chapter 4 markets, exchanges, and regulation

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Chapter 4Chapter 4

Markets, Exchanges, Markets, Exchanges, and Regulationand Regulation


MarketsMarkets The general market rule that has been common law to The general market rule that has been common law to

caveat emptor caveat emptor (“Let the buyer beware”) resulted from (“Let the buyer beware”) resulted from unethical sellers in the past and stands true today. unethical sellers in the past and stands true today. This has hinged on the belief that buyers and sellers This has hinged on the belief that buyers and sellers are of equal power.are of equal power.

Two general types of time contracts:Two general types of time contracts:– To arrive contractsTo arrive contracts call for delivery at some point in the call for delivery at some point in the

future with title immediately passing from seller to buyer.future with title immediately passing from seller to buyer.– Forward contractsForward contracts call for delivery at some point in the call for delivery at some point in the

future with title passing only upon delivery.future with title passing only upon delivery.– Timed delivery resulted in a third party, handlers.Timed delivery resulted in a third party, handlers.

(continued)(continued)


Markets Markets (continued)(continued)

Over time another axiom emerged, Over time another axiom emerged, caveat caveat venditorvenditor (“Let the seller beware”); the seller is (“Let the seller beware”); the seller is the responsible party and has to act the responsible party and has to act accordingly.accordingly.

Markets eventually evolved into the modern Markets eventually evolved into the modern microeconomic markets we have today.microeconomic markets we have today.


Economic Theory and MarketsEconomic Theory and Markets Microeconomic theory provides three market Microeconomic theory provides three market

classifications:classifications:– Perfectly competitive: many buyers and sellers, Perfectly competitive: many buyers and sellers,

homogenous product, no barriers to entry and exit; homogenous product, no barriers to entry and exit; often reclassified as often reclassified as workably competitive.workably competitive.

– Oligopoly: two or more firms producing a product Oligopoly: two or more firms producing a product that may or may not be homogenous and there are that may or may not be homogenous and there are some form of barriers to entry or exit in the market some form of barriers to entry or exit in the market place.place.

– Monopoly: a single producer with significant Monopoly: a single producer with significant barriers to entry.barriers to entry.



Economic Theory and Markets Economic Theory and Markets (continued)(continued)

Oligopolies and monopolies are Oligopolies and monopolies are noncompetitive markets because some market noncompetitive markets because some market power exists. They also refer to the production power exists. They also refer to the production side—that is, the sellers.side—that is, the sellers.– Monopsony—a single buyerMonopsony—a single buyer– Oligopsony—two or more buyersOligopsony—two or more buyers

The only way to achieve long-run economic The only way to achieve long-run economic profit is to have some form of noncompetitive profit is to have some form of noncompetitive market activity.market activity.


Using the Market Concepts and the Using the Market Concepts and the Role of the SpeculatorRole of the Speculator

Various market forms and economic Various market forms and economic assumptions are critical for assumptions are critical for arbitragersarbitragers——traders who attempt to take advantage of traders who attempt to take advantage of market imperfections in order to capture profit market imperfections in order to capture profit (also known as profit takers).(also known as profit takers).

Arbitragers are Arbitragers are speculatorsspeculators who have a very who have a very sophisticated knowledge of markets and how sophisticated knowledge of markets and how they function; they provide a vital role of the they function; they provide a vital role of the efficiency of market behavior.efficiency of market behavior.



Using the Market Concepts and the Using the Market Concepts and the Role of the Speculator Role of the Speculator (continued)(continued)

Arbitragers are classified in two major ways:Arbitragers are classified in two major ways:– Market Market relationshiprelationship arbitragers ( arbitragers (spreadersspreaders) look ) look

for abnormal patterns in time, place, and form. for abnormal patterns in time, place, and form. – Market Market positionposition arbitragers take positions in the arbitragers take positions in the

market believing that the market will move in their market believing that the market will move in their favor.favor.


Market Relationships: TemporalMarket Relationships: Temporal The difference between two markets that are separated The difference between two markets that are separated

by time and where the product is storable, if the by time and where the product is storable, if the markets are workably competitive, should be the cost markets are workably competitive, should be the cost of carry between the two time periods.of carry between the two time periods.

Spreaders use this concept with storable commodities.Spreaders use this concept with storable commodities.– They determine what the “normal” price is and then wait for They determine what the “normal” price is and then wait for

times when the spread is “abnormal.”times when the spread is “abnormal.” Table 4-2 illustrates a “reverse spread” Table 4-2 illustrates a “reverse spread” (see next slide).(see next slide). No matter the type of spread, the profit earned is the No matter the type of spread, the profit earned is the

difference between the normal spread and the difference between the normal spread and the abnormal amount.abnormal amount.


Market Relationships: SpatialMarket Relationships: Spatial The difference between two markets that are The difference between two markets that are

separated by space should be the cost of separated by space should be the cost of transportation.transportation.

Arbitragers would trade the differences if they Arbitragers would trade the differences if they were aberrant from the cost of transportation, were aberrant from the cost of transportation, just as they would for time differences.just as they would for time differences.


Market Relationships: FormMarket Relationships: Form The difference between the price of the raw The difference between the price of the raw

product and the finished product(s) should be product and the finished product(s) should be the cost of form change (manufacturing costs).the cost of form change (manufacturing costs).

Arbitragers watch the relationship and trade Arbitragers watch the relationship and trade when the difference is less or more than the when the difference is less or more than the cost to transform the products.cost to transform the products.

There must be a futures contract on the raw There must be a futures contract on the raw product and the finished product for successful product and the finished product for successful spreading.spreading.


Position TradersPosition Traders Position arbitragers take a market position if Position arbitragers take a market position if

they believe the market is undervalued or they believe the market is undervalued or overvalued other than by the three major overvalued other than by the three major relationships of time, space, and form.relationships of time, space, and form.

Arbitragers provide two major market activities:Arbitragers provide two major market activities:– They provide liquidity.They provide liquidity.– They are the glue for economic activity.They are the glue for economic activity.

They force the cash and futures markets to be They force the cash and futures markets to be tied together in a derivative relationship.tied together in a derivative relationship.


The ExchangesThe Exchanges The first to form a central trading place complete with rules of The first to form a central trading place complete with rules of

trade conduct was the Chicago Board of Trade (mid-1860s).trade conduct was the Chicago Board of Trade (mid-1860s). Other exchanges were formed in different areas, making Other exchanges were formed in different areas, making

contracts more regionally focused.contracts more regionally focused. Major change between the Civil War and World War II was Major change between the Civil War and World War II was

the creation of a separate clearinghouse. This split the the creation of a separate clearinghouse. This split the financial risk of default on contracts from the function of financial risk of default on contracts from the function of trading contracts.trading contracts.

Option trading began in the mid-1970s.Option trading began in the mid-1970s. Computerized trading is popular throughout the world; Computerized trading is popular throughout the world;

however it has not taken a large hold on the U.S. exchanges.however it has not taken a large hold on the U.S. exchanges.



The Exchanges The Exchanges (continued)(continued)

Chicago Board of TradeChicago Board of Trade– First to form as a place for traders to assemble, CBOT is First to form as a place for traders to assemble, CBOT is

known as the grandfather of U.S. exchanges.known as the grandfather of U.S. exchanges. Chicago Mercantile ExchangeChicago Mercantile Exchange

– Began officially in 1919, CME (the “Merc”) is the world’s Began officially in 1919, CME (the “Merc”) is the world’s largest derivative exchange.largest derivative exchange.

New York Mercantile ExchangeNew York Mercantile Exchange– Founded in 1872, the NYME is the premier energy Founded in 1872, the NYME is the premier energy

derivative exchange.derivative exchange. New York Board of TradeNew York Board of Trade

– Began in 1998, the NYBT offers derivatives in cocoa, Began in 1998, the NYBT offers derivatives in cocoa, coffee, orange juice, sugar, and milk.coffee, orange juice, sugar, and milk.




Minneapolis Grain ExchangeMinneapolis Grain Exchange– Founded in 1881, the MGE has been the major market for Founded in 1881, the MGE has been the major market for

hard red spring wheat.hard red spring wheat. Kansas City Board of TradeKansas City Board of Trade

– The nation’s second oldest exchange (founded in 1856), the The nation’s second oldest exchange (founded in 1856), the KCBT’s major derivative is hard red winter wheat.KCBT’s major derivative is hard red winter wheat.

Winnipeg Commodity ExchangeWinnipeg Commodity Exchange– Founded in 1887, Canada’s agricultural derivative Founded in 1887, Canada’s agricultural derivative

marketplace trades futures and options contracts on barley, marketplace trades futures and options contracts on barley, wheat, flaxseed, and canola.wheat, flaxseed, and canola.




OthersOthers– Exchanges are numerous, more now than ever.Exchanges are numerous, more now than ever.– U.S. exchanges have formed relationships with foreign U.S. exchanges have formed relationships with foreign

exchanges allowing for off-hour trading opportunities.exchanges allowing for off-hour trading opportunities.– Eurex US is the first fully electronic derivative exchange in Eurex US is the first fully electronic derivative exchange in

the United States.the United States.


Regulating GroupsRegulating Groups Commodity Futures Trading Commission (CFTC)Commodity Futures Trading Commission (CFTC)

– evolved in 1974.evolved in 1974.– developed regulations on futures contracts and other developed regulations on futures contracts and other

derivatives.derivatives.– has the task of regulating all derivative trading for the has the task of regulating all derivative trading for the

benefit of the public.benefit of the public. National Futures Association (NFA)National Futures Association (NFA)

– assists CFTC in the regulation of the markets.assists CFTC in the regulation of the markets.– is a self-regulatory group.is a self-regulatory group.

Canadian trading regulation is determined by each Canadian trading regulation is determined by each province and allows for the setting up of Self province and allows for the setting up of Self Regulatory Organizations under the Commodity Regulatory Organizations under the Commodity Futures Act of 1996.Futures Act of 1996.

chapter 4 markets, exchanges, and regulation

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