What’s in Your Future(s)? The Merger of the Chicago Exchanges

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Most people have little trouble ticking off the names of the big stock exchanges in New York, London and the major cities of Europe and Asia. But if regulators say “yes,” two less familiar exchanges in Chicago will combine to become the world’s largest.


In mid-October, the Chicago Board of Trade agreed to be purchased by the Chicago Mercantile Exchange for about $8 billion, topping a wave of exchange mergers in the U.S. and Europe. Two factors drove the deal, according to Wharton professors: the enormous growth in the use of futures, options and other derivatives to hedge risks and speculate, and the need for economies of scale to compete with exchanges that have grown through mergers.


Indeed, the business of executing investors’ buy and sell orders is changing rapidly, as markets go global and harness lightning-fast computers and communication technology. On Oct. 31, the 214-year-old New York Stock Exchange announced plans to close 20% of its storied trading floor, where men and women haggle face-to-face to get the best stock prices for their customers. The NYSE, following other exchanges around the world, is executing more and more trades with automatic, computerized systems.


As for the CBOT-CME merger, “The move is a bit surprising, given the longstanding rivalry between two hometown players,” suggests Wharton finance professor Richard J. Herring. “I would say they were brought together by their mutual concern about all the consolidation elsewhere that could leave them in a less strong position.” European exchanges are lusting after the mushrooming derivatives business, as is the New York Stock Exchange, he adds.


Wharton finance professor Marshall E. Blume agrees. “There’s a movement toward consolidation. One of the main reasons for that is Regulation NMS, which will result in substantial expenditures in technology across the board,” he notes, referring to an April 2005 regulation by the Securities and Exchange Commission requiring more efficient links between stock exchanges. NMS, which refers to “national market system,” is directed at stock exchanges but also affects derivatives exchanges because of the close links between derivatives prices and stock prices. “If you consolidate two big [Chicago exchanges], the transmission of information and the maintenance of order priority is much easier to do.”


“The other thing that is happening,” Blume adds, “is a blurring of distinctions between different types of investments.” Exchanges that have specialized in derivatives want to also trade stocks, while stock markets want to trade derivatives.


An investor who wants a diversified stock portfolio, for example, no longer has to buy a broad assortment of individual stocks; he or she can buy shares in a Standard & Poor’s 500 index fund. Or he can invest in an exchange-traded fund owning those stocks. Or he can buy an S&P 500 futures contract obligating him and his counter-party to trade at a set price on a future date. Or he can buy “call” or “put” options giving him the right, but not the obligation, tobuy or sell S&P 500 stocks at a set price in the future.


Big traders often prefer to bet on stocks through derivatives, instead of actual shares of stock, because buying or selling huge blocks of stock can drive prices up or down. That’s less likely if the bet is placed through derivatives. Derivatives are therefore big business. Together, the two Chicago exchanges will have a market value of about $26 billion and will trade about nine million futures contracts a day with a value of about $4 trillion.


The Smile of the Cheshire Cat


For companies looking for ways to manage risks, and for speculators eager to bet on them, Chicago is the place to go. When they were founded in the 19th century, the exchanges specialized in commodities like corn. By purchasing a corn futures contract, a producer could insure his right to sell his crop at a set price on a future date, eliminating the risk of a price drop at harvest time.


Today, commodities futures represent only a small part of the exchanges’ business. The most heavily traded contracts on the CME involve interest rates, stocks and currencies, while the CBOT does an enormous business in derivatives linked to Treasury bonds.


All derivatives get, or derive, their values from the price moves of underlying securities or instruments. A stock futures contract, for example, is an agreement for one party to sell a block of certain stock shares to a buyer at a set price on a given date. If the stock price moves above that level, the contract will become more valuable because its owner could buy stock at the low market price and immediately sell it for the higher price specified in the contract.


With a derivative, a trader can profit from a price change without tying money up in the underling instrument, says David K. Musto, finance professor at Wharton. “Futures are like the smile of the Cheshire Cat,” he adds, citing an oft-quoted maxim in the industry. Futures contracts are available for a mind-numbing variety of underlying instruments: currency exchange rates, individual stocks and stock indexes, interest rates, home mortgages, creditworthiness, commodities such as oil, corn, and beef, and so forth.


“I think it’s gotten to the point now where almost every company of a decent size is using some derivatives to hedge risk,” says Wayne R. Guay, accounting professor at Wharton. For the relatively small price of a derivatives contract, a manufacturer can shed the currency risk or interest-rate risk it faces and focus on its bigger worries. “For the typical firm that’s out there actually producing a product, most of the risks that keep them up at night are not interest rates or exchange rates. If I’m a software company, my main risk is that some other company is going to come up with better software.”


While some types of derivatives have been around for centuries, they have taken off in the past 15 years because of the intellectual breakthrough of the Black-Scholes options pricing model, which showed how they can be accurately priced, says Herring.


In addition, he notes, computers and communications have advanced enough that derivatives users can obtain and quickly analyze the vast amounts of data needed to spot price discrepancies. A hedge fund, for example, might find opportunities in price movements of a company’s stock relative to its bonds. “All these things can be put into a model in formula form, and it can be set up to monitor prices so that you can spot a discrepancy and collect what should be a relatively safe profit relatively quickly.”


In this decade, the exchanges have benefited from a trend toward standardized exchange-traded contracts after the collapse of Houston energy-trading giant Enron chilled enthusiasm for private deals.


Higher Fees?


The CME will close its trading floor as part of the deal, saving $125 million a year and making it the latest exchange to shut down the old-fashioned system with men and women shouting offers to buy and sellin favor of more efficient electronic systems. Several years ago the two exchanges combined their “clearing” operations — the back-office work that assures each party to a contract fulfills its side of the deal.


Savings of this type could result in lower trading fees that would benefit institutions and individuals who use derivatives, Herring says. But that’s not certain. While stocks are traded on multiple exchanges, enhancing competition, regulations give the CME and CBOT exclusive rights to their contracts. Those exchanges have raised many fees in recent years, and market power from the merger could enable them to push fees higher, he suggests.


Derivatives have been linked to market scares several times since the early 1990s, in high-profile cases such as the bankruptcy of Orange County, Calif., and the collapse of Long-term Capital Management hedge fund. But derivatives are fairly well understood today and there’s not much concern they are causing risk to be concentrated in ways that could cause crises in the broader markets, according to Musto. “You really are not changing the aggregate risk in the economy all that much,” adds Guay. “What you’re doing is redistributing it.”


Still, Musto notes that going through a trouble-free period can make the markets overconfident. Widespread use of some derivatives, such as credit-default swaps which rise and fall with an underlying company’s creditworthiness, is fairly recent. “There are types of derivatives, like credit default swaps, that have not been stress-tested very much…. Any sort of legal contract needs to go through a period of testing to see who really bears the risk.”

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