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What are the characteristics of price-taker markets?

admin — Sun, 28 Mar 2010 15:40:04 +0000

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.

FORWARD CONTRACTS ON individual STOCKS

admin — Mon, 17 Aug 2009 13:28:48 +0000

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.

THE STRUCTURE OF GLOBAL FORWARD MARKETS

admin — Tue, 04 Aug 2009 13:27:54 +0000

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

TERMINATION OF A FORWARD CONTRACT

admin — Tue, 21 Jul 2009 13:27:14 +0000

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.

ELEMENTARY PRINCIPLES OF DERIVATIVE PRICING

admin — Tue, 07 Jul 2009 13:26:22 +0000

In this post, we take a preliminary glance at how derivative contracts are priced. First, we introduce the concept of arbitrage. Arbitrage occurs when equivalent assets or combinations of assets sell for two different prices. This situation creates an opportunity to profit at no risk with no commitment of money. Let us start with the simplest (and least likely) opportunity for arbitrage: the case of a stock selling for more than one price at a given time. Assume that a stock is trading in two markets simultaneously. Suppose the stock is trading at $100 in one market and $98 in the other market. We simply buy a share for $98 in one market and immediately sell it for $100 in the other. We have no net position in the stock, so it does not matter what price the stock moves to. We make an easy $2 at no risk and we did not have to put up any funds of our own. The sale of the stock at $100 was more ! than adequate to finance the purchase of the stock at $98. Naturally, many market participants would do this, which would create downward pressure on the price of the stock in the market where it trades for $100 and upward pressure on the price of the stock in the market where it trades for $98. Eventually the two prices must come together so that there is but a single price for the stock. Accordingly, the principle that no arbitrage opportunities should be available is often referred to as the law of one price. Recall that we mentioned in earlier posts that an asset can potentially trade in different geographic markets and, therefore, have several spot prices. This potential would appear to violate the law of one price, but in reality, the law is still upheld. A given asset selling in two different locations is not necessarily the same asset. If a buyer in one location dis- covered that it is possible to buy the asset more cheaply in another location, the buyer would still have to incur the cost of moving the asset to the buyer’s location. Transportation costs could offset any such price differences.
We have just had a taste of not only the powerful forces of arbitrage but also a pricing model for one derivative, the forward contract. In this simple example, according to the pricing model, the forward price should be the spot price increased by the interest rate. Although there is a lot more to derivative pricing than shown here, the basic principle remains the same regardless of the type of instrument or the complexity of the setting: Prices are set to eliminate the opportunity to profit at no risk with no commitment of one’s own funds.
There are no opportunities for arbitrage profits.
Lest we be too naive, however, we must acknowledge that there is a large industry of arbitrageurs. So how can such an industry exist if there are no opportunities for riskless profit? One explanation is that most of the arbitrage transactions are more complex than this simple example and involve estimating information, which can result in differing opinions. Arbitrage involving options, for example, usually requires estimates of a stock’s volatility. Different participants have different opinions about this volatility. It is quite possible that two counterparties trading with each other can believe that each is arbitraging against the other.
But more importantly, the absence of arbitrage opportunities is upheld, ironically, only if participants believe that arbitrage opportunities do exist. If market traders believe that no opportunities exist to earn arbitrage profits, then they will not follow market prices and compare these prices with what they ought to be, as in the forward contract example given above. Without participants watching closely, prices would surely get out of line and offer arbitrage opportunities. Thus, eliminating arbitrage opportunities requires that participants be vigilant to arbitrage opportunities. In other words, strange as it may sound, disbelief and skepticism concerning the absence of arbitrage opportunities are required in order that it hold as a legitimate principle.
Markets in which arbitrage opportunities are either nonexistent or are quickly eliminated are relatively efficient markets. Recall from your study of portfolio theory and investment analysis that efficient markets are those in which it is not possible, except by chance, to earn returns in excess of those that would be fair compensation for the risk assumed. Although abnormal returns can be earned in a variety of ways, arbitrage profits are definitely examples of abnormal returns, relatively obvious to identify and easy to capture. Thus, they are the most egregious violations of the principle of market efficiency. A market in which arbitrage profits do not exist is one in which the most obvious violations of market efficiency have been eliminated.
Throughout this blog, we shall study derivatives by using the principle of arbitrage as a guide. We will assume that arbitrage opportunities cannot exist for any significant length of time. Thus, prices must conform to models that assume no arbitrage. On the other hand, we do not want to take the absence of arbitrage opportunities so seriously that we give up and believe that arbitrage opportunities never exist. Otherwise, they will arise, and someone else will take them from us.

CRITICISMS OF DERIVATIVE MARKETS

admin — Mon, 22 Jun 2009 13:25:43 +0000

Derivatives have been highly controversial for a number of reasons. For one, they are very complex. Much of the criticism has stemmed from a failure to understand derivatives. When derivatives fail to do their job, it is often the derivatives themselves, rather than the users of derivatives, that take the blame. Yet, in many cases, the critics of derivatives simply do not understand them well enough. As described in former posts, when homeowners take out mortgages, they usually receive a valuable option: the right to prepay their mortgages. When interest rates fall, homeowners often pay off their mortgages, refinancing them at lower rates. The holders of these mortgages usually sell them to other parties, which can include small organizations and individuals. Thus, we often find unsophisticated investors holding securities based on the payments from mortgages. When homeowners refinance, they capture huge interest savings. Where does this money come from? It comes from the pockets of the holders of mortgage securities. When these unsophisticated investors lose a lot of money, derivatives usually get the blame. Yet these losses went into the pockets of homeowners in the form of interest savings. Who is to blame? Probably the brokers, who sold the securities to investors who did not know what they were buying-which leads us to the next common criticism of derivatives.
The complexity of derivatives means that sometimes the parties that use them do not understand them well. As a result, they are often used improperly, leading to potentially large losses. Such an argument can, however, be used to describe fire, electricity, and chemicals. Used improperly, perhaps in the hands of a child or someone who does not know how to use them, all of these can be extremely dangerous. Yet, we know that sufficient knowledge of fire, electricity, and chemicals to use them properly is not very difficult to obtain. The same is true for derivatives; treat them with respect and healthy doses of knowledge.
Derivatives are also mistakenly characterized as a form of legalized gambling. Although gambling is certainly legal in many parts of the world, derivatives are often viewed as a government’s sanction of gambling via the financial markets. But there is an important distinction between gambling and derivatives: The benefits of derivatives extend much further across society. By providing a means of managing risk along with the other benefits discussed above, derivatives make financial markets work better. The organized gambling industry affects the participants, the owners of casinos, and perhaps some citizens who benefit from state lotteries. Organized gambling does not, however, make society function better, and it arguably incurs social costs.
We have taken a look at what derivatives are, where they come from, where they are now, why we have them, and what people think of them. Understanding derivatives, however, requires a basic understanding of the market forces that govern derivative prices. Although we shall cover derivative pricing in more detail in later posts, here we take a brief look at the process of pricing derivatives by examining some important fundamental principles.

THE PURPOSES OF DERIVATIVE MARKETS

admin — Sun, 07 Jun 2009 13:25:33 +0000

Derivative markets serve a variety of purposes in global social and economic systems. One of the primary functions of futures markets is price discovery. Futures markets provide valuable information about the prices of the underlying assets on which futures contracts are based. They provide this information in two ways. First, many of these assets are traded in geographically dispersed markets. Recall that the current price of the underlying asset is called the spot price. With geographically dispersed markets, many different spot prices could exist. In the futures markets, the price of the contract with the shortest time to expiration often serves as a proxy for the price of the underlying asset. Second, the prices of all futures contracts serve as prices that can be accepted by those who trade contracts in lieu of facing the risk of uncertain future prices. For example, a company that mines gold can hedge by selling a futures contract on gold expiring in two months, which locks in the price of gold two months later. In this manner, the two-month futures price substitutes for the uncertainty of the price of gold over the next two months.
Futures contracts are not, however, the only derivatives that serve this purpose. In fact, forward contracts and swaps allow users to substitute a single locked-in price for the uncertainty of future spot prices and thereby permit the same form of price discovery as do futures.
Options work in a slightly different manner. They are used in a different form of hedging, one that permits the holder to protect against loss while allowing participation in gains if prices move favorably. Options do not so much reveal prices as they reveal volatility. As we shall see soon, the volatility of the underlying asset is a critical factor in the pricing of options. It is possible, therefore, to infer what investors feel about volatility from the prices of options.
Perhaps the most important purpose of derivative markets is risk management. We define risk management as the process of identifying the desired level of risk, identifying the actual level of risk, and altering the latter to equal the former. Often this process is described as hedging, which generally refers to the reduction, and in some cases the elimination, of risk. On the other side is the process called speculation. Traditional discussions of derivatives refer to hedging and speculation as complementary activities. In general, hedgers seek to eliminate risk and need speculators to assume risk, but such is not always the case. Hedgers often trade with other hedgers, and speculators often trade with other speculators. All one needs to hedge or speculate is a party with opposite beliefs or opposite risk exposure. For example, a corporation that mines gold could hedge the future sale of gold by entering into a derivative transaction with a company that manufactures jewelry. Both of these companies are hedgers, seeking to avoid the uncertainty of future gold prices by locking in a price for a future transaction. The mining corporation has concerns about a price decrease, and the jewelry manufacturer is womed about a price increase.
An unfortunate consequence of the use of the terms “hedging” and “speculating” is that hedgers are somehow seen as on the high moral ground and speculators are sometimes seen as evil-a distortion of the role of speculators. In fact, there need be very little difference between hedgers and speculators. To restate an example we used when discussing swaps, consider a corporation that currently borrows at a floating rate. A common response to a fear of rising interest rates is for the corporation to use an interest rate swap in which it will make payments at a fixed rate and receive payments at a floating rate. The floating-rate payments it receives from the swap offset the floating-rate payments on the loan, thereby effectively converting the loan to a fixed-rate loan. The company is now borrowing at a fixed rate and, in the eyes of many, hedging.
But is the company really hedging? Or is it simply making a bet that interest rates will increase? If interest rates decrease, the company will be losing money in the sense of the lost opportunity to borrow at a lower rate. From a budgeting and cash flow standpoint, however, its fixed interest payments are set in stone. Moreover, the market value of a fixedrate loan is considerably more volatile than that of a floating-rate loan. Thus, our “hedging” corporation can be viewed as taking more risk than it originally had.
The more modem view of the reason for using derivatives does not refer to hedging or speculation. Although we shall sometimes use those terms, we shall use them carefully and make our intentions clear. In the grander scheme of things, derivatives are tools that enable companies to more easily practice risk management. In the context of our corporation borrowing at the floating rate, it made a conscious decision to borrow at a fixed rate. Engaging in the swap is simply an activity designed to align its risk with the risk it wants, given its outlook for interest rates. Whether one calls this activity hedging or speculation is not even very important. The company is simply managing risk.
Derivative markets serve several other useful purposes. As we show later when exploring the pricing of derivative contracts, they improve market efficiency for the underlying assets. Efficient markets are fair and competitive and do not allow one party to easily take money from another. As a simple example, we shall learn in near future buying a stock index fund can be replicated by buying a futures on the fund and investing in risk-free bonds the money that otherwise would have been spent on the fund. In other words, the fund and the combination of the futures and risk-free bond will have the same performance. But if the fund costs more than the combination of the futures and risk-free bond, investors have the opportunity to avoid the overpriced fund and take the combination.18 This decreased demand for the fund will lower its price. The benefits to investors who do not even use derivatives should be clear: They can now invest in the fund at a more attractive price, because the derivatives market forced the price back to its appropriate level.
Derivative markets are also characterized by relatively low transaction costs. For example, the cost of investing in a stock index portfolio is as much as 20 times the cost of buying a futures contract on the index and a risk-free bond as described above. One might reasonably ask why derivatives are so much less expensive in terms of transaction costs. The answer is that derivatives are designed to provide a means of managing risk. As we have previously described, they serve as a form of insurance. Insurance cannot be a viable product if its cost is too high relative to the value of the insured asset. In other words, derivatives must have low transaction costs; otherwise, they would not exist. It would be remiss to overlook the fact that derivative markets have been subject to many criticisms. We next present some of these complaints and the reasons behind them.

Personal and Intangible Factors

admin — Mon, 18 May 2009 17:55:13 +0000

Several communities may remain in the running at the end of the plant location evaluation process. It is at this point that the personal and intangible attributes of communities under consideration come into prominence. These attributes can be described best in terms of community leadership and attitudes, housing, schools, recreation, shopping, and overall community image. Most large companies are also concerned about their corporate image, and they want to be a good corporate neighbor. Their impressions of a potential location can be greatly enhanced if community leaders create an image of acceptance, cooperation, and fairness. This is a much easier task if community leaders can exhibit a history of creating a favorable environment for existing industrial plants. This is one factor that a community or area has a great deal of control. Personal factors have become increasingly important in recent years with the shift in industrial organization away from owner-manager firms and toward the corporate structure. In modern corporations, management and ownership are separated. Corporation owners (stockholders) do not make location decisions, managers do. Managers live with the plants, owners do not. Clearly, corporation management must select plant locations that will be profitable and earn sufficient net revenues for long term growth of the firm and to yield stockholders a satisfactory and competitive return to their investments. Beyond this constraint of a satisfactory profit, corporate managers may tend to emphasize personal factors rather than maximizing profits. The modern decision-making framework tends to increase the influence of desirable characteristics of plant location as a place to live and work more than would be expected in the owner-manager framework of the past. Worker productivity is always affected by these personal factors and can lead to attracting quality labor and management to a particular geographic area. Management is aware of these factors when considering plant location.
Making a community more attractive to industry also creates a better place to live for existing residents. Thus, even if a new industry does not come, the community reaps the benefit of its efforts.

FUTURES EXCHANGES

admin — Tue, 12 May 2009 10:39:14 +0000

A futures exchange is a legal corporate entity whose shareholders are its members. The members own memberships, more commonly called seats. Exchange members have the privilege of executing transactions on the exchange. Each member acts as either a floor trader or a broker. Floor traders are typically called locals; brokers are typically called futures commission merchants (FCMs). Locals are market makers, standing ready to buy and sell by quoting a bid and an ask price. They are the primary providers of liquidity to the market. FCMs execute transactions for other parties off the exchange.
The locals on the exchange floor typically trade according to one of several distinct styles. The most common is called scalping. A scalper offers to buy or sell futures contracts, holding the position for only a brief period of time, perhaps just seconds. Scalpers attempt to profit by buying at the bid price and selling at the higher ask price. A day trader holds a position open somewhat longer but closes all positions at the end of the day. Position trader holds positions open overnight. Day traders and position traders are quite distinct from scalpers in that they attempt to profit from the anticipated direction of the market; scalpers are trying simply to buy at the bid and sell at the ask.
Recall that futures exchanges have trading either on the floor or off the floor on electronic terminals, or in some cases, both. As previously described, floor trading in the United States takes place in pits, which are octagonal, multi-tiered areas where floor traders stand and conduct transactions. Traders wear jackets of specific colors and badges to indicate such information as what type of trader (FCM or local) they are and whom they represent. As noted, to indicate a willingness to trade, a trader shouts and uses a set of standard hand signals. A trade is consummated by two traders agreeing on a price and a number of contracts. These traders might not actually say anything to each other; they may simply use a combination of hand signals andlor eye contact to agree on a transaction. When a transaction is agreed on, the traders fill out small paper forms and turn them over to clerks, who then see that the transactions are entered into the system and reported. Each trader is required to have an account at a clearing firm. The clearing firms are the actual members of the clearinghouse. The clearinghouse deals only with the clearing firms, which then deal with their individual and institutional customers.
In electronic trading, the principles remain essentially the same but the traders do not stand in the pits. In fact, they do not see each other at all. They sit at computer terminals, which enable them to see the bids and offers of other traders. Transactions are executed by the click of a computer mouse or an entry from a keyboard.
Trading volume can be a misleading measure of the size of a futures markets; nonetheless, it is the measure primarily used. The structure of global futures exchanges has changed considerably in recent years. Exchanges in the United States, primarily the Chicago Board of Trade and the Chicago Mercantile Exchange, were clearly the world leaders in the past. Note that the volume leader now, however, is Eurex, the combined German-Swiss exchange. Eurex has been so successful partly because of its decision to be an all-electronic futures exchange, whereas the Chicago exchanges are still primarily pit-trading exchanges. Note the popularity of futures trading in Japan; four of the 20 leading exchanges are Japanese.

DELIVERY AND CASH SETTLEMENT

admin — Sat, 09 May 2009 10:38:46 +0000

As previously described, a futures trader can close out a position before expiration. If the trader holds a long position, she can simply enter into a position to go short the same futures contract. From the clearinghouse’s perspective, the trader holds both a long and short position in the same contract. These positions are considered to offset and, therefore, there is no open position in place. Most futures contracts are offset before expiration. Those that remain in place are subject to either delivery or a final cash settlement. Here we explore this process, which determines how a futures contract terminates at expiration. When the exchange designs a futures contract, it specifies whether the contract will terminate with delivery or cash settlement. If the contract terminates in delivery, the clearinghouse selects a counterparty, usually the holder of the oldest long contract, to accept delivery. The holder of the short position then delivers the underlying to the holder of the long position, who pays the short the necessary cash for the underlying. Suppose, for example, that two days before expiration, a party goes long one futures contract at a price of $50. The following day (the day before expiration), the settlement price is $52. The trader’s margin account is then marked to market by crediting it with a gain of $2. Then suppose that the next day the contract expires with the settlement price at $53. As the end of the trading day draws near, the trader has two choices. She can attempt to close out the position by selling the futures contract. The margin account would then be marked to market at the price at which she sells. If she sells close enough to the expiration, the price she sold at would be very close to the final settlement price of $53. Doing so would add $1 to her margin account balance. The other choice is to leave the position open at the end of the trading day. Then she would have to take delivery. If that occurred, she would be required to take possession of the asset and pay the short the settlement price of the previous day. Doing so would be equivalent to paying $52 and receiving the asset. She could then sell the asset for its price of $53, netting a $1 gain, which is equivalent to the final $1 credited to her margin account if she had terminated the position at the settlement price of $53, as described above.An alternative settlement procedure, is cash settlement. The exchange designates certain futures contracts as cash-settled contracts. If the contract used in this example were cash settled, then the trader would not need to close out the position close to the end of the expiration day. She could simply leave the position open. When the contract expires, her margin account would be marked to market for a gain on the final day of $1. Cash settlement contracts have some advantages over delivery contracts, particularly with respect to significant savings in transaction cost.
Contracts designated for delivery have a variety of features that can complicate delivery. In most cases, delivery does not occur immediately after expiration but takes place over several days. In addition, many contracts permit the short to choose when delivery takes place. For many contracts, delivery can be made any business day of the month. The delivery period usually includes the days following the last trading day of the month, which is usually in the third week of the month.
In addition, the short often has other choices regarding delivery, a major one being exactly which underlying asset is delivered. For example, a futures contract on U.S. Treasury bonds trading at the Chicago Board of Trade permits the short to deliver any of a number of U.S. Treasury bonds.14 The wheat futures contract at the Chicago Board of Trade permits delivery of any of several types of wheat. Futures contracts calling for physical delivery of commodities often permit delivery at different locations. A given commodity delivered to one location is not the same as that commodity delivered to another because of the costs involved in transporting the commodity. The short holds the sole right to make decisions about what, when, and where to deliver, and the right to make these decisions can be extremely valuable. The right to make a decision concerning these aspects of delivery is called a delivery option.
Some futures contracts that call for delivery require delivery of the actual asset, and some use only a book entry. For example, in this day and age, no one physically handles U.S. Treasury bonds in the form of pieces of paper. Bonds are transferred electronically over the Federal Reserve’s wire system. Other contracts, such as oil or wheat, do actually involve the physical transfer of the asset. Physical delivery is more common when the underlying is a physical commodity, whereas book entry is more common when the under- lying is a financial asset.
Futures market participants use one additional delivery procedure, which is called exchange for physicals (EFP). In an EFP transaction, the long and short arrange an alternative delivery procedure. For example, the Chicago Board of Trade’s wheat futures contracts require delivery on certain dates at certain locations either in Chicago or in a few other specified locations in the Midwest. If the long and short agree, they could effect delivery by having the short deliver the wheat to the long in, for example, Omaha. The two parties would then report to the Chicago Board of Trade that they had settled their contract outside of the exchange’s normal delivery procedures, which would be satisfactory to the exchange.