– Began officially in 1919, CME (the “Merc”) is the world’s
largest derivative exchange.
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New York Mercantile Exchange
– Founded in 1872, the NYME is the premier energy
derivative exchange.
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New York Board of Trade
– Began in 1998, the NYBT offers derivatives in cocoa,
coffee, orange juice, sugar, and milk.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Exchanges (continued)
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Minneapolis Grain Exchange
– Founded in 1881, the MGE has been the major market for
hard red spring wheat.
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Kansas City Board of Trade
– The nation’s second oldest exchange (founded in 1856), the
KCBT’s major derivative is hard red winter wheat.
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Winnipeg Commodity Exchange
– Founded in 1887, Canada’s agricultural derivative
marketplace trades futures and options contracts on barley,
wheat, flaxseed, and canola.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Exchanges (continued)
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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.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Regulating Groups
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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.
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National Futures Association (NFA)
– assists CFTC in the regulation of the markets.
– is a self-regulatory group.
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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.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation