In 2006, My paper 4 E's that cause the Gold Prices to Rise was treated with utmost contempt.
I can now say after 2 years that though I dont consider myself as a clarivoyant atleast I now believe that Markets are after all about common sense which is pretty uncommon.
Thanks to Sangeetha Shah of Financial times for this write up.
Thursday, September 25, 2008
Sunday, September 21, 2008
Impact of sporting Events on Commodity Prices. Singapore F1 GP ?
Beijing olympics had a huge impact on prices of commodities as China had to procure
previously unheard quantities of Steel,copper, Cement etc ahead of the Beijing Olympics.
Similary Singapore ,started the Same, Last year August 2007,which saw a considerable run up in prices of commodities,My Colleague Manoj and I had the opportunity to see the construction activity of the First Night Race GP at Singapore in person way back in July and had come out with our advisory on the same, Due to Compulsions we had to keep these details in private till now, now that there is Just a week away for the Singapore f1 GP here I share my view as well as Snaps of the same,
The 5.05km long street circuit would offer a number of 'twin side' overtaking
opportunities, fast turns and technically challenging sections for F1 race drivers would definetly make this wet race hot!
More than 70 per cent of the street circuit is made up of Singapore’s existing road network. The Paddock building houses the control tower, garages for the teams, hospitality lounges, Press Room and other facilities( A beautiful view of this from the Singapore Flyer is presented above, thanks manoj for this lovely shot taken on a very ordinary SLR)
i. Construction of a 1.2 km road that will form the eastern section of the circuit
ii. A new vehicular/pedestrian underpass and service road leading to the Pit Building
iii. Widening of a stretch of the promenade between the existing outdoor seating gallery and floating platform in Marina Bay
iv. Widening a section of Raffles Boulevard from Nicoll Highway to Temasek Avenue
v. Modifications to existing road kerbs and traffic islands.
Any guess on the quantity of commodities used, the unofficial news is that the Contractors Chan & Chan Co Pte Ltd estimated almost about 77 million dollars to raw material consumption alone :) !!! (Does not include the Lighting,energy and related tertiary commodity consumption)
Definetly a race that would have delighted Senna(and his fans as well), Afterall you can be 100% sure that it is going to rain in Singapore,not to rule out Proffessor and schumi as well.
There were a section of tracks that I observed (The new 1.2 km eastern section you can view that section from the verandah of the Indian Restaurant at the singapore Flyer).This section inspite of it being new I think would be extremely bumpy hopefully it is safe one.(and not end up a tamborella!)
As of rubber burning be sure that you would go back home with that 'incense' deep in yournose adicttive and making you want more and more of that smell!!
Dont miss out this 'commodity prices sensitive' Race Next week!! !!
More Snaps at http://picasaweb.google.co.in/dindiz/F1GPTrack
Sunday, August 31, 2008
Will she save America from the Oil Crisis ?
Was really surprised when i came to know about McCains mate, Sarah Palin(pronounced Pay lin),I first read about her a few years back when i was tracking Crude oil.
I read about this alaskan pipe line (apparently her pet project) and also how prosperous Alaska would become due to high oil prices (Every citizen of Alaska was promised that they will get some 1000-1500$ of Oil Debit Cards).
She was also some kind of Miss USA or Something (Sandra Bullock Miss Congeniality types).
Will her capable administration and ability to handle sensitive Oil Policy on which she is an expert (yes yes when she becomes the president, afterall Mc Cain has had some hundreds of surgeries!!) help America out of the Oil Glut.
Friday, August 29, 2008
Will The NSE "Rentseekers" be future of the Indian Democracy ?
The NSE has successfully launched the currency futures contract.
In about a couple of decades, if What Robin Hanson predicts comes true,it would be this seemingly innocous building which is currently a rent seeker in the Indian derivatives market that would become the seat of all Political Action.
Laws and policys would not only get vetted by servers at Bandra Kurla Complex but also get official thumbs up or down?
And who would give this thumbs up or down ?Politiciants? Officials ? Voters? No SPECULATORS would !!!
Robin Hanson had coined the term Futarchy way back in 2000 however at that time we would have only laughed at that idea! Here is his argument
This short "manifesto" describes a new form of government. In "futarchy," we would vote on values, but bet on beliefs. Elected representatives would formally define and manage an after-the-fact measurement of national welfare, while market speculators would say which policies they expect to raise national welfare.
Democracy seems better than autocracy (i.e., kings and dictators), but it still has problems. There are today vast differences in wealth among nations, and we can not attribute most of these differences to either natural resources or human abilities.
Instead, much of the difference seems to be that the poor nations (many of which are democracies) are those that more often adopted dumb policies, policies which hurt most everyone in the nation. And even rich nations frequently adopt such policies.
These policies are not just dumb in retrospect; typically there were people who understood a lot about such policies and who had good reasons to disapprove of them beforehand. It seems hard to imagine such policies being adopted nearly as often if everyone knew what such "experts" knew about their consequences. Thus familiar forms of government seem to frequently fail by ignoring the advice of relevant experts (i.e., people who know relevant things).
Would some other form of government more consistently listen to relevant experts?
Even if we could identify the current experts, we could not just put them in charge. They might then do what is good for them rather than what is good for the rest of us, and soon after they came to power they would no longer be the relevant experts. Similar problems result from giving them an official advisory role.
"Futarchy" is an as yet untried form of government intended to address such problems. In futarchy, democracy would continue to say what we want, but betting markets would now say how to get it. That is, elected representatives would formally define and manage an after-the-fact measurement of national welfare, while market speculators would say which policies they expect to raise national welfare. The basic rule of government would be:
When a betting market clearly estimates that a proposed policy would increase expected national welfare, that proposal becomes law.
Futarchy is intended to be ideologically neutral; it could result in anything from an extreme socialism to an extreme minarchy, depending on what voters say they want, and on what speculators think would get it for them.
Futarchy seems promising if we accept the following three assumptions:
1)Democracies fail largely by not aggregating available information.
2)It is not that hard to tell rich happy nations from poor miserable ones.
3) Betting markets are our best known institution for aggregating information.
GDP is today the most common measure of national wealth. It seems hard for frequent travelers to escape the impression that people in high GDP nations tend to be richer and better off than those in low GDP nations. Economists thus tend to be willing to recommend policies that macroeconomic data suggest are causally related to increasing GDP. It seems that it is not that hard to, after the fact, tell rich satisfied nations from poor miserable ones. GDP may be good enough, and with the full attention of our elected representatives, we should be able to do even better, such as by including happiness, inequality, health, leisure, and environment measures.
If we can measure how rich nations are, we can use such measurements to settle bets. This is good because betting markets, and speculative markets more generally, seem to do very well at aggregating information.
To have a say in a speculative market, you have to "put your money where your mouth is." Those who know they are not relevant experts shut up, and those who do not know this eventually lose their money, and then shut up. Speculative markets in essence offer to pay anyone who sees a bias in current market prices to come and correct that bias.
Speculative market estimates are not perfect. There seems to be a long-shot bias when there are high transaction costs, and perhaps also excess volatility in long term aggregate price movements.
But such markets seem to do very well when compared to other institutions. For example, racetrack market odds improve on the predictions of racetrack experts, Florida orange juice commodity futures improve on government weather forecasts, betting markets beat opinion polls at predicting U.S. election results, and betting markets consistently beat Hewlett Packard official forecasts at predicting Hewlett Packard printer sales. In general, it is hard to find information that is not embodied in market prices.
A betting market can estimate whether a proposed policy would increase national welfare by comparing two conditional estimates: national welfare conditional on adopting the proposed policy, and national welfare conditional on not adopting the proposed policy.
Betting markets can produce conditional estimates several ways, such as via "called-off bets," i.e., bets that are called off if a condition is not met.
Whether this is just fancy write up or the prediction of the future ? Any one wanting to bet on this ?
p.s:However The Trap a three part BBC Video documentary by Adam curtis is definetly an eyeopener, and answers the question is Market economy the real panacea of all ills ?(will definetly post it in My blog)
In about a couple of decades, if What Robin Hanson predicts comes true,it would be this seemingly innocous building which is currently a rent seeker in the Indian derivatives market that would become the seat of all Political Action.
Laws and policys would not only get vetted by servers at Bandra Kurla Complex but also get official thumbs up or down?
And who would give this thumbs up or down ?Politiciants? Officials ? Voters? No SPECULATORS would !!!
Robin Hanson had coined the term Futarchy way back in 2000 however at that time we would have only laughed at that idea! Here is his argument
This short "manifesto" describes a new form of government. In "futarchy," we would vote on values, but bet on beliefs. Elected representatives would formally define and manage an after-the-fact measurement of national welfare, while market speculators would say which policies they expect to raise national welfare.
Democracy seems better than autocracy (i.e., kings and dictators), but it still has problems. There are today vast differences in wealth among nations, and we can not attribute most of these differences to either natural resources or human abilities.
Instead, much of the difference seems to be that the poor nations (many of which are democracies) are those that more often adopted dumb policies, policies which hurt most everyone in the nation. And even rich nations frequently adopt such policies.
These policies are not just dumb in retrospect; typically there were people who understood a lot about such policies and who had good reasons to disapprove of them beforehand. It seems hard to imagine such policies being adopted nearly as often if everyone knew what such "experts" knew about their consequences. Thus familiar forms of government seem to frequently fail by ignoring the advice of relevant experts (i.e., people who know relevant things).
Would some other form of government more consistently listen to relevant experts?
Even if we could identify the current experts, we could not just put them in charge. They might then do what is good for them rather than what is good for the rest of us, and soon after they came to power they would no longer be the relevant experts. Similar problems result from giving them an official advisory role.
"Futarchy" is an as yet untried form of government intended to address such problems. In futarchy, democracy would continue to say what we want, but betting markets would now say how to get it. That is, elected representatives would formally define and manage an after-the-fact measurement of national welfare, while market speculators would say which policies they expect to raise national welfare. The basic rule of government would be:
When a betting market clearly estimates that a proposed policy would increase expected national welfare, that proposal becomes law.
Futarchy is intended to be ideologically neutral; it could result in anything from an extreme socialism to an extreme minarchy, depending on what voters say they want, and on what speculators think would get it for them.
Futarchy seems promising if we accept the following three assumptions:
1)Democracies fail largely by not aggregating available information.
2)It is not that hard to tell rich happy nations from poor miserable ones.
3) Betting markets are our best known institution for aggregating information.
GDP is today the most common measure of national wealth. It seems hard for frequent travelers to escape the impression that people in high GDP nations tend to be richer and better off than those in low GDP nations. Economists thus tend to be willing to recommend policies that macroeconomic data suggest are causally related to increasing GDP. It seems that it is not that hard to, after the fact, tell rich satisfied nations from poor miserable ones. GDP may be good enough, and with the full attention of our elected representatives, we should be able to do even better, such as by including happiness, inequality, health, leisure, and environment measures.
If we can measure how rich nations are, we can use such measurements to settle bets. This is good because betting markets, and speculative markets more generally, seem to do very well at aggregating information.
To have a say in a speculative market, you have to "put your money where your mouth is." Those who know they are not relevant experts shut up, and those who do not know this eventually lose their money, and then shut up. Speculative markets in essence offer to pay anyone who sees a bias in current market prices to come and correct that bias.
Speculative market estimates are not perfect. There seems to be a long-shot bias when there are high transaction costs, and perhaps also excess volatility in long term aggregate price movements.
But such markets seem to do very well when compared to other institutions. For example, racetrack market odds improve on the predictions of racetrack experts, Florida orange juice commodity futures improve on government weather forecasts, betting markets beat opinion polls at predicting U.S. election results, and betting markets consistently beat Hewlett Packard official forecasts at predicting Hewlett Packard printer sales. In general, it is hard to find information that is not embodied in market prices.
A betting market can estimate whether a proposed policy would increase national welfare by comparing two conditional estimates: national welfare conditional on adopting the proposed policy, and national welfare conditional on not adopting the proposed policy.
Betting markets can produce conditional estimates several ways, such as via "called-off bets," i.e., bets that are called off if a condition is not met.
Whether this is just fancy write up or the prediction of the future ? Any one wanting to bet on this ?
p.s:However The Trap a three part BBC Video documentary by Adam curtis is definetly an eyeopener, and answers the question is Market economy the real panacea of all ills ?(will definetly post it in My blog)
Sunday, August 3, 2008
Commodity Futures Markets,Singer-Prebisch thesis and Jevons Paradox
The Singer-Prebisch thesis (often referred to as the Prebisch-Singer thesis or sometimes the Prebisch-Singer hypothesis) is the observation that the terms of trade between primary products and manufactured goods tend to deteriorate over time. Developed independently by economists Raul Prebisch and Hans Singer in 1950, the thesis suggests that countries that export commodities (such as most developing countries for agriculutral commodities ) would be able to import less and less manufactured goods for a given level of exports.
Singer and Prebisch examined data over a long period of time suggesting that the terms of trade for primary commodity exporters did have a tendency to decline. A common explanation for the phenomenon is the observation that the income elasticity of demand for manufactured goods is greater than that for primary products - especially food. Therefore, as incomes rise, the demand for manufactured goods increases more rapidly than demand for primary products.
Some regard the Singer-Prebisch thesis as important because it implies that it is the very structure of the market which is responsible for the existence of inequality in the world system. This provides an interesting twist on Wallerstein's neo-Marxist interpretation of the international order which faults differences in power relations between 'core' and 'periphery' states as the chief cause for economic and political inequality. As a result, the Singer-Prebisch Thesis enjoyed a high degree of popularity in the 1960s and 1970s with neo-marxist developmental Economists and provided a justification for import substitution industrializing (ISI) policies and an expansion of the role of the commodity futures exchange as a tool for development.
Properly understood, the Singer-Prebisch thesis is an observation, not a theory. Singer and Prebisch noticed a similar statistical pattern in long-run historical data on relative prices, but such regularity is consistent with a number of different explanations and policy stances. Later in his highly influential career, Prebisch argued that, due to the declining terms of trade primary producers face, developing countries should strive to diversify their economies and lessen dependence on primary commodity exports by developing their manufacturing industry. Few economists today would agree that an import-substitution stance is the correct response to declining terms of trade.
The Singer-Prebisch thesis has lost some of its relevance in the last 30 years, as exports of simple manufactures have overtaken exports of primary commodities in most developing countries outside of Africa. For this reason, much of the recent research inspired by the Singer-Prebisch thesis focuses less on the relative prices of primary products and manufactured goods, and more on the relative prices of simple manufactures produced by developing countries and complex manufactures produced by advanced economies.(CHINA AND DENGISM(my friend says dengism is a bad word in telegu!))
However I was not able to personally think about the relevance of this to Crude Oil,which made me think more,get more confused and make me further search for answers.
I finally did hit upon an answer which made my confusion permanent! (and not temprorary as usually the case).
It was the Jevons Paradox,
In economics, the Jevons Paradox (sometimes called the Jevons effect) is the proposition that technological progress that increases the efficiency with which a resource is used, tends to increase (rather than decrease) the rate of consumption of that resource. It is historically called the Jevons Paradox as it ran counter to popular intuition. However, the situation is well understood in modern economics. In addition to reducing the amount needed for a given output, improved efficiency lowers the relative cost of using a resource – which increases demand. Overall resource use increases or decreases depending on which effect predominates.
What this means is that Because we think crude oil is expensive and hence make investments in enhancing energy efficeny then contrary to popular perception, the Demand for Crude oil would INCREASE FURTHER!!!!(yeah I am right and I smoke only tobacco nothing else mixed).
One way to understand the Jevons Paradox is to observe that an increase in the efficiency with which a resource (e.g.,Fuel/ crude oil) is used causes a decrease in the price of that resource when measured in terms of what it can achieve (e.g., work). Generally speaking, a decrease in the price of a good or service will increase the quantity demanded .
Thus with a lower price for work, more work will be "purchased" (indirectly, by buying more fuel).
The resulting increase in the demand for fuel is known as the rebound effect. This increase in demand may or may not be large enough to offset the original drop in demand from the increased efficiency.
Jevons Paradox occurs when the rebound effect is greater than 100%, exceeding the original efficiency gains.
Consider a simple case: a perfectly competitive market where fuel is the sole input used, and the only determinant of the cost of work. If the price of fuel remains constant, but the efficiency of its conversion into work is doubled, the effective price of work is halved and so twice as much work can be purchased for the same amount of money. If the amount of work purchased more than doubles (i.e. demand for work is elastic, the price elasticity is larger than 1), then the quantity of fuel used would actually increase, not decrease. If however, the demand for work is inelastic, the amount of work purchased would less than double, and the quantity of fuel used would decrease.
A full analysis would also have to take into account the fact that products (work) use more than one type of input (e.g. fuel, labor, machinery), and that other factors besides input cost (e.g. a non-competitive market structure) may also affect the price of work. These factors would tend to decrease the effect of fuel efficiency on the price of work, and hence reduce the rebound effect, making Jevons Paradox less likely to occur. Additionally, any change in the demand for fuel would also have an effect on the price of fuel, and also on the effective price of work.
Bottom line let commodity analysts keep worrying about the supply and demand of crude oil,we proletarians will keep using it anyway it is all about the degree of crib at the petrol bunk as they say.
Singer and Prebisch examined data over a long period of time suggesting that the terms of trade for primary commodity exporters did have a tendency to decline. A common explanation for the phenomenon is the observation that the income elasticity of demand for manufactured goods is greater than that for primary products - especially food. Therefore, as incomes rise, the demand for manufactured goods increases more rapidly than demand for primary products.
Some regard the Singer-Prebisch thesis as important because it implies that it is the very structure of the market which is responsible for the existence of inequality in the world system. This provides an interesting twist on Wallerstein's neo-Marxist interpretation of the international order which faults differences in power relations between 'core' and 'periphery' states as the chief cause for economic and political inequality. As a result, the Singer-Prebisch Thesis enjoyed a high degree of popularity in the 1960s and 1970s with neo-marxist developmental Economists and provided a justification for import substitution industrializing (ISI) policies and an expansion of the role of the commodity futures exchange as a tool for development.
Properly understood, the Singer-Prebisch thesis is an observation, not a theory. Singer and Prebisch noticed a similar statistical pattern in long-run historical data on relative prices, but such regularity is consistent with a number of different explanations and policy stances. Later in his highly influential career, Prebisch argued that, due to the declining terms of trade primary producers face, developing countries should strive to diversify their economies and lessen dependence on primary commodity exports by developing their manufacturing industry. Few economists today would agree that an import-substitution stance is the correct response to declining terms of trade.
The Singer-Prebisch thesis has lost some of its relevance in the last 30 years, as exports of simple manufactures have overtaken exports of primary commodities in most developing countries outside of Africa. For this reason, much of the recent research inspired by the Singer-Prebisch thesis focuses less on the relative prices of primary products and manufactured goods, and more on the relative prices of simple manufactures produced by developing countries and complex manufactures produced by advanced economies.(CHINA AND DENGISM(my friend says dengism is a bad word in telegu!))
However I was not able to personally think about the relevance of this to Crude Oil,which made me think more,get more confused and make me further search for answers.
I finally did hit upon an answer which made my confusion permanent! (and not temprorary as usually the case).
It was the Jevons Paradox,
In economics, the Jevons Paradox (sometimes called the Jevons effect) is the proposition that technological progress that increases the efficiency with which a resource is used, tends to increase (rather than decrease) the rate of consumption of that resource. It is historically called the Jevons Paradox as it ran counter to popular intuition. However, the situation is well understood in modern economics. In addition to reducing the amount needed for a given output, improved efficiency lowers the relative cost of using a resource – which increases demand. Overall resource use increases or decreases depending on which effect predominates.
What this means is that Because we think crude oil is expensive and hence make investments in enhancing energy efficeny then contrary to popular perception, the Demand for Crude oil would INCREASE FURTHER!!!!(yeah I am right and I smoke only tobacco nothing else mixed).
One way to understand the Jevons Paradox is to observe that an increase in the efficiency with which a resource (e.g.,Fuel/ crude oil) is used causes a decrease in the price of that resource when measured in terms of what it can achieve (e.g., work). Generally speaking, a decrease in the price of a good or service will increase the quantity demanded .
Thus with a lower price for work, more work will be "purchased" (indirectly, by buying more fuel).
The resulting increase in the demand for fuel is known as the rebound effect. This increase in demand may or may not be large enough to offset the original drop in demand from the increased efficiency.
Jevons Paradox occurs when the rebound effect is greater than 100%, exceeding the original efficiency gains.
Consider a simple case: a perfectly competitive market where fuel is the sole input used, and the only determinant of the cost of work. If the price of fuel remains constant, but the efficiency of its conversion into work is doubled, the effective price of work is halved and so twice as much work can be purchased for the same amount of money. If the amount of work purchased more than doubles (i.e. demand for work is elastic, the price elasticity is larger than 1), then the quantity of fuel used would actually increase, not decrease. If however, the demand for work is inelastic, the amount of work purchased would less than double, and the quantity of fuel used would decrease.
A full analysis would also have to take into account the fact that products (work) use more than one type of input (e.g. fuel, labor, machinery), and that other factors besides input cost (e.g. a non-competitive market structure) may also affect the price of work. These factors would tend to decrease the effect of fuel efficiency on the price of work, and hence reduce the rebound effect, making Jevons Paradox less likely to occur. Additionally, any change in the demand for fuel would also have an effect on the price of fuel, and also on the effective price of work.
Bottom line let commodity analysts keep worrying about the supply and demand of crude oil,we proletarians will keep using it anyway it is all about the degree of crib at the petrol bunk as they say.
Saturday, August 2, 2008
Soyabean Crush
There was this very interesting question posted to me by a gentleman who had asked me a question based on one of my earlier posts on EFP.
I had an opportunity to work on a similar problem when I was in Indore,this was my answer,comments as usual welcome.
Dear Srinivasan,
The query is related to Soybeans Hedging.
The scenarios is:
Supplier "A" in Latin America wants to sell 65,000 MT of Soybean seeds. Processor "B" is into Crushing the Soybeans and selling principal by-products such as Soymeal and Soy Oil.
1. Supplier "A" is already short on CBOT with equivalent Future lots (say 475 Lots) at say 13.5 $ per bushel.
2. Procesor "B" negotiates with Supplier "A" to buy the Soybeans at say CBOT + 20 cents
3. Supplier "A" transfers these lots to Processor "B". Thereby, Supplier "A" selling the Soybeans at (13.5$ + 20 cents) per bushel.
4. Processor B, curshes the seeds and sells the Soymeal and Soy Oil at existing market prices.
5. Whenever a physical sale for the Soymeal is made, Processor buy equivalent number of Soybean lots, to close out the long positions.
My query here is to understand, how is the hedge working for the processor "B" when the underlying commodity bought is Soybean seeds, but the sale is of Soymeal and Soy Oil.
It would be of great help, if you could help me understand the above scenario.
Thank you Srinivasan.
Best regards,
Jinendra
Firstly i dont think there can be a 100% hedge,not wanting to sound pompous or philosophical in case of your question in such cases it is better that you track the BCX price rather than the soyabean price.
BCX is synthetic in nature meaning Soybean Crush prices (BCX) are synthetically generated using CBOT soybean, soybean oil and soybean meal futures prices.
The result of the soybean crush calculation is then rounded to the nearest quarter of a cent. This is not a tradable futures contract. It is intended for informational purposes only.
Soybean Crush prices (BCX) are synthetically generated using CBOT soybean, soybean oil and soybean meal futures prices. The result of the soybean crush calculation is then rounded to the nearest quarter of a cent. This is not a tradable futures contract. It is intended for informational purposes only.
The Synthetic Soybean crush is based on CBOT Soybean, Soybean Oil, and Soybean Meal futures prices; in order to calculate the crush, prices of Soybean Oil and Soybean Meal need to be converted into dollars and cents per bushel.
To convert prices:
Soybeans: No conversion required
Soybean Meal: 44 lbs. (48% protein meal) / 2,000 lbs (per ton) = 0.022 x price of meal
Soybean Oil: 11 lbs. (oil per bushel) x price of oil
To calculate the Crush:
[(Price of Soybean Meal ($/short ton) x .022) + Price of Soybean Oil (¢/lb) x 11] – Price of Soybeans ($/bu.)
For example, if August Soybean Meal, Soybean Oil and Soybean futures prices were at $297.20/ton, $.3340/pound and $9.565/bushel, respectively, the Crush would be calculated as (297.20 x .022) + (.3340 x 11) - 9.565 = $.6474/bushel.
The Synthetic Soybean crush values are rounded to the nearest $0.0025/bu and displayed in eighths, the same way as soybean futures quotes. Therefore, the sample crush value of $.6474 would be displayed as 64'6 (64 3/4).
Cheers
I had an opportunity to work on a similar problem when I was in Indore,this was my answer,comments as usual welcome.
Dear Srinivasan,
The query is related to Soybeans Hedging.
The scenarios is:
Supplier "A" in Latin America wants to sell 65,000 MT of Soybean seeds. Processor "B" is into Crushing the Soybeans and selling principal by-products such as Soymeal and Soy Oil.
1. Supplier "A" is already short on CBOT with equivalent Future lots (say 475 Lots) at say 13.5 $ per bushel.
2. Procesor "B" negotiates with Supplier "A" to buy the Soybeans at say CBOT + 20 cents
3. Supplier "A" transfers these lots to Processor "B". Thereby, Supplier "A" selling the Soybeans at (13.5$ + 20 cents) per bushel.
4. Processor B, curshes the seeds and sells the Soymeal and Soy Oil at existing market prices.
5. Whenever a physical sale for the Soymeal is made, Processor buy equivalent number of Soybean lots, to close out the long positions.
My query here is to understand, how is the hedge working for the processor "B" when the underlying commodity bought is Soybean seeds, but the sale is of Soymeal and Soy Oil.
It would be of great help, if you could help me understand the above scenario.
Thank you Srinivasan.
Best regards,
Jinendra
Firstly i dont think there can be a 100% hedge,not wanting to sound pompous or philosophical in case of your question in such cases it is better that you track the BCX price rather than the soyabean price.
BCX is synthetic in nature meaning Soybean Crush prices (BCX) are synthetically generated using CBOT soybean, soybean oil and soybean meal futures prices.
The result of the soybean crush calculation is then rounded to the nearest quarter of a cent. This is not a tradable futures contract. It is intended for informational purposes only.
Soybean Crush prices (BCX) are synthetically generated using CBOT soybean, soybean oil and soybean meal futures prices. The result of the soybean crush calculation is then rounded to the nearest quarter of a cent. This is not a tradable futures contract. It is intended for informational purposes only.
The Synthetic Soybean crush is based on CBOT Soybean, Soybean Oil, and Soybean Meal futures prices; in order to calculate the crush, prices of Soybean Oil and Soybean Meal need to be converted into dollars and cents per bushel.
To convert prices:
Soybeans: No conversion required
Soybean Meal: 44 lbs. (48% protein meal) / 2,000 lbs (per ton) = 0.022 x price of meal
Soybean Oil: 11 lbs. (oil per bushel) x price of oil
To calculate the Crush:
[(Price of Soybean Meal ($/short ton) x .022) + Price of Soybean Oil (¢/lb) x 11] – Price of Soybeans ($/bu.)
For example, if August Soybean Meal, Soybean Oil and Soybean futures prices were at $297.20/ton, $.3340/pound and $9.565/bushel, respectively, the Crush would be calculated as (297.20 x .022) + (.3340 x 11) - 9.565 = $.6474/bushel.
The Synthetic Soybean crush values are rounded to the nearest $0.0025/bu and displayed in eighths, the same way as soybean futures quotes. Therefore, the sample crush value of $.6474 would be displayed as 64'6 (64 3/4).
Cheers
Sunday, July 20, 2008
The Invisible Hand is a Falsifiable Proposition
Statistical equilibrium of commodity derivative markets is impossible, empirically-seen. Commodity Derivatives markets cannot be correctly described as stationary processes.
Adam Smith’s Invisible Hand, which is assumed by economists to be of general validity, is an assumption that markets are in or near stable equilibrium, requiring the implicit assumption of a stationary process. Consider any market anywhere in the world. With unfilled limit orders the excess demand
ε(p,t), defined by dp/dt= ε(p,t), cannot vanish.
Market stability would be represented by the state of statistical
equilibrium, or at least a stable steady state, where the price p(t)
would satisfy the condition for a stationary stochastic process.
Standard economic theory has it wrong: apparently, one cannot
have both unregulated/deregulated markets and stability
simultaneously.
One might at best have either stable equilibrium or total lack of regulations/constraints, but not both. In between lies a whole spectrum of other possibilities based on the regulation of otherwise free markets, from less to more unstable.
Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.
An Over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled . It is usually from an sophisticated broker to its clients directly. Forwards and Swaps are prime examples of such contracts. It is mostly done via the computer or the telephone.
For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement.
This segment of the OTC market is occasionally referred to as the "Fourth Market."
OTC contracts world wide are unregulated or rather self regulated.
The NYMEX which has realised the importance of this instrument and acknowledged its overvehlming dominance over standard exchange contracts has created a clearing mechanism for a slate of commonly traded OTC derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.
This is what the Alan greenspan had to say about OTC Derivatives
Testimony of Chairman Alan Greenspan
The regulation of OTC derivatives
Before the Committee on Banking and Financial Services, U.S. House of Representatives
"I am pleased to be here today to present the Federal Reserve Board's views on the regulation of over-the-counter (OTC) derivatives. Under Secretary Hawke has already addressed the specific questions raised in your letter of invitation. The Board generally agrees with the Treasury Department's views on these issues. In particular, the Board supports a standstill of attempts by the Commodity Futures Trading Commission (CFTC) to impose new regulations on OTC derivatives as a minimalist approach to our longstanding concerns about CFTC assertions of authority in this area.
In my testimony I shall step back from these issues of immediate concern and address the fundamental underlying issue, that is, whether it is appropriate to apply the Commodity Exchange Act (CEA) to over-the-counter derivatives (and, indeed, to financial derivatives generally) in order to achieve the CEA's objectives--deterring market manipulation and protecting investors.
The CEA and Its Objectives
The Commodity Exchange Act of 1936 and its predecessor the Grain Futures Act of 1922 were a response to the perceived problems of manipulation of grain markets that were particularly evident in the latter part of the nineteenth and early part of the twentieth centuries.
For example, endeavors to corner markets in wheat, while rarely successful, often led to temporary, but sharp, increases in prices that engendered very large losses to those short sellers of futures contracts who had no alternative but to buy and deliver grain under their contractual obligations. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to corner a market.
It is not possible to corner a market for financial futures where the underlying asset or its equivalent is in essentially unlimited supply. Financial derivative contracts are fundamentally different from agricultural futures owing to the nature of the underlying asset from which the derivative contract is "derived." Supplies of foreign exchange, government securities, and certain other financial instruments are being continuously replenished, and large inventories held throughout the world are immediately available to be offered in markets if traders endeavor to create an artificial shortage.
Thus, unlike commodities whose supply is limited to a particular growing season and finite carryover, the markets for financial instruments and their derivatives are deep and, as a consequence, are extremely difficult to manipulate. The type of regulation that is applied to crop futures appears wholly out of place and inappropriate for financial futures, whether traded on organized exchanges or over-the-counter, and accordingly, the Federal Reserve Board sees no need for it.
The early legislation on the trading of commodity futures was primarily designed to discourage forms of speculation that were seen as exacerbating price volatility and hurting farmers. In addition, it included provisions designed primarily to protect small investors in commodity futures, whose participation had been increasing and was viewed as beneficial.
The Commodity Futures Trading Commission Act of 1974 did not make any fundamental changes in the objectives of derivatives regulation. However, it expanded the scope of the CEA quite significantly. In addition to creating the CFTC as an independent agency and giving the CFTC exclusive jurisdiction over commodity futures and options, the 1974 Act expanded the CEA's definition of a "commodity" beyond a specific list of agricultural commodities to include "all other goods and articles, except onions,...and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in."
Given this broadened definition of a commodity and an equally broad interpretation of what constitutes a futures contract, a wide range of off-exchange transactions would have been brought potentially within the scope of the CEA.
The Treasury Department was particularly concerned about the prospect that the foreign exchange markets might be found to fall within the Act's scope. Aside from the difficulty of manipulating these markets, Treasury argued that participants in OTC markets, primarily banks and other financial institutions, and large corporations, did not need the consumer protections of the Commodity Exchange Act.
Consequently, Treasury proposed and Congress included a provision in the 1974 Act, the
"Treasury Amendment," which excluded off-exchange derivative transactions in foreign currency (as well as government securities, and certain other financial instruments) from the newly expanded CEA. What the Treasury did not envision, and the Treasury Amendment did not protect, was the subsequent development and spectacular growth of a much wider range of OTC derivative contracts--swaps on interest rates, exchange rates, and prices of commodities and securities.
Potential Application of the CEA to OTC Derivatives and the message for global watch dogs
The vast majority of privately negotiated OTC contracts are settled in cash rather than through delivery. Cash settlement typically is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply, for example, Crude oilt or the palladium price (where no price dissemeniation is availible in India as of date, however India is one of the largest importers thanks to its use in catalytic convertors in car etc, so what would chennai(the largest automotive manufacturing base in south asia do) based ancilliary units who want to hedge their price risk without losing out on valuable foreign exchange do ?.
To be sure, there are a limited number of OTC derivative contracts that apply to nonfinancial underlying assets.
There is a significant business in oil-based derivatives or precious metals, for example.
But unlike farm crops, especially near the end of a crop season, private counterparties in oil or precious metals contracts have virtually no ability to restrict the worldwide supply of this commodity. (Even OPEC has been less than successful over the years.)
Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.
To be sure, a few, albeit growing, types of OTC contracts such as equity swaps and some credit derivatives have a limited deliverable supply. However, unlike crop futures, where failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. There is no reason to believe either equity swaps or credit derivatives can influence the price of the underlying assets any more than conventional securities trading does. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty in inducing sellers in privately negotiated transactions to pay significantly higher prices to offset their contracts or to purchase the underlying assets.
Finally, the prices established in privately negotiated transactions are not widely disseminated or used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can easily recognize the risks to which they would be exposed by failing to make their own independent valuations of their transactions, whose economic and credit terms may differ in significant respects. Moreover, they usually have access to other, often more reliable or more relevant sources of information. Hence, any price distortions in particular transactions could not affect other buyers or sellers of the underlying asset.
Professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from fraud and counterparty insolvencies. They have managed credit risks quite effectively through careful evaluation of counterparties, the setting of internal credit limits, and judicious use of netting and collateral agreements. In particular, they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. This, in turn, provides substantial protection against losses from fraud.
Dealers are established institutions with substantial assets and significant investments in their reputations. When they have been seen to engage in deceptive practices, the professional counterparties that have been victimized have been able to obtain redress under laws applicable to contracts generally. Moreover, the threat of legal damage awards provides dealers with strong incentives to avoid misconduct.
A far more powerful incentive, however, is the fear of loss of the dealer's good reputation, without which it cannot compete effectively, regardless of its financial strength or financial engineering capabilities. In these respects, derivatives dealers bear no resemblance to the "bucket shops" whose activities apparently motivate the exchange trading requirement.
I do not mean to suggest that counterparties will not in the future suffer significant losses on their OTC derivatives transactions. Since 1994 the effectiveness of their risk management skills has not been tested by widespread major declines in underlying asset prices. I have no doubt derivatives losses will mushroom at the next significant downturn as will losses on holdings of other risk assets, both on and off exchange. Nonetheless, I see no reason to question the underlying stability of the OTC markets, or the overall effectiveness of private market discipline, or the prudential supervision of the derivatives activities of banks and other regulated participants. The huge increase in the volume of OTC transactions reflects the judgments of counterparties that these instruments provide extensive protection against undue asset concentration risk. They are clearly perceived to add significant value to our financial structure, both here in the United States and internationally.
Accordingly the Federal Reserve Board sees no reason why these markets should be encumbered with a regulatory structure devised for a wholly different type of market process, where supplies of underlying assets are driven by the vagaries of weather and seasons. Inappropriate regulation distorts the efficiency of our market system and as a consequence impedes growth and improvement in standards of living.
Application of the CEA to Centralized Markets for Derivatives
Recently, some participants in the OTC markets have shown interest in utilizing centralized mechanisms for clearing or executing OTC derivatives transactions. For example, the London Clearing House plans to introduce clearing of interest rate swaps and forward rate agreements in the second half of 1999, and the Electronic Broking Service, a brokerage system for foreign exchange contracts, reportedly is planning to begin brokering forward rate agreements. The latter service may not be offered in the U.S., however, because of the threat of application of the CEA.
Even some who argue that privately negotiated and bilaterally settled derivatives transactions should be excluded from the CEA, nonetheless believe that such transactions should be subject to the CEA if they are centrally executed or cleared, for fear that such facilities can foster price manipulation. Leaving aside our concern about the regulatory regime of financial futures generally, the Federal Reserve Board is particularly concerned that the vast majority of the instruments currently traded in the OTC markets not be subject to the CEA, even if they become sufficiently standardized to be centrally executed or cleared. To be sure, OTC contracts between counterparties would then have many similarities to exchange-traded contracts. But, they would still retain distinct characteristics that would leave them economically far short of standardization. For example, participants in trade execution systems may seek to retain counterparty credit limits, and participants in clearing systems likely will resist constraints on their ability to customize the economic terms of contracts. To force full standardization would reduce the economic value of a bilateral contract to both parties, and to the marketplace as a whole. The 1992 Act as we read it authorized exemption of all OTC derivatives transactions between professional counterparties from the CEA, whether or not they are centrally executed or cleared. Even with centralized execution or clearing, the most relevant attributes of these markets would not resemble those of the agricultural futures markets and hence would not be susceptible to manipulation.
Harmonizing Regulation of the OTC Markets and Futures Exchanges
Beyond question, the centralized execution and clearing of what to date have been privately negotiated and bilaterally cleared transactions would narrow the existing differences between exchange-traded and OTC derivatives transactions. However, that is not a reason to extend the CEA to cover OTC transactions. As we have argued, doing so is unnecessary to achieve the public policy objectives of the CEA. Moreover, as the economic differences between OTC and exchange-traded contracts are narrowing, it is becoming more apparent that OTC market participants share this conclusion; their decision to trade outside the regulated environment implies they do not see the benefits of the CEA as outweighing its costs.
Instead, the Federal Reserve believes that the fact that OTC markets function so effectively without the benefits of the CEA provides a strong argument for development of a less burdensome regulatory regime for financial derivatives traded on futures exchanges. To reiterate, the existing regulatory framework for futures trading was designed in the 1920s and 1930s for the trading of grain futures by the general public. Like OTC derivatives, exchange-traded financial derivatives generally are not as susceptible to manipulation and are traded predominantly by professional counterparties.
Indeed, Congress has rejected the notion of a "one-size-fits-all" approach to regulation of exchange trading. The exemptive authority that Congress gave the CFTC in 1992 permitted it to create a less restrictive regulatory regime for professional trading of financial futures. However, the pilot program proposed by the CFTC evidently has not met the competitive and business requirements of the futures exchanges--no contracts are currently trading under the program. Last year, the Agriculture Committees of the House and the Senate both attempted to craft legislation that would spur development of such a new regulatory framework but were unable to achieve consensus on the best approach. In any event, if progress toward a more appropriate regime is not forthcoming soon, Congress should seriously consider passage of legislation that would mandate progress.
Conclusion
In conclusion, the Board continues to believe that, aside from safety and soundness regulation of derivatives dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Moreover, the Board questions whether the CEA as currently implemented is an appropriate framework for professional trading of financial futures on exchanges. The key elements of the CEA were put in place in the 1920s and 1930s to regulate the trading of agricultural futures by the general public.
The vast majority of financial futures traded simply are not as susceptible to manipulation as agricultural and other commodity futures where supplies are more limited.
And participants in futures markets are predominantly professionals that simply do not require the customer protections that may be needed by the general public. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living. In choosing a particular regulatory regime it is important to remember that no system will fully eliminate inappropriate or illegal activities.
Banking examiners, for example, find it difficult to unearth fraud and embezzlement in their early stages. Securities regulators have difficulty ferreting out malfeasance. Even trading on exchanges does not in itself eliminate all endeavors at manipulation, as the Hunt brothers' 1979-80 fiasco in silver demonstrated. The primary source of regulatory effectiveness has always been private traders being knowledgeable of their counterparties. Government regulation can only act as a backup. It should be careful to create net benefits to markets.
We assumed in the paragraph above that examples of stable
markets are not likely to be found. It is necessary to pose this
assertion as a scientific challenge: Is it possible to find examples of
stability in nonfinancial markets especially commodity derivatives?
One could search for market stability by using the following method: choose any nonfinancial market with data adequate for determining the time development of the empircal price distribution (we can study the timedevelopment of the finance distribution accurately because we have accurate data over the last twelve or so years).
If the distribution is stationary or approaches stationarity asymptotically, then The Invisible Hand stabilizes the market.
With a stationary process the variance approaches a constant as initial correlations die out, equilibrium markets are not volatile.
For diffusive markets like commodity derivatives ones, in contrast, the variance is always increasing with time Δt.
The question of the existence of Adam Smith’s Invisible Hand can be removed from politics and ideology, it can be decided scientifically.
We expect that empirical evidence for stationary markets cannot be found anywhere on the globe. This provides a direct challenge to economists, who advise and direct national and international agencies on the basis of the neo-classical model of equilibria, and where stability is assumed without having been demonstrated.
P.S: as of date there is no formal definition of the word commodity derivatives as per any act of the Government of India.
Adam Smith’s Invisible Hand, which is assumed by economists to be of general validity, is an assumption that markets are in or near stable equilibrium, requiring the implicit assumption of a stationary process. Consider any market anywhere in the world. With unfilled limit orders the excess demand
ε(p,t), defined by dp/dt= ε(p,t), cannot vanish.
Market stability would be represented by the state of statistical
equilibrium, or at least a stable steady state, where the price p(t)
would satisfy the condition for a stationary stochastic process.
Standard economic theory has it wrong: apparently, one cannot
have both unregulated/deregulated markets and stability
simultaneously.
One might at best have either stable equilibrium or total lack of regulations/constraints, but not both. In between lies a whole spectrum of other possibilities based on the regulation of otherwise free markets, from less to more unstable.
Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.
An Over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled . It is usually from an sophisticated broker to its clients directly. Forwards and Swaps are prime examples of such contracts. It is mostly done via the computer or the telephone.
For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement.
This segment of the OTC market is occasionally referred to as the "Fourth Market."
OTC contracts world wide are unregulated or rather self regulated.
The NYMEX which has realised the importance of this instrument and acknowledged its overvehlming dominance over standard exchange contracts has created a clearing mechanism for a slate of commonly traded OTC derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.
This is what the Alan greenspan had to say about OTC Derivatives
Testimony of Chairman Alan Greenspan
The regulation of OTC derivatives
Before the Committee on Banking and Financial Services, U.S. House of Representatives
"I am pleased to be here today to present the Federal Reserve Board's views on the regulation of over-the-counter (OTC) derivatives. Under Secretary Hawke has already addressed the specific questions raised in your letter of invitation. The Board generally agrees with the Treasury Department's views on these issues. In particular, the Board supports a standstill of attempts by the Commodity Futures Trading Commission (CFTC) to impose new regulations on OTC derivatives as a minimalist approach to our longstanding concerns about CFTC assertions of authority in this area.
In my testimony I shall step back from these issues of immediate concern and address the fundamental underlying issue, that is, whether it is appropriate to apply the Commodity Exchange Act (CEA) to over-the-counter derivatives (and, indeed, to financial derivatives generally) in order to achieve the CEA's objectives--deterring market manipulation and protecting investors.
The CEA and Its Objectives
The Commodity Exchange Act of 1936 and its predecessor the Grain Futures Act of 1922 were a response to the perceived problems of manipulation of grain markets that were particularly evident in the latter part of the nineteenth and early part of the twentieth centuries.
For example, endeavors to corner markets in wheat, while rarely successful, often led to temporary, but sharp, increases in prices that engendered very large losses to those short sellers of futures contracts who had no alternative but to buy and deliver grain under their contractual obligations. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to corner a market.
It is not possible to corner a market for financial futures where the underlying asset or its equivalent is in essentially unlimited supply. Financial derivative contracts are fundamentally different from agricultural futures owing to the nature of the underlying asset from which the derivative contract is "derived." Supplies of foreign exchange, government securities, and certain other financial instruments are being continuously replenished, and large inventories held throughout the world are immediately available to be offered in markets if traders endeavor to create an artificial shortage.
Thus, unlike commodities whose supply is limited to a particular growing season and finite carryover, the markets for financial instruments and their derivatives are deep and, as a consequence, are extremely difficult to manipulate. The type of regulation that is applied to crop futures appears wholly out of place and inappropriate for financial futures, whether traded on organized exchanges or over-the-counter, and accordingly, the Federal Reserve Board sees no need for it.
The early legislation on the trading of commodity futures was primarily designed to discourage forms of speculation that were seen as exacerbating price volatility and hurting farmers. In addition, it included provisions designed primarily to protect small investors in commodity futures, whose participation had been increasing and was viewed as beneficial.
The Commodity Futures Trading Commission Act of 1974 did not make any fundamental changes in the objectives of derivatives regulation. However, it expanded the scope of the CEA quite significantly. In addition to creating the CFTC as an independent agency and giving the CFTC exclusive jurisdiction over commodity futures and options, the 1974 Act expanded the CEA's definition of a "commodity" beyond a specific list of agricultural commodities to include "all other goods and articles, except onions,...and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in."
Given this broadened definition of a commodity and an equally broad interpretation of what constitutes a futures contract, a wide range of off-exchange transactions would have been brought potentially within the scope of the CEA.
The Treasury Department was particularly concerned about the prospect that the foreign exchange markets might be found to fall within the Act's scope. Aside from the difficulty of manipulating these markets, Treasury argued that participants in OTC markets, primarily banks and other financial institutions, and large corporations, did not need the consumer protections of the Commodity Exchange Act.
Consequently, Treasury proposed and Congress included a provision in the 1974 Act, the
"Treasury Amendment," which excluded off-exchange derivative transactions in foreign currency (as well as government securities, and certain other financial instruments) from the newly expanded CEA. What the Treasury did not envision, and the Treasury Amendment did not protect, was the subsequent development and spectacular growth of a much wider range of OTC derivative contracts--swaps on interest rates, exchange rates, and prices of commodities and securities.
Potential Application of the CEA to OTC Derivatives and the message for global watch dogs
The vast majority of privately negotiated OTC contracts are settled in cash rather than through delivery. Cash settlement typically is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply, for example, Crude oilt or the palladium price (where no price dissemeniation is availible in India as of date, however India is one of the largest importers thanks to its use in catalytic convertors in car etc, so what would chennai(the largest automotive manufacturing base in south asia do) based ancilliary units who want to hedge their price risk without losing out on valuable foreign exchange do ?.
To be sure, there are a limited number of OTC derivative contracts that apply to nonfinancial underlying assets.
There is a significant business in oil-based derivatives or precious metals, for example.
But unlike farm crops, especially near the end of a crop season, private counterparties in oil or precious metals contracts have virtually no ability to restrict the worldwide supply of this commodity. (Even OPEC has been less than successful over the years.)
Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.
To be sure, a few, albeit growing, types of OTC contracts such as equity swaps and some credit derivatives have a limited deliverable supply. However, unlike crop futures, where failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. There is no reason to believe either equity swaps or credit derivatives can influence the price of the underlying assets any more than conventional securities trading does. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty in inducing sellers in privately negotiated transactions to pay significantly higher prices to offset their contracts or to purchase the underlying assets.
Finally, the prices established in privately negotiated transactions are not widely disseminated or used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can easily recognize the risks to which they would be exposed by failing to make their own independent valuations of their transactions, whose economic and credit terms may differ in significant respects. Moreover, they usually have access to other, often more reliable or more relevant sources of information. Hence, any price distortions in particular transactions could not affect other buyers or sellers of the underlying asset.
Professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from fraud and counterparty insolvencies. They have managed credit risks quite effectively through careful evaluation of counterparties, the setting of internal credit limits, and judicious use of netting and collateral agreements. In particular, they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. This, in turn, provides substantial protection against losses from fraud.
Dealers are established institutions with substantial assets and significant investments in their reputations. When they have been seen to engage in deceptive practices, the professional counterparties that have been victimized have been able to obtain redress under laws applicable to contracts generally. Moreover, the threat of legal damage awards provides dealers with strong incentives to avoid misconduct.
A far more powerful incentive, however, is the fear of loss of the dealer's good reputation, without which it cannot compete effectively, regardless of its financial strength or financial engineering capabilities. In these respects, derivatives dealers bear no resemblance to the "bucket shops" whose activities apparently motivate the exchange trading requirement.
I do not mean to suggest that counterparties will not in the future suffer significant losses on their OTC derivatives transactions. Since 1994 the effectiveness of their risk management skills has not been tested by widespread major declines in underlying asset prices. I have no doubt derivatives losses will mushroom at the next significant downturn as will losses on holdings of other risk assets, both on and off exchange. Nonetheless, I see no reason to question the underlying stability of the OTC markets, or the overall effectiveness of private market discipline, or the prudential supervision of the derivatives activities of banks and other regulated participants. The huge increase in the volume of OTC transactions reflects the judgments of counterparties that these instruments provide extensive protection against undue asset concentration risk. They are clearly perceived to add significant value to our financial structure, both here in the United States and internationally.
Accordingly the Federal Reserve Board sees no reason why these markets should be encumbered with a regulatory structure devised for a wholly different type of market process, where supplies of underlying assets are driven by the vagaries of weather and seasons. Inappropriate regulation distorts the efficiency of our market system and as a consequence impedes growth and improvement in standards of living.
Application of the CEA to Centralized Markets for Derivatives
Recently, some participants in the OTC markets have shown interest in utilizing centralized mechanisms for clearing or executing OTC derivatives transactions. For example, the London Clearing House plans to introduce clearing of interest rate swaps and forward rate agreements in the second half of 1999, and the Electronic Broking Service, a brokerage system for foreign exchange contracts, reportedly is planning to begin brokering forward rate agreements. The latter service may not be offered in the U.S., however, because of the threat of application of the CEA.
Even some who argue that privately negotiated and bilaterally settled derivatives transactions should be excluded from the CEA, nonetheless believe that such transactions should be subject to the CEA if they are centrally executed or cleared, for fear that such facilities can foster price manipulation. Leaving aside our concern about the regulatory regime of financial futures generally, the Federal Reserve Board is particularly concerned that the vast majority of the instruments currently traded in the OTC markets not be subject to the CEA, even if they become sufficiently standardized to be centrally executed or cleared. To be sure, OTC contracts between counterparties would then have many similarities to exchange-traded contracts. But, they would still retain distinct characteristics that would leave them economically far short of standardization. For example, participants in trade execution systems may seek to retain counterparty credit limits, and participants in clearing systems likely will resist constraints on their ability to customize the economic terms of contracts. To force full standardization would reduce the economic value of a bilateral contract to both parties, and to the marketplace as a whole. The 1992 Act as we read it authorized exemption of all OTC derivatives transactions between professional counterparties from the CEA, whether or not they are centrally executed or cleared. Even with centralized execution or clearing, the most relevant attributes of these markets would not resemble those of the agricultural futures markets and hence would not be susceptible to manipulation.
Harmonizing Regulation of the OTC Markets and Futures Exchanges
Beyond question, the centralized execution and clearing of what to date have been privately negotiated and bilaterally cleared transactions would narrow the existing differences between exchange-traded and OTC derivatives transactions. However, that is not a reason to extend the CEA to cover OTC transactions. As we have argued, doing so is unnecessary to achieve the public policy objectives of the CEA. Moreover, as the economic differences between OTC and exchange-traded contracts are narrowing, it is becoming more apparent that OTC market participants share this conclusion; their decision to trade outside the regulated environment implies they do not see the benefits of the CEA as outweighing its costs.
Instead, the Federal Reserve believes that the fact that OTC markets function so effectively without the benefits of the CEA provides a strong argument for development of a less burdensome regulatory regime for financial derivatives traded on futures exchanges. To reiterate, the existing regulatory framework for futures trading was designed in the 1920s and 1930s for the trading of grain futures by the general public. Like OTC derivatives, exchange-traded financial derivatives generally are not as susceptible to manipulation and are traded predominantly by professional counterparties.
Indeed, Congress has rejected the notion of a "one-size-fits-all" approach to regulation of exchange trading. The exemptive authority that Congress gave the CFTC in 1992 permitted it to create a less restrictive regulatory regime for professional trading of financial futures. However, the pilot program proposed by the CFTC evidently has not met the competitive and business requirements of the futures exchanges--no contracts are currently trading under the program. Last year, the Agriculture Committees of the House and the Senate both attempted to craft legislation that would spur development of such a new regulatory framework but were unable to achieve consensus on the best approach. In any event, if progress toward a more appropriate regime is not forthcoming soon, Congress should seriously consider passage of legislation that would mandate progress.
Conclusion
In conclusion, the Board continues to believe that, aside from safety and soundness regulation of derivatives dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Moreover, the Board questions whether the CEA as currently implemented is an appropriate framework for professional trading of financial futures on exchanges. The key elements of the CEA were put in place in the 1920s and 1930s to regulate the trading of agricultural futures by the general public.
The vast majority of financial futures traded simply are not as susceptible to manipulation as agricultural and other commodity futures where supplies are more limited.
And participants in futures markets are predominantly professionals that simply do not require the customer protections that may be needed by the general public. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living. In choosing a particular regulatory regime it is important to remember that no system will fully eliminate inappropriate or illegal activities.
Banking examiners, for example, find it difficult to unearth fraud and embezzlement in their early stages. Securities regulators have difficulty ferreting out malfeasance. Even trading on exchanges does not in itself eliminate all endeavors at manipulation, as the Hunt brothers' 1979-80 fiasco in silver demonstrated. The primary source of regulatory effectiveness has always been private traders being knowledgeable of their counterparties. Government regulation can only act as a backup. It should be careful to create net benefits to markets.
We assumed in the paragraph above that examples of stable
markets are not likely to be found. It is necessary to pose this
assertion as a scientific challenge: Is it possible to find examples of
stability in nonfinancial markets especially commodity derivatives?
One could search for market stability by using the following method: choose any nonfinancial market with data adequate for determining the time development of the empircal price distribution (we can study the timedevelopment of the finance distribution accurately because we have accurate data over the last twelve or so years).
If the distribution is stationary or approaches stationarity asymptotically, then The Invisible Hand stabilizes the market.
With a stationary process the variance approaches a constant as initial correlations die out, equilibrium markets are not volatile.
For diffusive markets like commodity derivatives ones, in contrast, the variance is always increasing with time Δt.
The question of the existence of Adam Smith’s Invisible Hand can be removed from politics and ideology, it can be decided scientifically.
We expect that empirical evidence for stationary markets cannot be found anywhere on the globe. This provides a direct challenge to economists, who advise and direct national and international agencies on the basis of the neo-classical model of equilibria, and where stability is assumed without having been demonstrated.
P.S: as of date there is no formal definition of the word commodity derivatives as per any act of the Government of India.
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