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What are the characteristics of price-taker markets?

Consider the situation of Les Parrot, a Texas cattle rancher. In the financial pages of the local newspaper, he finds that the current market price of quality steers is 88 cents per pound. Even if his ranch is quite large, there is little that Parrot can do to change the market price of beef cattle. After all, there are tens of thousands of farmers who raise cattle. Thus, Parrot supplies only a small portion of the total cattle market. The amount that he sells will exert little or no effect on the market price of cattle. Parrot is a price taker.
The firms in a market will be price takers when the following four conditions are met:

• All the firms in the market are producing an identical product (for example, beef, or cattle, of a given grade).

• A large number of firms exist in the market.

• Each firm supplies only a very small portion of the total amount supplied to the market.

• No barriers limit the entry or exit of firms in the market.

When these conditions are met, firms selling in the market must accept the market price. This is why they are called price takers. If the firm sets a price above the market level, consumers will simply buy from other sellers. Why pay the higher price when the identical good is available elsewhere at a lower price? For example, if the price of wheat were $5.00 per bushel, a farmer would be unable to find buyers for wheat at $5.50per bushel. A firm would gain nothing by setting its price below the market level, because any small firm in the market can already sell as much as it wants at the market price. A price reduction would only reduce revenues. A firm that is a price taker thus faces a perfectly elastic demand for its product.

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FORWARD CONTRACTS ON individual STOCKS

Consider an asset manager responsible for the portfolio of a high-net-worth individual. As is sometimes the case, such portfolios may be concentrated in a small number of stocks, sometimes stocks that have been in the family for years. In many cases, the individual may be part of the founding family of a particular company. Let us say that the stock is called Gregorian Industries, Inc., or GII, and the client is so heavily invested in this stock that her portfolio is not diversified. The client notifies the portfolio manager of her need for $2 million in cash in six months. This cash can be raised by selling 16,000 shares at the current price of $125 per share. Thus, the risk exposure concerns the market value of $2 million of stock. For whatever reason, it is considered best not to sell the stock any earlier than necessary. The portfolio manager realizes that a forward contract to sell GI1 in six months will accomplish the client’s desired objective. The manager contacts a forward contract dealer and obtains a quote of $128.13 as the price at which a forward contract to sell the stock in six months could be constructed.
In other words, the portfolio manager could enter into a contract to sell the stock to the dealer in six months at $128.13. We assume that this contract is deliverable, meaning that when the sale is actually made, the shares will be delivered to the dealer. Assuming that the client has some flexibility in the amount of money needed, let us say that the contract is signed for the sale of 15,600 shares at $128.13, which will raise $1,998,828. Of course when the contract expires, the stock could be selling for any price. The client can gain or lose on the transaction. If the stock rises to a price above $128.13 during the six-month period, the client will still have to deliver the stock for $128.13. But if the price falls, the client will still get $128.13 per share for the stock.

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THE STRUCTURE OF GLOBAL FORWARD MARKETS

The global market for forward contracts is part of a vast network of financial institutions that make markets in these instruments as well as in other related derivatives, such as swaps and options. Some dealers specialize in certain markets and contracts, such as forward contracts on the euro or forward contracts on Japanese equity products. These dealers are mainly large global banking institutions, but many large non-banking institutions, such as Goldman Sachs and Merrill Lynch, are also big players in this market. Dealers engage in transactions with two types of parties: end users and other dealers. An end user is typically a corporation, nonprofit organization, or An end user is generally a party with a risk management problem that is searching for a dealer to provide it with a financial transaction to solve that problem. Although the problem could simply be that the party wants to take a position in anticipation of a market move, more commonly the end user has a risk it wants to reduce or eliminate.
As an example, Hoffman-LaRoche, the large Swiss pharmaceutical company, sells its products globally. Anticipating the receipt of a large amount of cash in U.S. dollars and worried about a decrease in the value of the dollar relative to the Swiss franc, it could buy a forward contract to sell the dollar and buy Swiss francs. It might seek out a dealer such as UBS Warburg, the investment firm affiliated with the large Swiss bank UBS, or it might approach any of the other large multinational banks with which it does business. Or it might end up dealing with a non-bank entity, like Memll Lynch. Assume that Hoffman-LaRoche enters into this contract with UBS Warburg. Hoffman-LaRoche is the end user; UBS Warburg is the dealer. Transactions in forward contracts typically are conducted over the phone. Each dealer has a quote desk, whose phone number is well known to the major participants in the market. If a party wishes to conduct a transaction, it simply phones the dealer for a quote. The dealer stands ready to take either side of the transaction, quoting a bid and an ask price or rate. The bid is the price at which the dealer is willing to pay for the future purchase of the asset, and the ask is the price at which the dealer is willing to sell. When a dealer engages in a forward transaction, it has then taken on risk from the other party. For example, in the aforementioned transaction of Hoffman-LaRoche and UBS Warburg, by entering into the contract, UBS Warburg takes on a risk that Hoffman-LaRoche has eliminated. Specifically, UBS Warburg has now committed to buying dollars and selling Swiss francs at a future date. Thus, UBS Warburg is effectively long the dollar and stands to gain from a strengthening dollarlweakening Swiss franc. Typically dealers do not want to hold this exposure. Rather, they find another party to offset the exposure with another derivative or spot transaction. Thus, UBS Warburg is a wholesaler of risk-buying it, selling it, and trying to earn a profit off the spread between its buying price and selling price. One might reasonably wonder why Hoffman-LaRoche could not avoid the cost of dealing with UBS Warburg. In some cases, it might be able to. It might be aware of another party with the exact opposite needs, but such a situation is rare. The market for financial products such as forward contracts is made up of wholesalers of risk management products who use their technical expertise, their vast network of contacts, and their access to critical financial market information to provide a more efficient means for end users to engage in such risk management transactions.
Dealers such as UBS Warburg lay off the risk they do not wish to assume by transacting with other dealers and potentially other end users. If they do this carefully, quickly, and at accurate prices, they can earn a profit from this market-making activity. One should not get the impression, however, that market making is a highly profitable activity. The competition is fierce, which keeps bid-ask spreads very low and makes it difficult to earn much money on a given transaction. Indeed, many market makers do not make much money on individual transactions-they typically make a small amount of money on each transaction and do a large number of transactions. They may even lose money on some standard transactions, hoping to make up losses on more-complicated, nonstandard transactions, which occur less frequently but have higher bid-ask spreads.
Risk magazine conducts annual surveys to identify the top dealers in various derivative products. Interest rate forwards are called forward rate agreements (FRAs). In the next series of posts, we shall study the different types of forward contracts and note that there are some others not covered in the Risk surveys. One of these surveys was sent to banks and investment banks that are active dealers in over-the-counter derivatives. The other survey was sent to end users. The tabulations are based on respondents’ simple rankings of who they think are the best dealers. Although the identities of the specific dealer firms are not critical, it is interesting and helpful to be aware of the major players in these types of contracts. Most of the world’s leading global financial institutions are listed, but many other big names are not. It is also interesting to observe that the perceptions of the users of these dealer b s ’services differ somewhat from the dealers’ self-perceptions. Be aware, however, that the rankings change, sometimes drastically, each year

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TERMINATION OF A FORWARD CONTRACT

Let us note that a forward contract is nearly always constructed with the idea that the participants will hold on to their positions until the contract expires and either engage in delivery of the asset or settle the cash equivalent, as required in the specific contract. The possibility exists, however, that at least one of the participants might wish to terminate the position prior to expiration. For example, suppose a party goes long, meaning that she agrees to buy the asset at the expiration date at the price agreed on at the start, but she subsequently decides to terminate the contract before expiration. We shall assume that the contract calls for delivery rather than cash settlement at expiration.
To see the details of the contract termination, suppose it is part of the way through the life of the contract, and the long decides that she no longer wishes to buy the asset at expiration. She can then re-enter the market and create a new forward contract expiring at the same time as the original forward contract, taking the position of the seller instead. Because of price changes in the market during the period since the original contract was created, this new contract would likely have a different price at which she would have to commit to sell. She would then be long a contract to buy the asset at expiration at one price and short a contract to sell the asset at expiration at a different price. It should be apparent that she has no further exposure to the price of the asset.
For example, suppose she is long to buy at $40 and short to deliver at $42. Depending on the characteristics of the contract, one of several possibilities could occur at expiration. Everything could go as planned-the party holding the short position of the contract on which she is long at $40 delivers the asset to her, and she pays him $40. She then delivers the asset to the party who is long the contract on which she is short at $42. That party pays her $42. She nets $2. The transaction is over.
t There is always a possibility that her counterparty on the long contract could default. She is still obligated to deliver the asset on the short contract, for which she will receive I $42. But if her counterparty on the long contract defaults, she has to buy the asset in the market and could suffer a significant loss. There is also a possibility that the counterparty on her short contract could fail to pay her the $42. Of course, she would then not deliver the asset but would be exposed to the risk of changes in the asset’s price. This type of problem illustrates the credit risk in a forward contract.
To avoid the credit risk, when she re-enters the market to go short the forward contract, she could contact the same counterparty with whom she engaged in the long forward contract. They could agree to cancel both contracts. Because she would be owed $2 at expiration, cancellation of the contract would result in the counterparty paying her the present value of $2. This termination or offset of the original forward position is clearly desirable for both counterparties because it eliminates the credit risk. It is always possible, however, that she might receive a better price from another counterparty. If that price is sufficiently attractive and she does not perceive the credit risk to be too high, she may choose to deal with the other counterparty and leave the credit risk in the picture.

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