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Chapter 4 Markets, exchanges, and regulation.

KEY TERMS

caveat emptor

to arrive contract

forward contract

caveat venditor

perfectly competitive

oligopoly

monopoly

monopsony

oligopsony

arbitrager

speculator

spreader

demutualization

mutual

exchanges

electronic trading

regulation

This chapter covers the basic economic factors that influence futures markets and a brief listing of the major agricultural futures exchanges and the regulating groups associated with the futures industry.

OVERVIEW

Modern day futures markets evolved from early cash markets as the risks of price changes associated with storage, transportation, and processing of agricultural commodities were securitized in various futures contracts. To assure the financial integrity of the new contracts, exchanges evolved as mutual organizations. A mutual is an organization whose members share equally in the profits and losses or in the running of the business if it is a nonprofit entity. All of the major North American futures exchanges were originally set up as mutual organizations and only in the early 2000s did they start the process of demutualization and the conversion to for-profit publicly traded corporations.

Markets

Central places to buy and sell items have existed longer than recorded history. Archaeological evidence of trading centers pre-dates recorded history by several thousand years. Market activities are some of the first items recorded as humans embarked on written language. Most modern markets today are little changed from those of several thousand years ago. Buyers and sellers come together in one physical location. Buyers can inspect the seller's merchandise and price is individually negotiated. That is the essence of all markets; buyers have to be satisfied that the seller's product meets their needs and the price is acceptable to both parties.

When buyers can physically inspect the product and use their own skill and judgment as to the condition and quality of the product, the general market rule has been in common law to be caveat emptor (Latin for "let the buyer beware"). Unethical sellers throughout history have preyed on this concept by various methods to fool or trick the buyer (watered wine, sand in grain, horse meat instead of beef just to name a few). The acceptance of caveat emptor into common law throughout history is hinged on the belief that buyers and sellers are of equal power and the buyer was free to inspect the item and thus had control over the transaction and was the responsible trader.

As economies became more complex, so did marketplaces. Buyers and sellers alike needed more than just a spot (cash) transaction that involved physical movement of the product to a central trading location and then a time-consuming inspection and price negotiation. Gradually, time (delivery) became part of the negotiation as well as alternative payment methods. Two general types of time contracts emerged that are still in use today: to arrive contracts and forward contracts. To arrive contracts call for delivery at some point in the future with title passing immediately from seller to buyer. Forward contracts call for delivery at some point in the future but title passes only upon delivery. Timed delivery created a new market participant--third-party handlers. These third-party handlers would perform the function of storing, delivering, and sorting of products (merchants, warehouses, and commercial transportation). Alternative forms of payment evolved from simple cash transactions to negotiable orders of withdrawals, checks, letters of credit, and purchase orders. These alternative forms of payment between buyers and sellers necessitated the development of other areas of professionals such as record keepers (bookkeepers and accountants), bankers, money changers (foreign exchange), and mediators (attorneys).

As time and payment choices were added to central markets, another axiom emerged--caveat venditor (Latin for "let the seller beware"). Under this rule, the seller is the responsible party and has to act accordingly. With both caveat principles in the minds of traders, a need developed whereby both buyers' and sellers' rights were honored in a more formal structure that also accommodated more complex trading terms.

Such markets developed in the mid-1800s entailing agricultural commodities throughout the United States, Canada, and Europe. Buyers, sellers, and the commodity would still be centrally located but certain rules of conduct and financial assurances were imposed by the central market to provide some measure of relief between buyer and seller on the risk of default. Livestock markets arose near water or rail routes so that buyers could move large volumes of animals to slaughter and large numbers of sellers would provide the pool of animals. Live auctions developed at these markets as an efficient way for many buyers to have access to all of the seller's products and sellers could be assured of more than one buyer having a chance to bid on purchase price.

By contrast, grain markets unfolded along a different path. Sellers would privately negotiate with a third-party handler (often a warehouse). In turn, buyers would do likewise with the third-party handler. Sellers (grain producers) needed to get rid of the product after harvest, and warehouses (later called elevators) would buy the grain and then perform the value-added function of storing the product. Buyers could buy from the warehouse throughout the year and avoid having to store the product themselves.

Economic Theory and Markets

Modern microeconomic theory classifies markets into three major forms: perfectly competitive, oligopoly, and monopoly. An understanding of each model will help understand the development of markets and how they have evolved to today.

Perfectly Competitive Markets

For markets to behave in a perfectly competitive way they have to have the following:

1. Many buyers and sellers with no one being large enough to have any market power over the others

2. A homogenous product

3. No barriers to entry or exit

The results of such a market are that the price in the short run oscillates around the cost of production and in the long run no excess economic profits exist.

[FIGURE 4-1 OMITTED]

In this market, traders can enter the market or exit at will. There are no legal, economic, or intellectual barriers. No seller can differential their product from another, that is, everyone is selling the same thing. There are many buyers to offer bids and many sellers all with the same product to offer and all of the buyers and sellers are approximately equal in size and power. Obviously, no known markets completely adhere to these assumptions. Most economists relax the assumptions and reclassify the perfectly competitive market as workably competitive. Workably competitive markets don't exactly meet the requirements, but behave or have the results expected from a perfectly competitive market.

In such a market, the interaction of the supply and demand curves yields the market price that, in turn, becomes the marginal revenue to each producer, as shown in Figure 4-1. Since no producer is big enough to affect price, each unit that the producer sells brings in the same revenue, thus the reason the market price is the same as the individual producer's marginal revenue curve. The individual's cost structure shows in Figure 4-1 that there is no profit. If something occurs to affect market demand such that the market price increases as shown in Figure 4-2, then the individual producer will have short-term profits. However, since there are no barriers to entry or exit, then the short-term profit will attract other producers (shifting the market supply curve to the right) and thus drive the market price back to where there is no profit for an individual producer as revealed in Figure 4-3.

The situation is the same if there is a loss. Producers will leave the industry and price will increase. Thus the competitive model yields the potential for short-term profits and losses for individual firms, but in the long run market price tends to seek the level associated with the total cost of production, thus no excess economic profits.

Not Perfectly Competitive Markets

An oligopoly is 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 marketplace. A monopoly is a single producer with significant barriers to entry. Both types of markets are considered noncompetitive because some market power exists. If oligopolies differentiate their products and do not enter into price wars with each other, they can sustain prices such that they have excess economic profits. Obviously a monopoly can do likewise. If a market sustains short-run or long-run excess economic profits, one or more of the assumptions of a perfectly competitive market have been violated. Oligopolies and monopolies refer to the production side of a marketplace, that is, the sellers of the product. A single buyer is called a monopsony and two or more buyers are referred to as an oligopsony.

[FIGURE 4-2 OMITTED]

[FIGURE 4-3 OMITTED]

[FIGURE 4-4 OMITTED]

Let's consider the situation of a monopoly first and then treat oligopolies as a special case of the monopoly model. Figure 4-4 shows the cost structure for a single firm and that they will price the product at the level that maximizes their profit (where marginal cost equals marginal revenue). Since they are the only producing firm, they can maintain that price and profit level. Consequently, most governments will endeavor to put limits on what monopolies, such as utilities, can earn so they cannot behave as a monopoly.

The monopoly model is useful in agricultural situations because sometimes a local business can behave in a manner not unlike what the monopoly model says will happen. For example, if there were only one feed processor in an area they could set their price at a level that would produce excess economic profits, even for the long run, if there were enough barriers to entry to keep other competition out. Rural areas do have businesses that behave in a fashion similar to monopolies, which over the years has caused farmers and ranchers to form cooperatives as a way to counter the monopoly practices of businesses.

Consider now the case of oligopolies' (more than one but less than many) producers. They try to differentiate their products such that consumers believe there are no substitutes, thus they can have some measure of monopoly profits. To the extent that consumers don't feel the products of two producers are different, then the two firms will compete with each other. If they do so on price, they might behave more like the competitive model where profits are bid away and over time no excess economic profits exist (the current situation with the airline industry). They might try to work together and avoid a price war and then divide the excess economic profit based on market share; however, that is illegal and oligopolies are constantly being monitored both at the federal as well as the state level for such actions of collusion.

The point of studying the economic models is that the only way to achieve long-run economic profit is to have some form of noncompetitive market activity. Most firms try to do this by differentiating their product (Coke versus Pepsi) or driving their cost structure so low that the market price is above their costs such that they can have excess economic profits beyond the short run (Southwest Airlines and Wal-Mart).

Using the Market Concepts and the Role of the Speculator

The various market forms and the economic assumptions are helpful to understand market behavior and are critical for market participants called arbitragers. An arbitrager is a trader who will attempt to take advantage of market imperfections in order to capture a profit. Arbitragers are also known as profit takers. Arbitragers are speculators who have a very sophisticated knowledge of markets and how they function and provide a vital role of the efficiency of market behavior.

Arbitragers will generally avoid markets that are characterized as either a monopoly or monopsony simply because one buyer or seller is de facto the market. One buyer or seller exists because of significant barriers to entry that preclude any other market participants. However, other than monopolistic markets, arbitragers can and do participate to the extent that they believe they can earn a profit for their knowledge and actions. Arbitragers can be classified in two major ways: (1) market relationships and (2) market positions. Relationship arbitragers (also known as spreaders) are looking for abnormal patterns in market associations such as time, place, and form. Position arbitragers take positions in the market believing that the market will move in favor of the position. Let us look at examples of both types of arbitragers.

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. For example, the price of a bushel of corn today in the cash market should be lower than the price of corn to be delivered in one month to the same location by the cost of storage (carry) for one month. If the cost of carry for one month was 5 cents per bushel, then the relationship between cash spot price today and one month later should be 5 cents per bushel. Consider how market forces maintain that relationship. If spot cash corn was trading at $3 per bushel today and the one-month delivery for corn to the same location was trading at $3.08 per bushel, arbitragers would enter the market by buying cash corn today and simultaneously selling it for delivery one month later for $3.08 per bushel. They would store the corn for the month incurring a cost of 5 cents and earning a tidy 3 cents per bushel profit. This action will be done by several traders. The markets will likely react as follows: the extra buying pressure on the cash market will bid the local cash price up and the simultaneous selling pressure for one-month future delivery will bid the price down, and the 3-cent profit will be bid away by the actions of the arbitragers. If the markets did not respond this way, arbitragers would look at alternative market models such as monopoly power to determine if, in fact, the markets were competitive.

Spreaders use this concept all the time with storable commodities on futures contracts. An arbitrage spreader will determine what is "normal" as a price difference between two or more futures market prices (the spread) and then watch for times when the spread is abnormal. If, for example, a spreader determined that the normal spread between March corn futures price and May corn futures price was 10 cents per bushel, they would watch for times when the spread was either less or more. If they observed that March corn futures was trading at $3.00 per bushel and May corn futures was trading at $3.14 per bushel, what should they do? They have determined that the normal spread is 10 cents (i.e., the cost of carry for two months) and then the spread suddenly widens to 14 cents. The theory says that the market will go back to the 10-cent spread. A spreader will simultaneously buy the March corn futures at $3.00 per bushel and sell the May corn futures at $3.14 per bushel. They have "put on a spread" by buying the nearby futures contract and selling the faraway contract. Then they wait. Their actions combined with those of other spreaders will most likely force the markets to adjust. There is buy pressure on the March contract, which will increase the price, and selling pressure on the May contract, which will lower the price and thus move the spread back to 10 cents. Table 4-1 shows this action. All that matters is that the spread goes back to the normal spread and the spreader will make as a profit the difference between the initial spread and the abnormal spread. The general rule is that when the spread is larger than the normal spread, the arbitrager will "put on a spread" which means that they simultaneously buy the nearby futures contract and sell the faraway futures contract.

If the spread becomes abnormally small, a spreader will do just the opposite, as revealed in Table 4-2. When the temporal spread becomes smaller than normal, the arbitrager will "put on reverse spread" whereby he or she simultaneously sells the nearby futures contract and buys the faraway futures contract. The selling of the nearby futures contract should cause the price to decrease and the buying pressure on the faraway should increase that price such that the spread increases.

Notice that in either the case of the normal spread or the reverse spread the profit earned is the difference between the normal spread and the abnormal amount. This action by spreaders helps keep the futures markets tied together by the cost of carry market model. The spread model is stronger than the reverse spread. If a spread is wider than normal and the markets don't go back to the normal spread, the spreader can take delivery of the nearby commodity, store the product until the faraway date, deliver at the later date, and capture the difference. However, if the markets are abnormal and the spreader puts on a reverse spread, the option of delivery is not available since the spreader cannot sell physical commodities that he does not have and buy later. In other words, the trader cannot have negative inventory in the storeroom. Accordingly, spreads are less risky than reverse spreads.

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. If the price of a bushel of corn was $3 in one location and $3.20 in another, and the cost of transportation between the two locations was only 15 cents per bushel, arbitragers would buy in the cheaper location and pay to transport to the other location and earn 5 cents profit for their actions. These actions should drive up the price in the cheaper location and down in the dearer location so that the difference represents the cost of moving the corn between the two locations.

Unlike temporal spreaders with futures contracts, no major special agricultural futures spreads exist as there are no agricultural products that are alike traded on two different exchanges separated by place.

Form

The difference between the price of the raw product and the finished product(s) should be the cost of form change (manufacturing costs). The price difference between raw soybeans and the meal and oil that result from crushing the beans should be the cost of processing. Arbitragers would watch the relationship and trade when the difference was less or more than the cost to transform raw products into finished products.

Form spreads exist in the energy field as crude oil is refined (cracked) into gasoline, heating oil, and other products. In fact the New York Mercantile Exchange has a cracking futures contract based on the cost of transforming (cracking) crude oil into its component parts.

Live cattle futures represent the final product while feeder cattle are an input into the process as well as the feed necessary to produce the fat cattle such as corn and soybeans. It is conceivable that a cattle crush or crack spread exists (a feeding spread), but thus far it has yet to be quantified in such a way as to be valuable to spread arbitragers (or if they have found it they are certainly keeping their mouths shut). Likewise it is conceivable that a similar relationship exists between raw milk prices and its component parts of butter and cheese.

What is necessary for successful spreading from differences is a futures contract on the raw product(s) and finished product(s) so spreaders can calculate what is normal as a processing or transforming cost and the prices of raw and finished products. Soybean crushing by spread arbitragers is very popular because futures contracts exist on the raw product (soybeans) and finished products (meal and oil). Soybean crush hedges are discussed fully in Chapter 5, but the concept is the same regardless of whether the action is a hedge or spread.

Spread arbitragers will spread relationships between two or more cash markets and likewise for two or more futures markets, and will also trade on differences between a cash market and a futures market price. These actions keep the cash and futures markets tied together by the three major relationships--time, space, and form.

Position Traders

Position arbitragers will 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 might sell corn for future delivery right before a major governmental report because they believe the report will be bearish. If the report is bearish, then they will have sold the corn before the report and can now buy the corn at a cheaper price to deliver against the contract. Position arbitragers will buy one type of cattle in one market because they know that type of cattle is always sold at a discount in that market, and sell the cattle into another market that pays a premium.

Arbitragers provide two major market activities. They provide liquidity because they are constantly monitoring markets and trading. They are also the glue for economic activity. Arbitragers are ready to exploit differences in time, space, form, discriminations, information, local monopolies, or any abnormal market situation to earn a small profit for their efforts and knowledge. Thus successful arbitragers are very sophisticated in their understanding of market forces and market participants.

Because arbitragers are ready, willing, and able to trade off differences between cash markets and futures markets, they force the two markets to be tied together in a derivative relationship. A futures contract derives it value from the underlying cash market, thus the reason early cash markets such as the Chicago Board of Trade evolved other forms of derivative contracts such as futures and options contracts.

The Exchanges

Exchange traded derivatives have gone through major changes followed by long periods of almost no change. The first major movement involved the actual formation of organized exchanges where the rules of trade could be developed and a central place existed to physically trade commodities. The first to form a central trading place complete with rules of trade and conduct was the Chicago Board of Trade (CBOT). Once the CBOT got started they created the first futures contracts, probably vintage civil war times (mid-1860s). The exact date is uncertain because the CBOT lost all of its records in the great fire of 1871.

Other exchanges developed during the period between the Civil War and the beginning of the twentieth century. Numerous commodities were traded and indeed, whole exchanges were created around a few products such as the Chicago Butter and Egg Board (later to be renamed the Chicago Mercantile Exchange). Exchanges were formed in Kansas City, Minneapolis, and New York, but they did not do anything new with futures contracts other than make futures contracts more regionally focused.

The only major change that occurred with futures exchanges between the Civil War (1860s) and World War II (1940s) was the formation of a separate clearinghouse. In 1926 the CBOT created a clearinghouse that was a separate unit from the trading exchange. Other exchanges followed, and in an interesting twist in 2004 the CBOT moved all of its clearing functions to the Chicago Mercantile Exchange (CME). The clearinghouse concept was a major shift as it split the financial risk of default on the futures contracts from the function of trading the contracts.

Futures markets, once developed in the mid-nineteenth century, remained virtually unchanged until the mid-1960s when the CME developed the first futures contracts on live animals--hogs and cattle. The CME followed in 1972 with the creation of a new division within the CME called the International Monetary Market (IMM) to trade the newly floating foreign currencies. Within a decade the CME had innovated new futures contracts on non-storable commodities and entered the world of financial derivatives. The CME introduced the first cash settled contract (Eurodollar contract) and the first index contract (S & P Stock Index). Other exchanges quickly followed suit with an almost infinite stream of index and financial products. The flood gates were opened by the CME; essentially anything that is traded in some way can have a derivative contract attached. The period between the early 1980s and the beginning of the twenty-first century is remarkably similar to the same time period one hundred years earlier--lots of new futures contracts on many different types of products, but no real structural or financial changes.

Surprisingly, during the period when the CME was developing new innovative futures contracts, none of the exchanges seriously looked at options until a rough group of traders in the early 1970s found a loophole in the Commodity Exchange Act of 1936 that banned options to open option trading on commodities. The Commodity Futures Trading Commission (CFTC) moved to close the loophole and ban all commodity options once again by the mid-1970s. The CFTC allowed a new pilot program on options on commodities in the early 1980s and exchange traded options quickly moved into the mainstream of derivative use.

Computerized trading is embraced throughout the world, yet it remains a stumbling block with U.S. exchanges. The U.S. exchanges have steadfastly refused to accept computerized trading as a substitute for open outcry auctions. The exchanges have tried to use handheld devices as a way to computerize while still keeping the physical trader in the pit. These devices met with dismal failure because they failed to use the power of computers and instead forced a new hard-to-use technology on traders whose biggest asset was the speed with which they could execute a physical open outcry trade. The uneasy truce that has evolved in the United States is a kind of dual system that allows for off-hour computerized trading and an active open outcry auction in the pits--neither a feast nor a foul bargain.

The latest change to occur with U.S. exchanges before 2000 had been the demutualization of the two largest exchanges. In 2000 the CME voted to become a for-profit, publicly traded stock company. In 2002 the process was complete, and the public can now own shares of the CME. The CBOT voted in 2004 to demutualize and the process was complete in 2005. All of the other U.S. exchanges remain mutual not-for-profit companies. All of the exchanges have excellent Web sites, many with downloadable data and more detailed information on futures and options contracts.

Chicago Board of Trade

The CBOT is the granddaddy of U.S. exchanges (often referred to as the "Board"). It was the first to form in 1848 as a place for traders to assemble and conduct business under mutually accepted guidelines for the professional conduct of business. The forerunner to futures contracts were called "to arrive" contracts. Traders negotiated quantity, quality, and price and then set a time for the product to be delivered ("to arrive"). Since the traders were all assembled in one location, these early contracts started to take on standard features that would allow for easier retrading, such as quantity and quality. Once the major features of the contracts were standardized, all that remained to be negotiated was price between traders. Exactly when these standardized "to arrive" contracts slipped into the form known today as futures contracts remains obscure because the early records of the exchange were destroyed in the Great Chicago Fire of 1871 (over a third of the city was destroyed including 18,000 buildings); however, the CBOT believes that sometime during 1865 the first futures contract began trading. The exchange trades a wide range of futures and options contracts but is generally known for its derivatives on grains and soybeans. The CBOT trades fertilizer contracts and in 2005 it added an ethanol contract. The Internet address for the CBOT is <http://www.cbot.com>.

Chicago Mercantile Exchange

The "Merc" started as the Chicago Butter and Egg Board in 1898 and officially changed to its present name in 1919. The CME has long been an innovator in the derivatives world. They started the first nonstorable commodity futures contract, live cattle, in 1964 and in 1966 followed up with a live hog contract. They were the first exchange to move into financial derivatives in 1972 with currency futures contracts. The CME built the first global electronic trading platform, GLOBEX, in 1992. U.S. exchanges have always been mutual nonprofit associations, but the "Merc" stopped that in 2002 by becoming the first exchange to demutualize and become a for-profit, publicly traded company. The CME became the world's largest derivative exchange in 2004 by trading a long and diverse list of products, but it is primarily known in the agricultural arena as the livestock exchange. The Internet address for the CME is <http://www.cme.com>.

New York Mercantile Exchange

The NYME (pronounced "nyemex") is one of the nation's oldest exchanges. It was founded in 1872 to trade butter, eggs, and cheese. It has long since abandoned those products and emerged in the last half of the twentieth century as the metals market trading gold, silver, copper, platinum, and palladium. The NYME made a major jump in the late 1970s by offering energy derivatives--crude oil and gasoline futures contracts. Many additional energy derivatives as well as some financial indexes have been added, and today the NYME is the premier energy derivative exchange in the world. The Internet address for the NYME is <http://www .nymex.com>.

New York Board of Trade

The NYBT came into being in 1998 via the merger of two very old exchanges--the Coffee, Sugar and Cocoa Exchange (founded in 1882) and the New York Cotton Exchange (founded in 1870). Today the NYBT is a major world derivatives player because it offers derivatives in cocoa, coffee, orange juice, sugar, and milk. It also has numerous financial derivative products. The Internet address for the NYBT is <http://www.nybot.com>.

Minneapolis Grain Exchange

This exchange has been the major market for hard red spring wheat derivatives since its founding in 1881. The MGE innovated the first agricultural commodity indexes in the early part of the twenty-first century and now trades indexes on corn, soybeans, hard red spring wheat, hard red winter wheat, and soft red winter wheat. These indexes remove specific delivery locations from the standardized component of the contract and thus are excellent tools to follow the general market price of these commodities. These indexes provide a "fixing" market for cash settlements in other markets (necessary for successful swap contracts). The Internet address for the MGE is <http://www.mgex.com>.

Kansas City Board of Trade

The nation's second oldest exchange was founded in 1856. The KCBT's major derivative product is hard red winter wheat, but in 1982 it launched the first financial derivative index futures contract, the Value Line. The Internet address for the KCBT is <http://www.kcbt.com>.

Winnipeg Commodity Exchange

Canada's agricultural derivative marketplace (founded in 1887) trades futures and options contracts on barley, wheat, flaxseed, and canola (rapeseed). The WCE demutualized in 2001, a full year ahead of the first U.S. exchange (the Chicago Mercantile Exchange). The WCE converted to full electronic trading on December 20, 2004, and thus became the first North American exchange to convert to the new digital format. Canada has always been on the forefront of electronic trading. In the 1960s Canada used the latest technology--the teletype machine--to trade cash hogs. This type of technology needed a new set of trading terms involving trading by description rather than by inspection, which ultimately laid the groundwork for the movement 20 years later away from physical assembly of livestock for cash markets to video and electronic trading. Now the WCE is leading the way for full electronic trading of derivatives. The last open outcry trade occurred on December 17, 2004. Consequently, the WCE is the only North American agricultural derivatives exchange to use a fully functioning electronic trading platform. The Internet address for the WCE is <http://www.wce.ca>.

Others

Derivative exchanges are more numerous now than at any time in history globally. During the last decade, many of the U.S. exchanges have formed relationships with exchanges in other countries to provide off-hour trading opportunities. One new U.S. exchange deserves to be mentioned individually because of the potential for change that it has and likely will have in the future. Eurex US opened for business February 8, 2004, as the first fully electronic derivatives market in the United States Furthermore, it is the first foreign exchange to ask for and get permission to open a new derivatives market in the United States Eurex US is operated by the Deutsche Borse AG and SWX Swiss Exchange, which is the world's largest fully electronic derivatives exchange. Currently Eurex US is trading only financial derivatives. All of the U.S. exchanges have been slow to embrace electronic trading and even in 2005 still relied primarily on physical open outcry auction with lukewarm plans for expansion into electronic trading. Eurex US has got a foothold in the United States now and a proven electronic trading platform that can provide some much needed competition for derivatives trading. The Internet address for Eurex US is <http://www.eurex.com>.

Table 4-3 shows a list of all of the agricultural futures contracts traded on the major North American exchanges. It is interesting to note that the list (current as of June 2005) contains only the major commodities. Yet five years ago the list contained peas, shrimp, and fresh pork bellies just to name a few. Exchanges have had a long history of trying new contracts as long as they feel a need by an industry for the product. A list of all agricultural futures ever traded in the long history of the U.S. and Canadian exchanges would run for several pages and include most agricultural products produced or traded in North America; however, to have staying power futures contracts have to sustain a trading volume to justify trading space at the exchange. To date, only the major commodities can justify such space. This is all the more reason to move to fully electronic trading platforms that don't need bricks and mortar and thus large capital outlays and the variable costs of live traders.

Regulating Groups

Commodity Futures Trading Commission (CFTC)

The forerunner to the CFTC was the Commodity Exchange Authority. As futures contracts emerged on financial products and other derivatives emerged such as options and swaps, new regulations had to evolve. In 1974 the Commodity Exchange Authority was eliminated and the Commodity Futures Trading Commission was formed. New legislation and changes were added in 1982 with the Futures Trading Act, in 1992 with the reauthorization of the CFTC, and likewise in 2000 with the Commodity Futures Modernization Act. Each of these adjustments allowed for overlapping regulations via the Securities Exchange Commission (SEC) and the Federal Reserve Board (FED) and the ways they have to work together.

The CFTC has the task of regulating all derivative trading including exchanges, traders, and terms of trading for the benefit of the general public. They do not regulate cash and forward contracts except as they relate to manipulation and impacts on derivative markets. The Internet address is www.cftc.gov.

National Futures Association (NFA)

When the CFTC was created in 1974, a provision was added to the act to allow for the creation of futures associations to assist in regulation of the markets. Each exchange develops and enforces its own set of rules and regulations with oversight by the CFTC. The NFA is a self-regulatory group charged with overseeing the market participants that deal with the trading public. As such, all market participants must join and abide by the rules and regulations of the NFA (currently over 4,200 firms and 55,000 individuals are registered). The Internet address for the NFA is www.nfa.org.

Canadian Regulation

Canadian derivatives trading falls under the Commodity Futures Act (CFA) of 1996. Under this law, derivatives trading is regulated by each province and allows for the setting up of Self Regulatory Organizations (SRO). As such the Winnipeg Commodity Exchange has its own SRO which is in turn regulated by the Manitoba Securities Commission. The Internet address for the Manitoba Securities Commission is <http://www.msc.gov.mb.ca>.

CHAPTER 4--QUESTIONS

1. If an arbitrager assumed the normal difference between the March corn futures price and the May futures price was $0.15 per bushel, then saw that the difference had moved to $0.07 per bushel, what action would he take and why?

2. A speculator has observed that the cost of processing soybeans into meal and oil costs on average $0.35 per bushel, yet for the last two years the crush margin has been over $1.00 per bushel. What could the speculator do, if anything, and why?

3. Why are most of the major North American exchanges moving from a mutual organization to a for-profit publicly traded corporation?

4. Caveat emptor has long been the mantra of free enterprise markets, yet another term, caveat venditor, has emerged. Why?

5. Canadian exchanges are regulated in a much different fashion than U.S. exchanges. What is the major difference?
Table 4-1 Normal Temporal Spread

Buy March corn futures @ $3.00/bushel
Sell May corn futures @ $3.14/bushel

                                     Spread of 14 cents/bushel

Later ...

Sell March corn futures @ $3.02/bushel
Buy May corn futures @ $3.12/bushel

                                     Spread of 10 cents/bushel

Profit of two cents per bushel on the March leg (buy @ $3.00,
sell @ $3.02)

Profit of two cents per bushel on the May leg (sell @ $3.14,
buy @ $3.12)

Total Profit = 4 cents/bushel

Table 4-2 Reverse Temporal Spread

                                Normal spread March-May = 10 cents

Sell March corn futures @ $3.00/bushel
Buy May corn futures @ $3.07/bushel

                                Spread of 7 cents/bushel

Later ...

Buy March corn futures @ $2.99/bushel
Sell May corn futures @ $3.09/bushel

                                Spread of 10 cents/bushel

Profit of 1 cent per bushel on the March leg (sell @ $3.00, buy
@ $2.99)
Profit of 2 cents per bushel on the May leg (buy @ $3.07, sell
@ $3.09)

Total Profit = 3 cents/bushel

Table 4-3 Major Agricultural and
Agriculturally Related Futures Contracts

             Contract                    Size        Delivery Months

Chicago Board of Trade (CBOT)
  Corn                              5,000 bushels    Dec, Mar, May,
                                                       Jul, Sept
  Soybeans                          5,000 bushels    Sep, Nov, Jan,
                                                       Mar, May, Jul,
                                                       Aug
  Soybean oil                       60,000 pounds    Oct, Dec, Jan,
                                                       Mar, May, Jul,
                                                       Aug, Sep
  Soybean meal                      100 tons           Oct, Dec, Jan,
                                                     Mar, May, Jul,
                                                       Aug, Sep
  Oats                              5,000 bushels    Jul, Sep, Dec,
                                                       Mar, May
  Wheat                             5,000 bushels    Jul, Sep, Dec,
                                                       Mar, May
  Rough rice                        2,000 cwt        Sep, Nov, Jan,
                                                       Mar, May, Jul
  SA soybeans (South American)      5,000 bushels    Jan, Mar, May,
                                                       Jul, Aug, Sep,
                                                       Nov
  Ethanol                           29,000 gals      All calendar
                                                       months
  Mini corn                         1,000 bushels    Jul, Sep, Dec,
                                                       Mar, May
  Mini soybeans                     1,000 bushels    Sep, Nov, Jan,
                                                       Mar, May, Jul,
                                                       Aug
  Mini wheat                        1,000 bushels    Jul, Sep, Dec,
                                                       Mar, May
  Dow jones AIG                     $100 x Index     Jan, Feb, Apr,
    Commodity index                                    Jun, Aug, Oct,
                                                       Dec

Chicago Mercantile Exchange (CME)
  Live cattle                       40,000 pounds    Feb, Apr, Jun,
                                                       Aug, Oct, Dec
  Feeder cattle                     50,000 pounds    Jan, Mar, Apr,
                                                       May, Aug, Sep,
                                                       Oct, Nov
  Lean hogs                         40,000 pounds    Feb, Apr, Jun,
                                                       Jul, Aug, Oct,
                                                       Dec
  Frozen pork bellies               40,000 pounds    Feb, Mar, May,
                                                       Jul, Aug
  Class II milk                     200,000 pounds   All calendar
                                                       months
  Class IV milk                     200,000 pounds   All calendar
                                                       months
  Random length lumber              110,000 board    Jan, Mar, May,
                                      feet             Jul, Sep, Nov
  Butter                            40,000 pounds    Mar, May, Jul,
                                                       Sep, Oct, Dec
  Non-fat dry milk                  44,000 pounds    All Calendar
                                                       Months
  DAP (fertilizer)                  100 tons         Mar, May, Jul,
                                                       Sep, Dec
  VAN (fertilizer)                  100 tons         Mar, May, Jul,
                                                       Sep, Dec
  UREA (fertilizer)                 100 tons         Mar, May, Jul,
                                                       Sep, Dec

New York Board of Trade (NYBOT)
  Coffee                            37,500 pounds    Mar, May, Jul,
                                                       Sep, Dec
  World sugar no. 11                112,000 pounds   Mar, May,
                                                       Jul, Oct
  Domestic sugar no. 14             112,000 pounds   Jan, Mar, May,
                                                       Jul, Sep, Nov
  Cocoa                             10 metric tons   Mar, May, Jul,
                                                       Sep, Dec
  Cotton #2                         50,000 pounds    Mar, May, Jul,
                                                       Oct, Dec
  Frozen concentrated
  Orange juice                      15,000 pounds    Jan, Mar, May,
                                                       Jul, Sep, Nov

Minneapolis Grain Exchange (MGEX)
  Hard red spring wheat             5,000 bushels    Mar, May, Jul,
                                                       Sep, Dec
  Hard red winter wheat index       5,000 bushels    All calendar
                                                       months
  Soft red winter wheat index       5,000 bushels    All calendar
                                                       months
  Hard red spring wheat index       5,000 bushels    All calendar
                                                       months
  National corn index               5,000 bushels    All calendar
                                                       months
  National soybean index            5,000 bushels    All calendar
                                                       months

Kansas City Board of Trade (KCBT)
  Hard red winter wheat             5,000 bushels    Jul, Sep, Dec,
                                                       Mar, May

Winnepeg Commodity Exchange (WCE)
  Canola                            20 tonnes        Jan, Mar, May,
                                                       Jul, Sep, Nov
  Feed wheat                        20 tonnes        Mar, May, Jul,
                                                       Oct, Dec
  Western barley                    20 tonnes        Mar, May, Jul,
                                                       Oct, Dec
  Flaxseed                          20 tonnes        Mar, May, Jul,
                                                       Oct, Dec
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Publication:Risk Management for Agriculture
Date:Jan 1, 2007
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